The Invisible Hands

Hedge funds Off the Record – Rethinking Real Money

Book by Steven Drobny

Article and Review by GlobalMacroForex

This book is a must-read for anyone interested in Global Macro.  Author Steven Drobny does an amazing job of interviewing Global Macro hedge fund managers “off the record” (meaning the managers are anonymous).  The theme throughout the book is advice to ‘real money’ managers, which is defined as long-only non-leveraged institutional investors in things such as public and private pension funds, university endowments, insurance company portfolios, foundations, family offices, sovereign wealth funds, and mutual funds.  Since these interviews take place after the 2007-2008 financial crash, it offers a unique twist to the classic investing theme.

“The massive growth of real money funds took place in a very benign environment where inflation was falling and virtually all assets performed well.  In such conditions, static rule-based strategies such as buy and hold stocks for the long run, and the Endowment Model worked.  But in a new, less benign world of higher volatility, a change in standard practice is required.”

While the theme of the book is what should be done about ‘real money’ investors, the book is mainly themed to benefit an up-and-coming Global Macro manager. We will cover only a portion of the interviews and only small parts within in each interview from the vast amount of knowledge presented.  I highly recommend this book!

The Family Office Manager

The first fund manager interviewed (aka Family Office Manager) emphased that cash isn’t trash because it offers great opportunities when situations arise.  For example in 2008, Ghanaian Eurobonds traded at 59 cents on the dollar, but there no reason to believe in nonpayment.  Family Office Manager bought them leading to a 72 percent return over 10 months.

Family Office Manager criticizes the Endowment model, inspired by David Swenson for giving up liquidity for return, believing a leveraged portfolio will be blown up quickly if leverage is defined as borrowing more to do the same thing.  The key principle that must be employed is that the added leverage has to be actually doing something that will respond differently to market conditions or drawdowns.  If an investor is already long a bunch of US equities, going long different US equities won’t change the risk.  Family Office Manager gives the example of a 100% equity long portfolio that then has leverage added to go long government fixed income.  From back testing results from 1992 to 2009, he found that adding 100% leverage to buy US Treasuries increased annual yield by almost 5 percent while reducing the worst drawdown by 10%.

 “Diversification only works when you have assets that are valued differently when some things are cheap and other things are expensive.  If everything is expensive, everything will go down, so it doesn’t really matter if you own different things for diversification’s sake.”

Family Office Manager points out how government fixed income is the only thing that reliably goes up when everything else is plummeting in price.  As far as valuations of the overall market, he uses Tobin’s Q or a Cyclically adjusted P/E to capture the bubbles.  However, he points out some problems with the assumption that diversification will lead to capital preservation.  By pointing to the historical evidence Family Office Manager asks,

“Why do we not have very wealthy Roman families who have compounded their capital over millennia?”

The “House”

The second anonymous fund manager interviewed is House, who tilts the odds in his favor like the casino owner, not the gambler.  House points out the need to have some assets in cash and in being flexible with liquidity exactly for situations like 2007/08.

“If you have flexibility in turbulent markets, the market will pay you for that flexibility.”

House gives the example of how, during 2008, there were cheap long-dated vega positions which originally had been held by leveraged players, and now there were no natural buyers.  By stepping into these misvalued markets while others suffered liquidity problems, House was able to capture alpha from his flexibility.  Also, he stresses finding trades with an asymmetric risk-reward payoff.  One example was in credit spreads.

“If fixed income volatility went to zero forever, which is a rather stupid assumption, the maximum loss was bearable while the upside was fairly large.”

This section of the book discusses the ‘Paradox of Perfection,’ which referred to central banks lowering the risk premium enough to spark a credit bubble.   The more central banks try to stabilize markets, the less stable they become.

The Philosopher

This hedge fund trader (aka the Philosopher) started as a money markets prop trader at a bank, which taught him the inner workings of the plumbing that underpins the global financial system.  Yet despite his expertise knowledge in the financial plumbing, the Philosopher questions people who come up with market explanations so quickly.  He points out when he was a prop trader at the bank, his colleagues would come up with explanations for a price movement in currencies too quickly, while he wasn’t sure that there was a definitive answer.

“Most market explanations are really rationalizations, making up simple stories to explain complex situations.  But markets are not that simple”

The Philosopher instead says the biggest question that people should be asking is, “What type of market are we in?”  If the Philosopher can identify that he can custom tailor his (or her) specific strategy and outlook to those conditions.  The Philosopher points out how the drivers of the market are constantly changing and he had to adapt.  Instead of forming some grand “vision” where he knew the exact direction and levels of prices, he instead formed a probabilistic set of hypotheses about how the world could look and what might drive markets going forward.  In this sense, it’s like taking a poll of market sentiment, but rather than physically asking people, the Philosopher  looked at prices and valuations, predicting sentiment more than outcomes.

“While most pundits and many market participants try to decide which potential outcome will be the right one, I am much more interested in finding out where the market is mispricing the skew of probabilities.  If the market is pricing that inflation will go to the moon, then I will start talking about unemployment rates, wages going down, and how we are going to have disinflation.  If you tell me the markets are pricing deflation forever, I will start talking about the quantity theory of money, explaining how this skews outcomes the other way.  … People tell stories to rationalize historical price action more frequently than they use potential future hypotheses to work out where prices could be.”

Bond Trader – Prop Desk

A trader looks at computer screens on the trading floor of Bankinter bank during a Spanish bond auction in Madrid September 20, 2012. REUTERS/Susana Vera

The Bond Trader works at a major bank’s prop desk.  He not only trades himself but oversees a large staff and allocates risk among them.  Immediately he points out that there’s no quick shortcuts and single guru analyst you can listen to.  There’s no substitute for hard work.

“The key is solving the puzzle, forming you own economic view of the world and comparing that view with what is already priced into markets.  There are no shortcuts.  You have to do the work yourself”

The Bond Trader points out how what is driving a particular cycle will change, and the investor has to adapt to the market’s changing underlying drivers.

“You cannot use the same economic data as your leading indicator, year in and year out.  It depends on what is going on in the world at the time.  Things change, and you have to change with them.”

He says lacking proper risk control is the most common reason for prop traders failing.

The Professor

This Macro trader (aka the Professor) focuses primarily on what the worst case scenario or drawdown would be.  He calls it the Armageddon or Titanic scenario.  Then he looks to trade profitable risk vs. reward situations where it’s not going to lead to a total wipeout should the Titanic situation come up.

“We look for situations where asset prices do not correctly reflect macro fundamentals or do not identify and anticipate structural shifts in the economy”

The Professor points out how outside of G7, markets are more inefficient so there are more opportunities.  He points out how noneconomic actors dwarf the market participants (such as a government buyer) and how this can distort the picture.  In addition, the Professor points out the benefits from boots-on-the-ground research.  One example of this is that the Professor went into Turkey right before the IMF was going to make a decision on whether or not the IMF would give an economic aid package to Turkey.  If they had met the package requirements, then Turkey’s equities would rise significantly.  He concluded from his own research in person they would meet these requirements and made a killing.

The Professor also tells us the necessity of reading history for contextualizing events.  He uses the example of the current situation of the US being in a trade deficit with China.  He speculates that because the US is a military superpower, the debt may not actually be paid in full.  The Professor puts this in context by comparing today’s situation to the period in the mid-1800s when the British Empire was the world’s military superpower and ran a very large balance of payments with China during the opium trade.  He points out how rather than pay its debt, the British ultimately resorted to military action.

The Commodity Trader

The Commodity Trader focuses on the long end of the futures curve because he sees spot prices as harder to predict.  He tries to reduce the short-term noise that in the long run isn’t as important.

“Emotionally living and breathing every move in the markets can be a distraction from my main job, which is one of hard analysis and trying to figure out where markets are heading over an extended period of time.  It is a marathon, not a 100-meter race.”

The Commodity Trader points out how commodities are different than other types of markets because the commodity price curves are often negative yielding and experience violent, whipsaw reactions more regularly than other markets.  That’s why he avoids the front end of the price curve because of these hidden risks.  When the curve switches from steep backwardation to a big contango, it can have huge drawdowns, just off the smallest change in supply.

The Commodity Trader criticizes traders who have a book with a lot of positions but say they are only really passionate or have a lot of conviction in a few of them.  Never add positions just for the sake of it.  But on the opposite end of the spectrum, the Commodity Trader criticizes oversizing and points out that this is what kills most traders;  they get too excited about an idea and overleverage on it.  one has to have patience and risk management.  The good ideas take time to play out.

The Commodity Investor

The Commodity Investor talks about the need to integrate both the macro and micro views.  He gives an example of many investors being bull corn for ethanol production, which is a longer-term macro view.  However, the short-term micro reality in this example was there was a bumper corn crop recently that crushed the corn price.  So he stresses the importance of both aspects of trade aligning. 

In regards to 2008, he stressed the importance of taking things into perspective.

“Market participants extrapolated an Armageddon scenario indefinitely.  Fear blinds market participants to the self-correcting mechanisms at the extremes.”

The Commodity Investor points out how correlations among asset classes tend to increase during risk-off periods.  If the macro matrix is showing a lot of cross-correlation, then there is likely going to be increased volatility ahead.  The investor wants to reduce exposure, not just add hedges.  This is because the hedges are adding overall exposure if everything is increasing correlation.

Commodity Hedger

he Commodity Hedger does traditional macro plays but keeps a commodity mindset filter on at all times.  For example, she saw the commodity futures curves switch from backwardation to contango in 2005 and knew this would mean an inverted US Treasury yield curve.  That would normally be a bond trader’s move, but she does it with a commodity mindset.

“Most of the time identifying a good trade comes from something else people might miss or may even consider insignificant.  Everything quantitative, everything related to economics, everything numerical that can be number-crunched and is widely available is all in the rear-view mirror.  The key is finding a piece of information that people are missing that is relevant for the future.”

The Commodity Hedger gives us an example of seeing first hand in Hong Kong the remittances of people to the Philippines.

She noticed the market was very bear the Philippine peso but yet the Phillippines had higher interest rates than the inflation they were likely to get.  So she went long the peso and made a killing.

Even if the trade is making money but the underlying hypothesis for the trade hasn’t materialized, she gets out.

“Making money for the wrong reasons means you are rolling the dice, not trading.  We are not here to gamble.  Trades have to be making money for the reasons that we have identified and have the proper risk versus reward.”

The Commodity Hedger uses risk collars to mitigate negative risk, which proved useful in 2007.  She thinks 2007 was all about liquidity.  She points out when liquidity should be valued most.

 “The need for liquidity is often inversely related to valuation.  Valuations are so low now that you can buy and hold certain illiquid instruments if you have both the cash and long enough horizon.”

The Commodity Hedger evaluates illiquid investments based on how crowded the trade is.  If it’s crowded and everyone is talking about it, it’s going to be harder to get out when it turns the other way.

The Predator

The Predator enjoys the competitive nature of markets and tries to know all the other market participants very well.  While he’s sized up others, he finds that others will have a hard time understanding him.  That’s because his strategy and method are constantly changing and evolving over time.  The Predator tells us his timeline for 2008; he first reduced risk-on equities, transitioned to cash, and reduced leverage.  Then he shorted the S&P500 and went long corporate bonds.  Finally he switched to a long S&P500 fund, thinking he will switch into a dividend yield fund.  By adapting to the market, the Predator picks the strategy that will do the best at each turning point in a crisis.

The Predator mentions how some people say you can’t time markets, such as David Swanson or finance professors.  The Predator says that might be true at the exact moment that you say that, but opportunities arise and through consistent valuation checking, he can identify when those opportunities do arise.

In addition to timing the markets, there is value in living through past crisis.  For example from the LTCM and Russian crisis, the Predator learned prime brokers pull leverage in a liquidity crisis.  Therefore, he learned to scale down leverage in 2007.

Conclusion

This book offers a great perspective on a variety of different Global Macro strategies.  My brief summary only took a few of the points from each interview, and I did not write summaries for nearly half the interviews including those of some of the macro traders, equity traders, and pension managers.  I highly recommend you purchase this book to get all the details of these great strategies and hear the advice from the fund managers themselves.