Seeking to Diversify Systematic Risk with Global Macro
March 21, 2022 | Nic Millikan & Nicholas Reade | CAIS
Last week, the U.S. Federal Reserve (Fed) took the broadly expected step of raising interest rates for the first time since 2018 to attempt to rein in rampant inflation. The 25-basis point (bps) hike, while small, is significant as it marks a potential shift to a tightening regime that may set us on the path towards a more normalized approach to monetary policy. At the same time, we have seen a resurgence of COVID-19 cases in Asia that threatens to disrupt already fragile supply chains, Russia’s continued incursion of the Ukraine continues to threaten and destabilize both the geopolitical and global economic landscape. Taken together, these events have impacted markets from a macro perspective, potentially ushering a forward return environment that may be driven more by macroeconomic factors than it has been in recent history. Against such an economic backdrop, global macro hedge funds may provide a diversification benefit to offset volatility and the lasting impacts of global uncertainty.
Revisiting Global Macro
Before we dive into the potential diversification benefits of global macro hedge funds, it is worth revisiting what they are. A global macro hedge fund is generally defined as a strategy that seeks to take directionally long or short exposures to different macroeconomic and geopolitical factors, including but not limited to, interest and foreign exchange rates, political events and international relations, essentially focusing on the systematic risk of markets.[1] They can employ discretionary or systematic styles, and may utilize fundamental or technical inputs to alpha generation from the exposure to different risk premia, or betas.[2] Given global macro’s historical ability to deliver positive absolute returns in prior crises, such as the credit crisis, tech bubble burst and pandemic sell-off[3], many investors seek exposure to global macro as a way to diversify equity market risks.[4] Given the confluence of macroeconomic and geopolitical risks impacting equity markets, we are again seeing renewed interest in macro hedge funds by advisors.
Seeking to Diversify Equity Market Risk with Global Macro
Effective diversifiers are investments that when added to a portfolio, either increase the expected return per unit of risk, or reduce a portfolio’s overall risk, leaving expected return unchanged.[5] The historical performance of global macro hedge funds highlights how this strategy can potentially do both.
First, looking at historical correlations of global macro hedge funds relative to the 60/40 stock/bond portfolio over the last 30 years, we can see that in periods of crises, correlations have declined and moved toward zero. This divergence in performance indicates the diversification benefit of global macro strategies. In some instances, correlation has not only declined, but it has turned negative, allowing global macro hedge funds to potentially add to a portfolio’s overall return while value of the 60/40 stock/bond portfolios would decline.
