Spring, 2012

Measuring Global Macro Managers:

Why the Long-Short Report Card Does Not Work
Working Paper

Global Macro is a uniquely important element in alternative strategies

Investors increasingly value the benefits of alternative strategies Top-down analysis and portfolio liquidity are unique Global Macro benefits Global Macro should be considered a core strategy

The process of identifying a macro manager differs from other strategies

Standard performance attribution metrics are incomplete Manager universes are intrinsically impaired by survivorship bias Macro return analysis for short periods is potentially meaningless

The Drivers of Decision Making (DDM) Approach provides a better framework for diligence and monitoring
DDM penetrates manager investment process DDM establishes the importance of ex-ante risk management

Gravelle Pierre, CFA gpierre@iharborcap.com Chris Nicholson, CFA cnicholson@iharborcap.com Jacqueline Hayot jhayot@iharborcap.com www.iharborcap.com

2012 Iron Harbor Capital Management. All rights reserved.

Global Macro: Understanding the Essentials

In these unsteady markets, data shows that investors increasingly value the benefits of alternative strategies in their portfolios.1 It is now broadly accepted among investors that such strategies can reduce both total portfolio volatility and drawdown risk while earning an attractive and reasonably consistent return. The broadest and most difficult to categorize of investment ideas via highly liquid financial instruments such as indices and futures in equity, quickly. fixed-income, and commodities markets, which can be converted to cash This liquidity permits investors to retain greater access to capital in times of stress, which has been highlighted as a recent point of failure of many other alternative-

the alternative strategies is global macro.

Global macro is a particularly important stand-out in the alternatives universe due to unique benefits that are not available with other alternative strategies. Alternative strategies, in the broadest sense, are generally attractive to investors for their ability to

investment strategies.

global macro could be considered a core strategy

Another unique hallmark of global macro is the top-down analytical approach. This can be of

generate returns that have low systematic risk;

or rather, low correlations to traditional asset classes such as equities and bonds. By reducing systematic risk, an allocation to alternative strategies like global macro can improve overall risk-adjusted performance. Unlike other alternative strategies, however, global macro managers can express their

substantial benefit to investors who value a

capital allocation methodology which considers both international and the inter-asset class of opportunities. Given importance

allocation decisions on portfolio performance, global macro could be considered a core strategy, subject to the right risk-management practices and limits.2

Morningstar. Annual Survey Finds Continued Strong Usage of Alternative Investments Accessed February 25, 2012. http://corporate.morningstar.com/us/asp/subject.aspx?xmlfile=174.xml&filter=PR4614.
1 2

Research indicates that asset allocation can account for up to more that 90% of the return variation between portfolios. See Scott Lummer and Mark Riepe, The Role of Asset Allocation in Portfolio Management, in Global Asset Allocation: Techniques for Optimizing Portfolio Management, ed. Jess Lederman et al. (New York: John Wiley & Sons, 1994), 1-7.

Macro Managers: What to Look For

Once an investor recognizes the need for a
broad, cross-asset strategy in their portfolio, the real work of finding a skilled manager begins. The process of identifying a skilled macro manager differs from other strategies as the category lends itself more readily to an absolute, rather than relative benchmark. The Box 1. Unique Factors to Consider When Assessing Macro Managers
Global Macro is distinct among alternative strategies due to its broad investment mandate and its ability to give investors portfolio exposure to a specialized investment style which differs from manager to manager. Thus, in assessing a manager, one must take the following into account:

performance
measure investment an

attribution
equity or

metrics
bond

used

to

managers

skills--benchmark

comparisons,

Sharpe and information ratios, and portfolio turnover--are metrics that are thus too often either incomplete or significantly misleading.

Macro managers can simultaneously maintain long and short positions in multiple products
including futures, options, swaps and forward contracts.

Managers often hold positions over varying lengths of time from a few months or less to
several years depending on the underlying strategic positioning. Benchmarks based on manager universes are intrinsically impaired by survivorship bias which skews benchmark returns primarily by excluding the performance of funds that have, in effect, blown up and have returned remaining capital to investors.1,2 There is little uniformity among managers: the abundance and variety of sources of advantage for macro investment teams means a great diversity of strategies exist within the macro category. Consequently, a particular risk profile and investment strategy can significantly influence the properties of performance return distribution (i.e., can produce asymmetric and kurtotic distributions) and make mean or median return analysis for periods of less than perhaps ten years potentially meaningless.3
1

The utilization of significant amounts of leverage and inappropriately narrow strategies have caused extreme failures in a significant percentage of funds; manager benchmarks in no way capture this data. Furthermore, benchmarks can overstate returns by 3% to 9% per year or more. There is a wide variation of results between different fund indices in common use. See William Fung and David Hsieh, Hedge-Fund Benchmarks: Information Content and Biases. Financial Analysts Journal (2002).
2

Little is published about the role of survivorship bias in under-reporting the standard deviation of returns across funds. But, as an example, the bottom 25% of funds across a number of major hedge-fund categories lost 25-40% in value during the course of 2011 per Fundwizard Investor's Hedge Fund Barometer. The use of options strategies provides the best example. See Andrew W. Lo, Risk Management for Hedge Funds: Introduction and Overview. Financial Analysts Journal (2001): 17-20.
3

Identifying the Drivers of Decision-Making (DDM)

Sophisticated investors have become Investors leading their are buying from a processa sources monitoring

increasingly aware of the challenge of macro manager evaluation. Many investors simply rely on a few years worth of monthly returns as a key step in evaluating manager performance. Benchmarks from the competitor universe are also considered, as well as Modern Portfolio Theory statistics relative to various indices. in Box 1. Some investors take a step further and attempt to design factor models to disaggregate the effect of bets on inflation, interest rates, regional and asset class exposures, etc. These evolutions in evaluation are helpful in arriving at a more informed total view of a managers skill and risk awareness, as well as style, but can also provide a misleading sense of quantitative rigor and security. As customdesigned benchmarks are theoretically possible but complicated to construct, many investors turn to the only readily available alternative to evaluate global macro managers: manager universes. Each of these approaches misses the mark for reasons described above

specialized investment style. We are seeing evaluators capital and beginning to promote a deeper approach in manager diligence process. Given the dearth of quantitative

measures that can be used to evaluate macro managers, these fund investors place a rigorous and nuanced qualitative approach at the core of their evaluation process. This effort penetrates a managers investment process

and

identifies

the

skill-based,

repeatable

drivers underlying portfolio manager decisionmaking. The Qualitative Core of Manager Evaluation Investors should begin by themselves four questions evaluating a macro manager: asking when

1. Can the manager articulate a consolidated and informed view of current macro and geopolitical trends? 2. Does the manager have a process framework to understand global trends? 3. Is the manager able to clearly communicate articulate his/her investment selection process? 4. Does the manager disclose a clear view of ex-ante risk to investors?

Skilled managers will have both a robust and comprehensive system which accommodates the breadth of inputs used to identify opportunities and risk elements. They will also have the ability to execute the most efficient trading tactics relative to the objectives of risk minimization and alpha generation. Manager evaluators must take care to avoid a generic process hand, template general which is not and actually peopleexecutable by the manager given their skills at management management ability, and firm size/flexibility or culture characteristics.

from

which

manager

can strategically An informed view and prioritization

position a portfolio on a consistent basis and tune for risk and reward. gathering, resources. processing, reveals the breadth of a managers information

investors must take care to avoid a generic process template which is not actually executable by the manager
All managers, regardless of strategy, should arguably have a consolidated and informed view of macroeconomic and geopolitical trends. In global macro, however, this criterion is an absolute requirement for the following reasons:
It organizes ideas by imposing a hierarchy on the relative importance of information. As a noise filter, it screens the endless flow of data and prevents distractions.

The DDM Approach

Consolidated View of Current Macro and Geopolitical Trends. A productive first step in evaluating managers is to assess their command of global structural issues and ongoing events. A macro manager should A have a consolidated and informed view of macroeconomic and geopolitical trends. consolidated view reveals that a manager has established a working hypothesis on the confluence of global trends and their total impact on financial markets. This is the basis

Multi-source information gathering prevents behavioral biases related to frame-dependency.1

As a risk management tool, it helps to prevent overconfidence as managers who have identified a range of potential consequences are less likely to treat any given outcome with certainty. The involvement of multiple key parties in the formation of market view greatly reinforces overconfidence-related risk reduction.

See Massimo Massa and Andrei Simonov, "Behavioral Biases and Investment, INSEAD (2002).

As in the production of all goods and services, there is a high correlation between input and output quality and it is important for investors in global macro strategies to determine the quality of input that is driving manager decisionmaking. A consolidated and informed view is indicative of the type of quality input that, over time, should yield consistent and high-quality investment decisions. A Process Framework to Understand Global Trends. they The second ideas. step in evaluating and Managers should have the capacity to conduct
primary research. Passive reliance on secondary research (which may be subject to institutional biases) is no substitute for primary research in establishing a basis of true critical thinking.

Managers should be skillful evaluators of

outside input. A healthy and formalized skepticism is beneficial when parsing an array of helpful or misleading data and enables managers to have a better read on the markets expressed opinion versus the truth as implied by fundamentals.

A process framework is important to the decision-making process because it imposes

managers is to assess the process by which

formulate Collecting processing the vast amount of relevant data that determine global trends is the great challenge of executing a macro strategy. A skilled manager is more likely than an unskilled manager to have an established procedure for collecting information, data, converting data into and then forming investment

procedural consistency and discipline which

are useful criteria for inventorying the real strengths and weaknesses possessed by all managers, reveals an even the most skillful of, and of and a successful. Furthermore, a process framework understanding to, the commitment challenge good

stewardship and out-performance which active managers take on.

theses based on that information. There are specific items of this process on which investors should focus:
The process should be formalized which helps to ensure discipline. Managers with an explicit step-by-step approach to idea generation are more likely to be prepared to accommodate major unforeseen risks.

A consolidated and informed view is indicative of the type of quality input that, over time, should yield consistent and highquality investment decisions.

Clearly Articulated Investment Selection Process. The third step in manager evaluation is to assess the process by which managers take action and make individual investment decisions. In other words, investors need to understand how a manager decides where and when to go in the context of global macros flexible mandate. A manager should be able to explain the criteria for determining how an investment idea is expressed in terms of asset class and trade structure and how risk is quantified. As in each step of the evaluation process, investors should be looking for procedural consistency.

Ex-Ante Risk Measurement1. Many hedge fund return return. investors information have a misdirected belies a preoccupation with unadjusted performance which misunderstanding of the roles of risk and Return is a function of risk--always! Thus, the amount of risk a manager employs to achieve a given level of return is absolutely as important as the returns themselves. If an investor has a particular target return in mind without a matching risk budget, they are making a naive investment decision, and are in many ways complicit in any subsequent underperformance.

The Three Rs of Global Macro Risk, Risk, Risk Risk allocation is a critical part of the decision-making process: 1. How many unique themes are expressed within the portfolio normally? 2. How independent are these themes, and at what point is breadth versus a best ideas focus the more significant factor?

Return is a function of risk always!

Investors should know both the technique a manager uses to quantify risk and the amount

of risk a manager assumes on an ex-ante

basis; it is the only way for an investor to know if a managers approach is consistent with the investors objective. Managers should therefore disclose regularly their key ex-ante risk variables.

3. In what ways is risk for each idea quantified and budgeted?

A useful summary of the key differences between ex-ante and ex-post risk is given by Professor David Friedman of Santa Clara University. (Laws and Order. Chapter 7: Coin Flips and Car Crashes.) Friedman uses the example of attempted murder to show that a measurement of outcomes is not sufficient to uncover prudent process leading to those outcomes.

Risk is appropriately allocated to a few sources:

1. Tracking error--the likelihood that the funds strategy could underperform aggregate asset markets. 2. Gross portfolio volatility--the nominal variation of portfolio value around a base trend. 3. Liquiditythe risk that a security cannot be sold quickly enough 4. Operational risksthe risk of monetary losses resulting from inadequate or failed internal processes, people, and systems or from external events.1

Given

the

key

importance

of

allocation

decisions on investment returns and risks, prudent active management must play a key role in portfolios.2 It is important to acknowledge both the value and the cost of such management relative to the gross returns of any one asset class. Thus, while evaluation of of cross-asset risk and portfolio managers poses for additional challenges, it also holds the benefit performance rewards

successfully identifying and selecting a skilled

manager.

Final Thoughts
With the Drivers of Decision Making (DDM) approach, we identify the key aspects of

prudent active management must play a key role in portfolios.

Investors can minimize the possibility of systematic capabilities. manager underperformance by investing in truly sophisticated due diligence Such investment is presently being made at leading capital sources and we are optimistic that this trend will become more widely adopted. The economic realities and overall satisfaction of investors will benefit greatly from this trend, as will the dignity and

risk

management

and

idea

generation

which drive the investment process. Skilled managers are more likely to adhere to these criteria in a consistent and disciplined way, resulting in superior risk-adjusted performance. The primary objective of manager performance evaluation is to identify investment skill that

drives capital preservation in the short term

and capital appreciation in the long term.
1 2

appeal of both the asset management and

manager-evaluation professions.

Jose A. Lopez, What Is Operational Risk? FRBSF Economic Letter 2002-02 (2002).

A balanced discussion of active versus passive management is given by Arnerich Massena in their August, 2007 note, "Active versus Passive Investment Management: Putting the debate into perspective." This piece notes that active management tends to beat the market in down periods. In addition, long-term outperformance by active managers is more common in smallercapitalization stocks. This may be logically extended to developing markets, commodities and alternatives, somewhat more complex securities, and other markets with less mass-market research coverage.