Quant Strategies in the Finance 3.0 Series - Macro

Global Macro:

Global Macro has the broadest investment mandate out of all investment strategies. Having a broad investment mandate gives investors the ability to profit in any market and being able to do so is the textbook definition of a successful investor. Worth noting is that some of the most famous traders such as Paul Tudor Jones, George Soros and Julian Robertson are all considered discretionary Global Macro investors. With the advancement of technology, Systematic Macro emerged from discretionary Global Macro at the end of the 20th century as a Macro 2.0 type of investment strategy that also has a similar global investment mandate. One particular Systematic Macro manager that has been extremely successful is Ray Dalio and his Bridgewater Associates, which is the largest hedge fund in the world managing about USD 160 billion as of 2019. With improvements in data gathering, increases in computing power and development of machine learning techniques, the Systematic Macro funds are now entering a Finance 3.0 paradigm.

Billionaire macro investor preaching about how to create a meritocratic firm. https://www.youtube.com/watch?v=HXbsVbFAczg

His best video -> https://www.youtube.com/watch?v=PHe0bXAIuk0&t=614s

Systematic Macro – A Heterogeneous Approach

A common feature among all Systematic Macro managers is that their strategy seeks to profit on an opportunistic basis by identifying mispriced securities across liquid fixed income, commodity, equity and currency markets. The key for profiting is to anticipate price trends and capitalize on spread moves by utilizing various econometric trading techniques based economic data such as GDP growth, inflation, international trade flows, term structure and exchange rates. Other features that Systematic Macro funds have in common is the ability to trade both long and short and applying leverage to magnify returns. Given the vast investment mandate yielded to Systematic Macro managers, the investment strategy is naturally heterogeneous and together we will explore the edge of this relatively intuitive yet quantitative investment approach.

Opportunistic strategies include Managed Futures and Global Macro in the CFA curriculum.

Where Does Systematic Macro Fall On the Convergent/Divergent Spectrum?

Most investor portfolios are convergent in nature meaning that even if the portfolios are diversified across asset classes they fail to diversify how returns are extracted from within those asset classes during crisis periods. For example, equity bond correlations could turn positive and thus drop in value at the same time even if the relationship has been negative in recent periods. To protect against spiking correlations, investors can allocate a portion of their portfolios to Managed Future funds such as CTAs, which are divergent in nature and differentiates how returns are extracted from within asset classes. This in turn provides diversification to an investor’s generally convergent portfolio. The CTAs or so-called trend followers deliver diversification by using statistical techniques on past price action to forecast future price trends. Systematic Macro is another form of Managed Futures as trading occurs in liquid futures markets, but instead of relying on technical/statistical indicators to probabilistically predict future price movements, the Systematic Macro strategy generates forecasts based on economic fundamentals. By analyzing fundamental factors from a macro economic perspective, Systematic Macro captures a different source of alpha than CTAs. In addition to generating alpha, Systematic Macro has a low correlation to public equity, private equity, venture capital and fixed income markets, which means that the correlation between a Systematic Macro fund to the typical institutional investor portfolio is low as well.

The Meaning Of A Fundamental Strategy Plus Strength and Weaknesses Of Systematic Macro

A fundamental strategy by definition uses economic data as predictive inputs to analyze relationships between securities, asset classes, markets and inter markets. A theory for why fundamental models are profitable is that people are anchored on the current price of goods and services. If people underreact to new information, the observed current price of an asset will deviate from its intrinsic value. If, over time, the observed price then slowly adjusts to its intrinsic value models based on fundamental forecasts will profit. Given that the universe of fundamental variables is so large, Systematic Macro hedge funds apply a rules based investment style with little to no human intervention on liquid derivatives such futures, options and swaps, which are easy contracts to trade and marked to market on a daily basis.

1. Following Are Characteristics Of Opportunistic Strategies

· Can be based on technical or fundamental data

· Discretionary or systematic

· Trade any type of instrument across any asset class

2. Strengths Of Systematic Macro

· Always positioned in the market

· Trades across all liquid instruments

· Ability to go Long/Short

· Effective use of leverage

· Great diversifier to a traditional 60-40 portfolio despite relying on convergence

· Low historical correlation to both trend-following and traditional asset classes

· Performs well during historical drawdowns

· Benefits from high volatility

· Outperforms when asset prices are not supported by fundamentals (mean reversion)

3. Weaknesses Of Systematic Macro (That Can Be Turned To An Advantage)

· Inability to forecast new emerging relationships based on past historical data

· Fundamental data gets revised by economists

· Fundamental data is noisy and error prone

· Relationships change and are sometimes not persistent

· Unable to perform if the market participants disregard fundamentals

Systematic Macro return decomposition from Morgan Stanley.

A Thematic Coded Approach To Investing

Systematic Macro is classified as either outright directional in which a manager bets on a discrete price movement or as refined relative value in which a manager bets on a perceived mispricing between two or more instruments. Going long a USD dollar index or short the 10-year German bund is an example of the former, while going long Apple and short Microsoft or long GBP and short USD in hope that the relationship mean reverts is an example of the latter. Relative mispricing can also be compared against a global composite of instruments. For example, a manager can analyze how a 10-year U.S. government bond future behaves in relation to a global basket of bond futures based on fundamental factors. To identify if there is an anomaly, one can measure how far the 10-year bond deviates from its normal relationship with the composite and if the bond is trading far away from what is considered normal then the manager can bet on the bond to snap back. To profit from these macro relationships, a foundational computer algorithm must be created for both directional and relative value models and this key algorithm must be supported by empirical evidence. To create a model based on empirical evidence, the quant must first form a hypothesis for why a particular relationship exists and how to profit from that particular relationship.

The theory must be executable in code!

Macro Hypothesis

A hypothesis could be that currencies in countries that experiences higher growth will appreciate relative to currencies in countries with lower growth. To test this currency hypothesis, an algorithm must be written and trained on historical data. If the hypothesis is proved by empirical evidence and the algorithm is profitable despite trading costs, the model can be deployed in the actual trading portfolio. Unlike discretionary traders, whom might only have three current optimal themes and monitor their positions constantly, a benefit for systematic managers is that there is no human intervention after a model is launched. A systematic manager can therefore deploy many models with each model capitalizing in proportion with observed opportunity. The end goal for a systematic manager is then to optimally build a portfolio of as many models necessary to create a unique blend that maximizes the portfolio’s Sharpe and achieves other key characteristics.

Systematic Macro Themes Across Currency, Fixed income, Equity and Commodity Markets

1. Valuation Drivers: This theme tries to identify the underlying valuation drivers in each specific asset class to analyze if the intrinsic value deviates from its current observed value

PPP example

Purchasing power parity (PPP) is a theory that concerns the long-term equilibrium exchange rate between two currencies. In the long run, currencies tend to move towards their fair value. The foundational theory of PPP is the law of one price, which states that a basket of goods in country A should cost the same as an identical basket of goods in country B absent transaction cost. However, theory is most often different from practice and by comparing baskets of goods between countries a systematic trader can identify if country A or country B is cheaper to live in, which might impact the future exchange rate between the countries. If the basket of goods in B is 100 EUR and the identical basket in A is 150 USD, the real exchange rate is 1.5 USD/EUR. However, the actual exchange rate might be 1.2 USD/EUR. This means that the EUR in country B is cheaper than the USD in country A in real terms. The PPP theory then states that prices should narrow over time between A and B by either a change in the exchange rate or inflation rate. A simple systematic trading model is to buy the cheaper currency of B against A in hope that PPP holds over time. This type of trading model can be made more complex by analyzing individual currencies against a basket of currencies. A systematic macro manager can measure, in standard deviations, how far away the currency is trading from its fair value. The further away from its fair value, the more likely the currency is likely to snap back.

Above example shows USD/GBP exchange rate and relative price level. Worth noting is that the relative price level is less volatile and downward sloping in this case.

2. Risk Premia: is another theme common among Systematic Macro managers. A risk premia is the excessive return above the risk free rate earned as compensation for holding on to a risky asset or risk factor across all asset classes

Within each asset class, there are underlying risk factors that explain why investors get compensated for holding a specific asset. Three well-known risk premias are carry, value and momentum and these can be found across currencies, equities, fixed income and commodities. There are also inherent risk premia to specific asset classes. In equities, there is the famous equity risk premia, which is an investor’s compensation for buying risky equities. Then there is risk premias associated with fixed income, as holding a corporate bond includes being exposed to default risk, duration risk and inflation risk. A longer-term bond has relatively higher exposure to these risk factors and as a result, the compensation is higher than shorter-term bonds. A well-known risk premia that Systematic Macro funds capture in fixed income is known as carry and relative carry across government bonds in different nations. The simplest form of carry is a long position in a relatively higher yielding bond against a short position in a relatively lower yielding bond. The spread between these two positions is known as carry. This trade is not without risk as there is a reason why the compensation is larger for the higher yielding bond. Perhaps, the higher yielding bond is a government bond in an emerging market with a more uncertain macroeconomic outlook. For example, a Greek 10-year note yields higher than a German 10-year note, despite that both of their bonds are denominated in EUR and backed by the ECB.

The sourcing of data and complex techniques utilized by hedge funds generates alpha from known alternative risk premias

3. Macro Economic Factors and Business Cycle: is a theme that explores the relationship between the economic variables and the underlying price of instruments across all asset classes within a specific country or between countries

Another theme pitched by Systematic Macro mangers to generate a higher risk adjusted return is to analyze fundamental macro trends. Systematic Macro traders take long positions in assets for which fundamental macroeconomic trends are improving and short assets for which fundamental macroeconomic trends are deteriorating by researching trends in variables such as M2 to see if the money supply is expanding or contracting, government debt to analyze debt issuance, GDP forecast revisions to find out an economy’s relative growth path, trends in a country’s inflation to predict the future path of its exchange rate and trade balances between countries to scope the current account status of a nation. This trading style is a form of macro economic momentum and spans all asset classes. For example, if inflation is comparatively trending high in country A, it could mean that its currency and fixed income investments will take a hit relative to country B. A systematic manager might therefore go long B and short A if the manger has a model that places currency and fixed income bets based on changes in relative inflation.

Hypothetical Macro Momentum strategy. For a full description of the strategy, please click following link: https://www.aqr.com/Insights/Research/White-Papers/A-Half-Century-of-Macro-Momentum

4. Orthogonal Macro: Idiosyncratic theme. Models are asset class specific based on, for example, investment flows or opportunities within the fixed income and commodity term structures

Term Structure for Fixed Income

Relative value in fixed income is based on taking spread bets across instruments based on their option adjusted spreads, swap spreads, credit ratings, yield curves and spread volatilities. A common relative value strategy is yield curve analysis on similar bonds such as treasury bonds. The yield curve measures the relationship between yield, which is the compensation received when you buy a bond, and maturity as measured by time. The slope of the yield curve reflects beliefs about the future of the economy. Usually, the yield curve is upward sloping as longer-term bonds are exposed to more risks such as inflation and potential default, which can take place at any point in the future. Longer maturity bonds should therefore have a higher yield than shorter-term bonds, all else equal, when the current growth rate is expected to continue. However, the yield curve is most likely not going to be an upward sloping smooth line in practice. Sometimes the yield curve is flat and when investors are expecting a recession, the yield curve can be inverted, as investors are willing to earn a lower yield now as they might expect the central bank to lower interest rates much further in the future to prevent the equity market from crashing. A Systematic Macro investor can analyze the historical term structures/yield curves through utilizing econometric tools to find unusual price fluctuations generated by economic variables such as inflation, economic growth and the Taylor rule (monetary policy). Based on patterns generated by the analysis, the Systematic Macro quant then builds a model that can systematically place bets to profit when dislocations occur in the term structure. For example, if there is a kink in the yield curve at the 5-year maturity, the Systematic Macro investor might have a model that will short the 5-year and go long the 2-year plus the 10-year, which then profits as the curve normalizes.

Theoretical term structure of interest rate curve. In reality, the curve has all sorts of kinks and inversions, but worth noting is that above demonstrates that longer-term bonds have a higher yield.

Conclusion

Systematic Macro managers leverage econometric/statistical tools to place bets on instruments that has an observed current price that differs from its intrinsic value as indicated by underlying fundamental data. Systematic Macro has emerged as an alternative approach to Global Macro managers with the same broad investment mandate. The tools utilized to extract alpha from fundamental analysis and place bets across all kinds of liquid markets such fixed income, currencies, commodities and equities is similar to CTA managers, but with a different objective function. Given the vast universe of fundamental variables and relationships between instruments, the Systematic Macro investment strategy is heterogenous. However, as a per group, Systematic Macro managers share some common features such as the ability to go long/short, having low correlation to a 60-40 portfolio and the application of leverage. The future for Systematic Macro is bright, as new types of econometric techniques and higher processing power have emerged with technology advancements. Technology has also made it easier for economists to collect data, which is the cornerstone for a successful quant macro fund.

The End!

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