Perfect Swing

There are loads of reasons I trade global macro. Rather than, say, specialist commodities money, European long/short, asset allocation or, heaven forbid, long only regional cash.

And probably the most important is that it puts me in a much better position to control risk.

At its simplest, global macro trading is all about working out which quadrant the market will pass through over the next six months.

If you believe it’s a disinflationary boom (growth with diminishing inflationary pressure – or more likely here, slowing growth, with surprisingly rapid diminishing inflationary pressure) – then you buy the biggest, lowest cost producers, you buy US and Asian consumer and insurance plays, Asian and Latam real estate, you buy bonds, the dollar, and you sell commodities and resource stocks – and you buy the best bombed out bank.

Deflationary bust; buy bonds, sell equities & commodities. Inflationary bust; own commodities, sell stocks, bonds and rate futures.

Now, the beauty of this construction is that if you make a call – for disinflation (as I did two or three weeks ago) – and you put all the trades on (not just your favourites) – you can afford to be a fair bit wrong and not lose. If it’s a deflationary bust, the gains on your long dollar, long rate futures, and short commodities should offset losses on your long equities.

If, instead, it’s an inflationary boom (growth and inflationary pressure), your gains on stocks, offset some losses on commodities, rate futures and the dollar. And, at the very least, it should buy you some time to change your mind.

If you’re right, the market will still flit between segments, even during a sustained disinflationary phase, this spread of assets will reduce your volatility, increase your sharpe ratio, or, in words I understand, it will help you preserve your equanimity, and all that good stuff.

And this works because it’s pretty hard for the economy to lurch from corner to corner – from disinflationary boom to inflationary bust, for instance. It tends to go from side-to-side, or up & down.

So, when I set up my fund to play disinflation two or three weeks ago, I went with the same ‘double sized’ risk I went with into the ‘inflationary bust’ trade in mid-May. I was standing +35% three weeks ago and, in line with my trading rules, that allowed me to increase exposure and widen loss limits. But when I take on more risk, my risk discipline remains unaltered, if I hit a stop, I cut, period.

What happened next was highly unusual. The market flip-flopped between disinflation and inflationary bust. Corner-to-corner. And this took away the automatic macro hedge in my portfolio, with a vengeance. Either every position won, or every single thing lost. I think this happened because the accelerating moves down in the banks and the accelerating moves up in coal and oil were big on momentum and positioning, but mutually exclusive.

So I started seeing some intense volatility in the fund. Maybe three times what I’m used to. After a 9% drawdown in the week to Monday last, the fund recovered aggressively and now stands at a new high, up 44% for the year.

Now I’ve trained myself to deal with some decent market swings. But this degree of movement suggests to me that I risk breaking my only golden rule of investment; never blow yourself up. Or, to be more accurate, never get into a drawdown doldrums that puts you off making money.

So I took advantage of the moves yesterday morning to take a third of my risk off the table.

Now, I would never put as much risk on the table, a-priori, as it turned out I did, ex-post. But as Gavekal is wont to say, fund managers are paid to adapt – and I think that reducing risk now is right – even during a good run, in a market prone to acute macro schizophrenia. Even if I think that the good ‘disinflation’ personality in the market will win out over the evil ‘inflationary bust’ persona over the coming weeks and months.

There is another way to run global macro money that helps with what I call ‘real risk’. Not the VAR type measures that missed every one of the 31 listed hedge fund blowups over the last 12 months. But the real risk when positioning is extreme and fundamentals reverse.

And it is to watch what I call, for want of a better phrase, behavioural correlation. Now, what I do is look at the big, long in the tooth themes. And this is for me a bit more of an art than a science. Basically, I look for long running theme, with a lot of historic P&L, chunky positioning, and loads of front page coverage.

So you have three types of theme – loved, hated, and ignored. And what I do is create an index of each. So, as an example of a theme, peak oil, I wouldn’t just use the oil price as the index. I’d use the uranium price, the coal price, the deep sea drilling day rate, oil drillers shares etc.

Then I look at each instrument I’m trading, and I run a correlation with the index. I then work a weighted correlation for the fund against the theme.

So the idea is – be non-correlated/negatively correlated with the ‘heavy’ themes. And be happy to be positively correlated with hated themes, and sneakily involved with ignored themes. If you make a mistake, cut.

So what I’m trying to get at is what the difference is between real risk/reward, volatility risk, and mistake risk.

Each requires a different attitude. I use stop losses to guard against mistake risk. I use volatility adjusted gross limits to guard against volatility risk (my fund’s volatility was higher than I thought it would be over the last two weeks, so I cut my gross). I use ‘behavioural correlation’ to make sure I’m running good ‘real’ risk reward.

Now, that’s all good, but there’s another type of risk. What I’d call extreme thematic risk.

I’m only just beginning to deal with this sort of risk in my macro fund. The attraction is that plays are often micro thematic – they’re opportunities to make money when something unusual happens. And if you’re early enough – they are ‘ignored’ on my behavioural correlation tests. When I’ve bought some time in the fund, I’ll go looking for some ‘extreme themes’ to make me some extreme, unusually uncorrelated returns. My first trade, four months ago, was Pico holdings. Macro, schmacro, in a major West Coast water shortage, Californian water assets are the wrong price.