Ian Bremmer is one of the smartest people I know. He’s the founder of Eurasia Group, a global political risk research and consulting firm. His expertise is geopolitics. Mine is alternative investments. Both of us think 2015 will be a year to remember, although for different reasons.
In an Altegris webinar, Bremmer outlined four impending crises, with worsening relations with Russia topping the list, followed by the fight against ISIS, China’s muscle-flexing in the Pacific and struggles in Europe. My prediction is that the tumultuous global political and economic landscape could benefit global macro hedge funds and, by extension, strengthen the argument for active management.
For many of us, global macro funds were our introduction to hedge funds. Three legendary hedge fund investors, George Soros, Julian Robertson and Michael Steinhardt, made huge profits in the ‘80s and ‘90s with gutsy moves, most memorably Soros’ correct $10 billion bet that the British pound was overvalued. They showed us there was a way to invest beyond stocks and bonds.
In the world of active managers, global macro fund managers are arguably the most active of them all. They have no index, no S&P 500 or Russell 2000 against which to measure their performance or invest in. They might go long or short equities, bonds, currencies or commodities, and they often reinforce their positions with leverage and derivatives. These “go anywhere” funds scour developed and emerging markets, trying to anticipate macro events and placing huge bets on those outcomes. They thrive on uncertainty and conflict.
Global macro hedge funds have posted ho-hum results since 2008, though. Volatility has been at historic lows. In their attempts to stimulate economic growth and escape deflation, central banks around the globe have printed money, kept interest rates low and bought up fixed-income instruments. The result has been that bond prices have gone up and yields have gone down. Investors have shifted assets to “risk-on” assets such as equities, sending many of those markets higher. In an environment of low volatility and rising equities markets, active managers have a hard time distinguishing themselves.
Their lackluster performance has generated lots of talk about the end of active management, none as provocative as Charles Ellis’ recent article, “The Rise and Fall of Performance Investing,” in the Financial Analysts Journal. Ellis argued that active management is the victim of its own success. In his view, the thrill of beating the market attracted so many smart, talented young professionals over the past 50 years that the task of finding mispriced securities has become much harder. All those analysts poring over all that information have researched the inefficiencies away. It’s become much harder to match the markets, let alone beat them, especially after taking costs and fees into account.
I don’t disagree with Ellis that pricing errors were much easier to find in the past. However, despite a fire hose of information, markets are still inefficient—smart managers can and do outwit the market. Moreover, passively-managed, cap-weighted index strategies still have the problem of favoring yesterday’s winners—and as we know, it’s hard for yesterday’s winners to continue to outperform.
If you are going to predict the fall of active management, perhaps it’s best to wait until the current bull market is over. Active managers have historically underperformed in rising markets, but have the opportunity to outperform on the downside. The period of outperformance for active managers came when interest rates were steadily rising, and underperformance occurred during the many years of falling interest rates, according to a recent study by Barron’s. A five-year bull market, fueled by falling rates, was a perfect scenario for passive indexing.
That scenario looks likely to change. The consensus calls for rising interest rates in the U.S. in late 2015 or early 2016. It’s a similar story for Britain, and eventually rates are expected to rise again in Europe, once it emerges from its recession. The role of central banks should recede, and the role of the global macro investor could re-emerge. If Eurasia Group’s Bremmer is right and 2015 becomes a year of political turmoil, the global macro funds will find themselves in familiar—and welcome—territory.