MACRO STRATEGIES attempt to identify extreme price valuations in stock markets, fixed-income markets, interest rates, currencies, and commodities and make bets on the anticipated price movements in these markets, sometimes in a leveraged fashion. Trades may be designed as an outright directional bet on an asset class or geographical region (e.g., long Japanese equities), or they may be designed to take advantage of geographical imbalances within an asset class (e.g., German 10-years relative to U.S. 10-years). To identify extreme price valuations, managers generally employ a top-down, global approach that concentrates on forecasting how global macroeconomic and political events affect the valuations of financial instruments. These approaches may be either systematic or discretionary.

Macro investors look for the extraordinary sets of macro conditions that occur only occasionally and that make a particular investment approach very effective while those conditions persist. They enjoy a great deal of investment policy flexibility and will therefore invest on a leveraged base across multiple sectors, markets, instruments, and trading styles as the macro conditions dictate. They invest based on macroeconomic analysis and forecasts of changes in interest rates, currency markets, equity markets, and global political and economic policy. They often pursue other hedge fund strategies while waiting to take the large, opportunistic directional positions for which they are more famous. Generally, macro investors look for unusual price fluctuations. They refer to such extremes as FAR-FROM-EQUILIBRIUM CONDITIONS. In such situations, market participants’ perceptions and the actual state of affairs are very far removed from one another and create a persistent price trend. The macro investor makes profits by identifying where in the economy the risk premium has swung farthest from equilibrium, investing in that situation, and recognizing when the extraordinary conditions that made that particular approach so profitable have deteriorated or have been counteracted by a new trend in the opposite direction. For the macro investor, timing is everything.

Think of prices as falling on a bell curve. Macro investors argue that most price fluctuations in financial markets fall within one standard deviation of the mean. They consider this volatility to be the ordinary state of affairs, which does not offer particularly good investment opportunities. However, when price fluctuations of particular instruments or markets push out more than two standard deviations from the mean into the tails of the bell curve, an extreme condition occurs that may only appear once every two or three decades. As discussed in previous chapters, when market prices differ from the “real” value of an asset, there exists an ARBITRAGE opportunity. The macro investor makes profits by arbitraging such extreme price/value valuations back to normal levels. Some examples of far-from-equilibrium conditions that have occurred in recent years are the collapse of the tech industry in 2001 and 2002, the drop in the dollar beginning in 2002, junk bonds and emerging-market debt in the early 1990s, Eurodollars in 1994, and the Japanese yen during the late 1980s and again from 1995 to 1998.

As with all investors, macro managers look to find situations with the optimum combination of risk, reward, and probability—ideally low risk and high return with high probability. Unlike many other strategies, however, their main edge is often not information collection, but their ability to exploit these asymmetric scenarios as a result of the broad scope of their mandate, and their ability to use leverage. One trade that many macro managers made was selling the dollar at various times since the middle of 2002. What made this trade difficult was that, to most observers, the dollar seemed overdue to fall once the stock market bubble burst in early 2000.

One of the key factors influencing Russia’s creditworthiness was the collapse of most Asian economies in 1997. The impact on global demand was material and resulted in sharply lower oil prices in 1998, which hurt Russia’s balance of payments position. Because Russia relies on oil and energy prices for the majority of the hard currency revenue it uses to service external debt, the collapse in oil and energy prices was significant and meant that Russians would have to reduce their spending or see their capacity to service debt meaningfully decline. But, when Russian export prices were declining, Russia was actually increasing its consumption of imports (i.e., spending), which was unsustainable.

Macro investors are not confined by a market niche, enjoying the flexibility and objectivity to move from opportunity to opportunity and trend to trend. This is particularly important because macro investors’ asset size per fund tends to be significantly large. Asset size potentially can hinder the execution of strategy, but macro investing makes asset size an advantage rather than a hindrance. Macro investing is often portrayed as risky directional betting or speculating. This view is reinforced by the large profits and losses that these funds generate when concentrated leveraged bets pay off—or fail.

As shown in FIGURE 10.1, from January 1990 to December 2004, macro hedge funds recorded an average annualized return of 16.26 percent, with an annualized standard deviation of 8.45. These returns were more than 5 percent greater than the S&P 500 index of blue-chip stocks recorded for the same period, with significantly lower volatility. Since 1990, macro funds have returned positive performance in fourteen of the fifteen years. Seven of the years have produced returns greater than 15 percent: 1991-1993, 1995, 1997, 1999 and, most recently, 2003. Other than 1994, when they recorded a loss of 4.31 percent, macro funds have exhibited consistently high performance, with a 0.38 correlation to general stock market price changes since 1990. While total assets in the macro category have dropped from the largest to the fourth largest of all the strategies since 1998, the performance has carried the strategy with an annualized return of 9.21 percent during the six-year period.