FX hedge funds’ underperformance to reverse as macro trends shift
Global macro trends will normalize, boosting volatility and FX returns, argue analysts, despite the unflattering returns of FX hedge funds, the fall in AUM of currency-specific funds last year – even as the industry received bumper inflows – and recent high-profile failures.
A dichotomy lies at the heart of the global hedge fund industry: on a five-year annualized basis, it has markedly underperformed the benchmark S&P 500.
Last year, it generated a return of 8% to 11%, depending on which firm’s figures are taken, against the S&P’s near-30% upside, but both its aggregate assets under management (AUM) and headline number of firms continue to jump.
More specifically, though, for the macro and quantitative funds that heavily feature FX, the past year has been poor, again, with notable failures underlining the difficult operating environment, including the closure of QFS Asset Management’s currency-only trading fund this year, and last year’s bankruptcy of FX Concepts, once the world’s biggest currency hedge fund.
Although hedge funds added more than $360 billion in capital last year alone, the Bank for International Settlements (BIS) reported a slump in total assets run by currency specific funds, from around $35 billion at the start of 2008 to approximately $6 billion in 2013.
Market players are questioning whether the recently beleaguered macro hedge funds sector that utilizes FX heavily fares better than last year.
The relative disappointment of FX returns lies in the fall in volatility.
A key part of the problem for FX macro hedge funds is the wider operational remit of the world’s central banks. Since Lehman’s failure, the previously usual relationships between monetary policy actions and their consequences for currencies have broken down.
In broad terms, for example, the type of global imbalances that underpinned a fundamentals-driven strategy are no longer clear cut.
Says Robert Savage, CEO of the multi-asset multi-strategy quantitative hedge fund CCTrack Solutions, in New York: “To take the apotheosis of this idea, look at the difference in current accounts between the US and China 10 years ago and there was a huge difference, which prompted major investment money flows. But look at them now and there’s virtually no difference.”
Similarly, he adds, the cause and effect of the different components of monetary and fiscal policy being exercised is no longer straightforward. “For example, the economic fundamentals of the eurozone remain highly precarious, but the euro stays bid, whilst Brazil has repeatedly raised interest rates – to the highest level amongst the major economies, in fact – but the real still looks [prone to selling],” says Savage.
Aside from the difficulty for momentum traders to gain any returns-traction under such unpredictable circumstances, the 2007/08 crisis-induced move towards a lower interest-rate environment around the globe also negatively impacted the previous return-generating industry standby, the carry trade, says Jan Viebig, chief executive officer of Harcourt Investment Consulting hedge fund, in Zurich.
“Given the scope of the central banks’ activities since the crisis, and the concomitant smoothing down of major movements in the FX market, the traditional investment trends for currencies have been unreliable as the major strategies work best in times of bigger moves up or down than we have seen in the past four or five years,” he adds.
And Amy Bensted, head of hedge fund products for alternative investments intelligence firm Preqin, in London, says whilst in broad terms this trend of lower volatility in the markets has been matched by lower volatility across the hedge fund industry from the start of 2011 – decreasing from around 10% to about 5% – for FX-related funds, lower market volatility has generally made for a disastrous operating environment.
Christopher Cruden, CEO of Insch Capital Management hedge fund, in Lugano, adds: “For a lot of FX hedgers to make money, you need big moves up and big moves down – it doesn’t matter which. But with central banks smoothing out the bumps in the road, we have seen volatility at historically low levels since around 2008/09.”
In fact, even during the recent mini blow-up in emerging markets (EMs), the global Volatility Index (VIX) still only stood at around the 21 level (briefly), relative to its 20-year average of about 20.50, and indeed has spent most of this year trading below 13.
Although the lower volatility returns’ profile of the hedge fund sector in general – an average Sharpe ratio of 1.1 and a high of 2.0 during the past five years – has indicated to institutional investors that hedge fund managers in general are more adept at generating additional returns, even when taking on less risk, for FX-related funds headline low market volatility results in the inability to rely on any single strategy, be it carry, momentum or mean reversion.
Having said this, the outlook for hedge funds generally appears bright, with Deutsche Bank’s annual alternative investment survey finding that investors remain bullish on industry growth. Hedge fund players are redoubling their allocation pitch, which should benefit inflows into currency-specific funds.
In general terms, says Insch’s Cruden, taking the S&P 500 as the golden benchmark is a meaningless occupation in a multi-asset investment environment diversified away from the equities sector.
“Investors are turning to hedge funds for more than just absolute returns,” he adds. “Rather, they are also looking for funds to produce strong returns over the risk-free rate (RFR) [0.5% against 4% just before Lehman’s crash in 2008] with low volatility on a consistent basis, and the performance of hedge funds in the past two or three years has delivered this.
“If you look at the actual returns of the average hedge fund over the two- to three-year period, then you’re looking at a 16-times return over the RFR, if they’re generating an average of 8% absolute return, and that’s a compelling performance as far as institutional investors are concerned.”
The bank finds that global hedge funds’ AUM are expected to hit a record $3 trillion by the end of this year, up from current estimates of between $2 trillion to $2.6 trillion, and that 57% of institutional investors plan to increase their hedge fund allocations this year.
Hedge funds that retain a substantial FX constituent are therefore likely to benefit from such flows over time, as the influence of macroeconomic fundamentals gradually reverts to traditional levels, and the scale and timing of central-bank intervention eases off, says CCTrack’s Savage.
“You can see this already happening with the [US’s] Fed, as it continues to taper down its QE programme,” he says.
As these two factors switch back closer to normal, so volatility might pick up again, as was seen in the EMs’ FX arena last month when the Fed cut another $10 billion per month from its monthly bond buying, adds Viebig.
“The recent decline in hedge funds’ FX returns are just a natural part of longer-term market cycles,” he says. “If you look at the last 100 years of financial markets, you will see regular periods of four to five years a time when FX does poorly, and this last period began in 2008/2009, so there is an increasing probability that we will see a turnaround this year or next.”
If FX hedge funds succeed in bulking up allocations, their impact on market dynamics will be difficult to pinpoint, even as they account for substantial volumes in spot and forwards during the past three years, accounting for 14% and 17% respectively, and 21% of the options volume.
Savage says, as the BIS highlights, much FX trading has migrated from being dealt on a personal basis to being executed electronically.
“Ten years ago, you knew if someone big was banging the markets around, but nowadays it’s like heating up frogs from cold water – you don’t know the scale of what’s happening until the things blow up.”