Macaskill on markets: Reasons to be fearful – the big three
The return of market volatility in late August put a focus on asset managers, with investment banks for once ceding the spotlight during a period of turmoil. There will surely be some bank trading mishaps, but the main threat to revenues is likely to come from diminished demand for investment products rather than dealing room blow-ups.
A Gross miscalculation
The fall in equity markets produced a near-term bonus for banks in the form of demand for hedges and trades to cut exposure quickly – combined S&P500 and EuroStoxx options volume was roughly $575 billion on August 24 when prices were falling fastest, for example.
Most asset managers were bloodied but unbowed by the slump then partial recovery in global stock indices, but the return of volatility and heightened uncertainty over cross-asset price relations will increase scrutiny of their strategies and scepticism about the robustness of their risk-management policies.
Three American fund managers are likely to be watched particularly closely: Larry Fink, head of BlackRock, the world’s biggest asset manager; Ray Dalio, founder of Bridgewater, the world’s largest hedge fund; and Bill Gross, dethroned last year as head of the top global bond fund at Pimco, but still the embodiment at his new firm Janus of bold fixed income investment with its attendant risks.
Gross delivered an early example of unexpected fallout from the market disruption when his Janus Unconstrained Bond Fund lost roughly 2.9% on Monday, August 24. There is a clue in the title of the ‘Unconstrained’ fund, but almost 3% was still a substantial amount for a bond fund to lose on a day when big fixed income markets took a back seat to slumping equity indices.
The Treasury market, the primary underlying benchmark for US bond funds, rallied on August 24 as money moved out of stocks, without showing unusual volatility.
A BlackRock fund with a comparable mandate to the Janus Unconstrained fund (though with far higher assets at over $30 billion compared with roughly $1.5 billion for Janus) managed a reasonably respectable dip of 0.2% on the same day.
Commentators keen to give a name to the crisis were divided on whether it should be called the Great Fall of China, or the Great Squall of China. It has certainly cast a Great Pall
So what went wrong for Gross’s fund? Asset allocation at the end of July of 20% to high-yield bonds, with big exposure to unrated bonds and 6% to equity-linked paper seems to supply the answer in broad outline.
Investors looking for more detailed clues may have read the most recent investment outlook published by Gross on July 30, without being any the wiser. Gross opened with a typically rambling prelude about the different wording of Catholic and Protestant versions of the Lord’s Prayer (and his own childhood habit of praying for his brother’s cat Stinky), before condemning the ranks of “zombie and future zombie” corporations that are supported by access to the high-yield debt markets in an environment of near zero rates.
The loss in his Janus Unconstrained fund on August 24 indicates that Gross may have been taking a risk by seeking to maximise returns from these zombie corporations before being mauled by high-yield bond underperformance (zombie company debt can move surprisingly quickly).
Buyers should certainly beware of any investment that describes itself as unconstrained, and the reverse for the Janus fund may ensure that its assets end up comprised mainly of Gross’s own money, along with a Soros family office investment that tracks the fund. So there is no systemic threat from any further adventures Gross undertakes by roaming in and around his core fixed income areas of expertise.
Hedge fund investments also carry an implicit ‘buyer beware’ label and have not been viewed as a significant big risk since the bailout of LTCM in 1998 ushered in a new era of lower leverage. Hedge funds delivered mixed performance in the 2008 credit crisis, with some high-profile gains from shorting of mortgage instruments by funds such as Paulson failing to outweigh losses at other firms that had simply tracked broad markets. Hedge funds did very little to exacerbate the crippling losses caused by bank exposure to mortgage securities, however.
In the years since 2008 the hedge fund industry has recovered enough to surpass previous records for assets under management while remaining relatively lightly leveraged in aggregate.
That does not obviate intense interest in the real exposure of hedge funds in an environment of elevated paranoia, such as the one that was ushered in by the Chinese inspired slump in global markets of late August.
Commentators keen to give a name to the crisis were divided on whether it should be called the Great Fall of China, or the Great Squall of China (which sounds like it might blow over, with any luck). It has certainly cast a Great Pall over prospects for the rest of the year and increased scrutiny of hedge funds, which remain black-box investments, however much their founders may seek to outline strategic priorities in investor newsletters.
Dalio’s Bridgewater Associates is one focus of speculation because its core risk parity investment approach is different from the traditional hedge fund mix of relatively concentrated exposure that is partially offset by mitigating trades.
Bridgewater has a curiously light footprint in global markets for the biggest hedge fund group in the world – roughly $170 billion of assets – and Dalio has fostered a mildly sinister cult of his own personality, which adds to the intrigue.
Risk parity strategies, where leveraged fixed income investments balance equity exposure, were suffering before the latest bout of global turbulence, and cross-asset correlations have been shifting in unusual ways all year. This left outsiders wondering if Dalio’s recent prediction that the Federal Reserve would be forced into further quantitative easing by deflation – even if it does deliver a 2015 rate hike – was a Hail Mary call designed to help hold up fixed income prices.
Dalio has a strong historical track record, however, and is not alone in publicly calling on the Federal Reserve to avoid tightening monetary conditions while the global economy is fragile.
So perhaps investors looking for reasons to be fearful should focus on potential weaknesses in the infrastructure of the modern asset management industry. That is where Fink’s BlackRock comes in.
With assets of $4.7 trillion at the end of the second quarter, BlackRock has been the biggest beneficiary of the shift in trust away from banks and towards asset managers in the years since the 2008 crisis. Its funds have a reputation for sensible risk management – as the relative performance of the unconstrained bond funds at BlackRock and Janus shows.
But as BlackRock looms increasingly large on the investment landscape, its role in defending and improving market structure becomes ever more important. BlackRock is putting enormous effort into addressing concerns about market liquidity, with pronouncements ranging from analytical studies to opinion articles in media outlets. This risks identifying BlackRock very closely with particular investments, as was seen with a robust defence of bond exchange-traded fund liquidity in a recent article co-authored by BlackRock’s head of trading Richie Prager and head of ETFs Mark Wiedman.
They and their boss Fink must be hoping that the next wave of volatility does not come with any embarrassing glitches in BlackRock-sponsored product lines.
Jon Macaskill is a leading capital markets and derivatives journalist with more than 25 years' experience covering financial markets from London and New York. He was for a period of time employed by Deutsche Bank.