A bright spot on a bleak horizon: alternatives offer some respite in tough markets
Alternative investment strategies have been a relative bright spot in an otherwise bleak year for investment returns—and global macro funds have stood out among alternatives. We take a closer look at this one type of alternative investment and the conditions that have been driving its returns.
Alternatives are often used as a portfolio ballast to traditional asset classes, especially in periods of heightened volatility, and investors who have followed that approach this year have benefited. However, alternatives come in all shapes and sizes, and the diversity in returns from different strategies across different market environments is why diversifying across strategies is important to ensure investors can aim to maximize the potential return-enhancing or downside protection characteristics that holding a range of strategies offers.
Maintaining diversified exposure across alternatives is an important approach to help maximize the different roles that strategies can play within a portfolio.
Global macro funds are an alternative investment strategy that invest globally based on broad macro themes such as monetary policy, inflation, interest rates, unemployment, and politics. Macro funds can invest in almost any market globally through multiple sectors and instruments in fixed income, equities, commodities, and currencies. With an ability to invest both long and short, macro strategies can trade regardless of market direction. As testament to the prevalence of macro-driven trends this year, the HFRI Macro Index, an asset-weighted global index of macro investment managers, earned 17.55% through the end of September. In comparison, the Bloomberg U.S. Aggregate Bond Index is down 14.61% and the S&P 500 Index is down 23.87%.
What’s helping global macro funds outperform?
Macro funds trade trending markets, regardless of whether the trend is up or down. And one of the primary risks driving macro trends this year is persistently rising inflation across developed markets.
The extent of central banks’ concern around high inflation is evidenced by their aggressive monetary policy stance and interest-rate hikes, and it’s a warranted concern. For two decades—between 2000 and the start of 2021—inflation averaged 2.30%, 1.94%, 1.69%, and 2.01% in the United States, Canada, Europe, and the United Kingdom, respectively. Now, in major markets such as the United Kingdom and European Union, inflation is pushing through double digits. October inflation in the United States eased slightly to 7.70%, from 8.20%, in September, which is encouraging but still too early to indicate a steady trajectory. In the U.K., October inflation reached a new high of 11.10%.
Decades-high inflation is driving macro trends
Developed markets CPI, 2000–2022 (%)
Source: U.S. Bureau of Labor Statistics, Macrobond, Manulife Investment Management, as of 11/16/22. The Consumer Price Index (CPI) is a comprehensive measure used for estimation of price changes in a basket of goods and services representative of consumption expenditure in an economy.
Persistently high inflation has been the primary catalyst of the trends that macro funds have been trading, including higher and more volatile commodity prices and a strong U.S. dollar.
Strong U.S. dollar
The significant strength of the U.S. dollar relative to other major currencies such as the euro, Japanese yen, Chinese yuan, British pound sterling, and Canadian dollar, has provided prime trading opportunities for macro funds that have been buying the U.S. dollar and shorting other currencies, often using a combination of carry and trend strategies to add gains. This year, to September 30, the British pound lost 17.45% against the U.S. dollar, most of which was within a two-month period. Between August 3, 2022, and September 26, 2022, the British pound lost 12.00% against the U.S. dollar to reach a multidecade low. Rising U.S. interest rates have helped attract investors looking to benefit from rising U.S. Treasury yields, further strengthening the currency. Global macro funds actively trade currency markets and generally have more opportunity when currencies are volatile, and even more so when volatility is sustained, which a persistently strong U.S. dollar is driving.
U.S. dollar strength pushes other major currencies to multidecade lows
Source: Macrobond, Manulife Investment Management, as of 10/26/22. Rebased to 100, where 100=1/3/22.
Volatile commodity prices
Volatile and rising commodity prices are another major trading theme. Large segments of the commodity markets, which were disrupted following Russia’s invasion of Ukraine, remain volatile and are entering the most difficult period of the year as demand for energy commodities increases ahead of and during winter. The OPEC+ group of oil producing countries’ October decision to cut production is anticipated to keep Brent crude oil prices high, adding to the challenge of reducing inflation, which in turn keeps markets unsettled and prolongs potentially high volatility.
Brent crude oil prices per barrel
Source: U.S. Energy Information Administration, October 2022.
Also within commodities, precious metals have provided shorting opportunities after reaching highs in March 2022. Due to a stronger U.S. dollar and rising interest rates, prices for most precious metals have weakened throughout 2022. While gold has been moderately supported by central bank purchases, silver, which is typically affected by industrial demand and the strength or weakness of the U.S. dollar (weakness is better), is the worst-performing precious metal in 2022.
Precious metals prices
Source: London Platinum & Palladium Market, London Bullion Market Association, Macrobond, Manulife Investment Management, as of 10/28/22. Indexed to 100, where 100=1/3/22.
The extent to which inflation remains persistently high and central banks continue on an aggressive path will determine how volatile markets and different asset classes are likely to remain. This year has been conducive to strong returns from macro strategies, and indications are that similar factors will continue driving markets in the near term; however, it’s also prudent for investors to consider how to position portfolios moving forward.
Outlook going forward
Broadly, macro strategies outperform in periods of strong macro trends and high continuous volatility. Conversely, they can face challenges, on a relative basis, as trends shift and volatility recedes. This typically creates an environment in which other strategies such as long/short equity or relative value may perform better through positions within sectors of markets that are no longer trending. An important reminder for investors is that different types of alternatives can have meaningfully different risk/return characteristics, not only relative to each other, but also over time. Therefore, maintaining diversified exposure across alternatives such as long/short equity, market neutral, or merger arbitrage is an important approach to help maximize the different roles that strategies can play within a portfolio from offering potential downside protection to providing differentiated sources of return.
Portfolios that have a greater percentage of alternatives may have greater risks. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.
Alternative investments by their nature involve a substantial degree of risk, including the risk of total loss of an investor's capital. Further, alternative investments are subject to less regulation than other types of pooled investment vehicles, may be illiquid, and cannot assume that investments in the asset classes identified will be profitable or that decisions we make in the future will be profitable. Alternative investments may also involve significant use of leverage, making them substantially riskier than other investments.