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Despite being the laggards of the hedge fund industry over the past five years, macro funds are looking to return to form in 2013 as a dramatically shifting global environment plays to their advantage. However, some trends observed by industry experts may weigh on the ability of managers using these strategies to outperform the broader hedge fund industry. A change in investor types has shifted the focus from large scale profit and loss swings to managing towards lower volatility. This reduced risk appetite may keep many funds on below average hedge fund performance, despite a favorable macro environment for the strategy.

Over the last five years macro focused hedge funds, which use elaborate models to allocate capital between various regions based on economic outlook, have only earned approximately 2.2 percent per year. This compares poorly to the 2.8 percent for the broader hedge fund index, even though that level of return is somewhat disappoint in of itself. This year hedge funds have shown some signs of improvement with an average return of 4.4 percent after fees to the end of April, but macro funds continue to trail posting only a 2.3 percent gain.

New School, Old School Approaches to Risk Taking

In their analysis of the performance of macro funds, the Financial Times cited the commentary of Mark Dow, who writes the Behavioral Macro Blog. Dow believes that macro fund managers can be broadly split into two groups, with an old school or new school approach. Old school managers, reminiscent of George Soros, took big fundamentally driven bets with substantial risk, as they were willing to take large swings in their period return in order to outperform over time. The new school managers take a much more conservative approach, using macro models primarily for risk management purposes.

One of the big drivers behind this switch is the clientele of hedge funds today. Prior to the financial crisis, hedge funds were the domain of risk takers or otherwise sophisticated investors that could tolerate some volatility if it suited their portfolio objectives. Now, however, this clientele base has shifted with hedge funds marketing aggressively to pension funds and other institutional investors. In order to attract many these clients, lower volatility in earnings is required when compared to the old school, more cowboy approach to macro fund management.

Low Volatility Approach Likely to Remain as Long as Institutional Money stays Interested

This focus on lower volatility is likely to continue so long as hedge funds are viewed as a viable mainstream investment class for institutional money managers. With fixed income yields hovering near historical lows, these fund managers will continue to look to hedge funds as a source of diversification that may offer more return upside than languishing Treasuries. And of course, hedge funds will be eager to capture this potentially large source of fee revenue by making adjustments to their investment strategies.

That said, a real opportunity does exist for macro fund managers in light of the untested monetary policy being undertaken in many countries today. Rapid currency movements and highly volatility equity and debt markets will remain the name of the game for some time. If some fund managers adopt a more old school approach, they could certainly stand out as all-stars in a segment of the hedge fund world that has been struggling to post exceptional returns.

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Hedge funds have seen a significant change in their investor base in the last year as wealthy individual investors exit the asset class, according to a recent Reuters article, no longer seeing the same return potential in the lower risk strategies being executed by hedge funds today. The industry is beginning a transition back to its roots in many ways, focusing on providing an alternative asset class that provides consistent returns but is not linked to equity or fixed income indexes. Who is the big buyer of these kinds of investments? Institutional investors such as pension plans and endowment funds that are seeking out higher returns than fixed income can currently offer, while still providing a low beta to traditional equity indexes.

For many hedge funds, the big investments sizes and longer term commitments of institutional investors are hard to pass up. Overhead and transaction costs are lower as well when dealing with large investment block sizes, which reduces costs for the fund, often pocketing some of the savings.

Growth of the Industry Driven by Institutional Demand

The hedge fund industry has grown rapidly in the past two decades, from a mere $200 billion in the mid-nineties to the $2 trillion industry that exists today. This massive growth required significant institutional money, and the industry will require continuing support of big pension funds to maintain their current assets under management.

Initially, hedge funds were largely an asset class used by institutional investors to diversify their holdings and earn consistent returns using sometimes unconventional strategies. During the several year run up in equity markets, leading to the 2007 pullback, hedge funds began taking larger risks to ensure their returns were competitive with highly attractive equity indexes. Funds did this through the addition of leverage, through either traditional margin transactions or through the use of derivatives to enhance returns. Institutional investors enjoyed the higher returns, but were sharply bitten when markets retreated and hedge funds were hit hard. At that point, there was somewhat of a retraction of some institutional money from the hedge fund space. The industry focused on high return strategies for the following years as they attempted to beat the equity indexes for the redemption needed to retain their clients. Some funds were successful, but many funds continued to lag indexes or experienced undesirably high volatility. A change in focus was required.

The institutional investor’s reluctance to invest in hedge following the crash began to wane along with the decline in fixed income yields. Bonds provided an important diversification tool for portfolio managers, but historically low yields made it difficult for fund managers to meet performance benchmarks. Some institutional fund managers began to look to the hedge fund industry to provide products that offered consistent returns, without being overly correlated with equity indexes. This was really a call to return to the roots of hedge fund investing.

Does This Have Implications for Job Seekers?

The hedge fund industry has been surprisingly resilient over what is turning out to be a tumultuous decade. While hedge funds are currently looking to reduce costs where possible through eliminating overhead and some trading activities, the industry does remain more steady than, for example, IPO investment banking. The hedge fund industry’s shift back to its roots does demand a different skill set than the high risk trades that we saw in the years following the turn of the millennium. The industry now is focusing more on traditional portfolio and risk management techniques, rather than elaborate trading strategies. This certainly opens a door for individuals with experience in these areas, as many funds don’t have great bench strength in what were under-utilized niches of the investment profession.

The outlook in the industry remains mixed. If historically low bond prices remain, hedge funds are likely to see increased investment from institutional investors desperate to squeeze additional return from their portfolios. At the same time, regulation and overall concerns about the economy weigh on funds. Those seeking employment in the sector should have a high level of relevant experience, and they will need to be extremely opportunistic to seize the more desirable opportunities.

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