Global macro views combine with quantitative models to produce consistent returns

The team behind River and Mercantile Group’s global macro strategy team operates under two key principles: that macro is the most important aspect of any investment decision and that decision-making should incorporate both systematic and discretionary processes.

Running a hedge fund is a relatively new experience for River and Mercantile. Although known more for providing a range of services including long-term investment funds to asset management, pensions advice and fiduciary services, it was logical to move into more alternative solutions. 

While macro – with $2.1 billion assets under management – is the smallest of River and Mercantile’s four investment lines, it is the natural home for the group’s first hedge fund, the Global Macro Fund, which launched in February 2018 and is managed in the UK.

“It was a natural progression for us. For a long time we’ve built quantitative models to help inform our macro views, and these have fed a discretionary decision-making process. Over the past five years though, we’ve taken this further. The global macro strategy is systematic – we’ve made the link between the quantitative models and positioning more explicit,” explains co-portfolio manager Joe Andrews. 

With nine years of industry experience, Andrews co-manages the portfolio with industry veteran Mike Faulkner, who, with 27 years of experience, is group chief investment officer. 

The team begins with several advantages not usually available to start-up hedge funds. River and Mercantile provides substantial infrastructure and operational benefits for the fund, allowing the portfolio managers to focus purely on investment and keeping fees competitive. The group’s substantial derivatives trading team is another plus as it can efficiently execute positions within the portfolio, also keeping costs down. 

 

A different take

The strategy is a different take on the more traditional global macro quantitative funds usually run by hedge funds. River and Mercantile’s global macro strategy is run on a systematic basis using a series of models to size positions. The evolution of these models is led by the discretionary research undertaken in-house. 

“We decide where to direct our research – something that’s underplayed by a lot of pure systematic strategies. There are elements of discretion in every systematic process. We are big believers in having a balance between those two pieces,” says Andrews.

The models determine how the portfolio should be positioned and in which markets while, on a discretionary basis, the portfolio managers – using their overall global macro view – try to pinpoint and understand where the models could be wrong and where to direct future research.

“We have to have a clear understanding of the models’ weaknesses. We direct our research to the factors we think might be more important in the current market environment versus the last one. It’s a crucial part of how we evolve the strategy through time,” Andrews explains.

This does not mean ‘humans’ are continually tinkering with the models – rather, the team examines the relationships between the systematic model and the global macro view expressed by the team. “We have to be able to reconcile the output of our models with our views. We’re guided by a systematic framework, but our overall global macro (view?) oversees these processes,” he adds.

There also needs to be a solid correlation between the economic transmission mechanisms that guide the variables. For example, data may present a false relationship between the price of oranges and Chinese factory output over a particular timeframe. Such false relationships make no sense, but could be captured by models unchallenged by a global macro overlay. “While guided by a systematic framework, things need to make sense, and it is the discretionary decisions and the overall global macro view that oversees these processes,” says Andrews.

 

Market forces

There are a series of macro factors and signals – which Andrews calls market forces – used as inputs to the models. These forces have different timeframes, and understanding them is an important part of being able to use them to construct a portfolio. For example, valuations are a longer-term input. Just because a market is expensive does not mean it is going to fall in the short term.

Andrews says: “Markets don’t fall just because they are expensive, especially if other shorter-term forces are supporting them. Valuations give you an idea of vulnerability. If other macro forces turn against an expensive market, you can lose a lot, but it’s the shorter-term forces that cause it to turn against you. The speed of each force is crucial.” 

The direction of prices is influenced more by shorter-term factors. If something such as credit conditions weaken over a short horizon, the strategy will take note of it quickly.

Traditional macroeconomic factors such as GDP and the purchasing managers’ index that the team build forecasts for, are macro factors that work over a medium-term horizon. “Essentially, the way we package macro factors/forces recognises that some are quicker, with varying impacts,” he notes.

River and Mercantile’s venture into hedge fund builds on its belief that global macro is the purest form of its best ideas, accessing what the company has learned works well, combining a macro view with what it calls a ‘market motion’ to determine position size, allocating across multiple asset classes and strategies.

An element of the strategy unique to River and Mercantile is its use of market motion. It identifies five phases of motion, which are used to give confidence in a position: trending up, trending down, consolidating to move up, consolidating to move down, and drift. The portfolio allocations focus on motion that is persistent over six months on average, with the models looking at a timeframe of between two to six months.

Unlike many other strategies, Andrews sees trend as only one type of motion: “It’s the most distinct, well known and easily quantifiable. It is probably the most powerful in terms of return generation, but there are other types of market behaviour that we think are useful.”

 

The importance of trend 

While macro is a significant driver of how the portfolio is positioned, trend is also an important factor. However, trend has its own challenges and environments where it just does not work. “The key missing link was the macro environment. The strength of trends and whether they are likely to persist or not is driven by the state of the macro environment,” he says. This means that, when other managers may find market conditions difficult to produce returns, River and Mercantile’s approach may find value.

When considering motion, there are factors that can shorten or lengthen duration depending on the prevailing environment. “We know trends can move quicker or slower depending on the macro environment, but generally we focus around six months. That’s where our macro views really start to kick in.”

The macro view is built across a series of assets, including credits, rates, currencies, commodities and equities. The process overlays this with market motion. Andrews says: “If we’re expecting an asset to move in a particular direction, and it is, we can be quite confident we’re on the right path. If an asset is moving in the opposite direction to how we expect it to, then there’s clearly something we’re missing and we won’t allocate.” 

For example, the absence of a negative trend can be a good time to be invested if an asset delivers a high amount of income, in particular. “We’re not just looking at markets that are trending. We’re trying to consider the whole concept of how markets are behaving and interacting with our macro views before making allocations.”

There is always a judgemental overlay to ensure the systematic and discretionary views are consistent. “We stick to the market we know and understand. We restrict ourselves to around 30 major markets and different asset classes that we think respond to how we look at the world,” notes Andrews.

For example, one area the fund steers clear of is foreign exchange. Andrews sees little value in focusing on this area, instead preferring equity, credit rates and commodity markets where the risk-adjusted returns are stronger.

On the whole, Andrews believes investors will be interested in this strategy because it targets a high absolute and risk-adjusted return, and should add stability to any portfolio in a consistent way. 

“We’ve been managing macro portfolios for 16 years and we’ve taken all of that thinking and what we have learned over the years and built it into this strategy – where we have more flexibility and can really reflect our views at a particular point in time – rather than be constrained by restrictions that come with ‘traditional’ mandates,” he says.

The team conducts most of its own research. Andrews notes: “We think for ourselves. We want to know and understand every position and the factors that are causing the allocations – we don’t want to lose sight of the key factors driving our models. We’re not aiming to build an artificial intelligence beast that controls what’s going on. We know our markets, areas and the factors that matter and we keep focused on that,” notes Andrews.

Existing investors in the fund are often those already familiar with River and Mercantile’s long-only global macro investments. “We wanted another way for our clients to access our macro views and to attract new clients in a strategy that focuses on generating return,” Andrews says.

 

Conclusion

The decision to launch a Ucits fund was made with one eye on the existing investor base as well as the popularity of the structure. The strategy fits well into the Ucits format and Andrews believes it is not restricted by the constraints placed on Ucits funds.

He admits the fund was not set up to conform with the industry’s view of what a macro hedge fund ‘should’ look like, or compete with a specific peer group. It shows little correlation to the other more traditional global macro funds already established. 

The intention is to deliver high absolute and risk-adjusted returns, but that depends on the strategy’s ability to be positioned on the right side of the market. “We have the ability to be flexible and vary the level of risk we are taking. We don’t target a level of volatility. We don’t target having to own a particular number of assets at different points in time. We’re happy running a volatility annualised at 5% per year or running that up to 20% if we see the opportunities.

“Higher volatility would be as a result of high conviction in our macro views and how strongly market behaviour supported those views. If we have a positive macro view for a number of assets and a responsive, supportive market environment behind them, we will allocate meaningfully to take advantage of that market environment.”

“We only want to be allocated to markets that we think are supported. When opportunities aren’t there, we will reduce exposure right down. That’s a big factor in being able to deliver consistent and high risk-adjusted returns,” confirms Andrews.

This approach has paid off with a performance of around 11% in 2019 with a volatility of around 7% and a Sharpe ratio above 1.0. The fund, launched with internal seeding of only $7 million in early 2018 and grew to more than $120 million by the end of 2019.

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