An insider's look at hedge funds with Steve Drobny
Steve Drobny is the chief investment officer of Drobny Global Asset Management (DGAM) and author of Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets, a critically acclaimed book in which Drobny interviews 13 hedge fund managers and traders about global macro investing.
Prior to starting DGAM, Drobny was co-founder of Drobny Global Advisors (DGA), an international macroeconomic research and advisory firm. Drobny spoke with CME Magazine about some of the key themes in his book, as well as hedge fund regulation.
CME Magazine: Global macro funds from 1990 to December 2005 posted average annual returns of 15.62 percent and a positive return in 15 out of 16 years, with 1994 being the only down year at 4.31 percent. How have they done since, in 2006?
Steve Drobny: For 2006, macro funds were up about 10 percent on average. It wasn't a great year but it wasn't a bad year either. Since 2003, there has been an incredible equity bull run off the back of what we call “the great macro experiment” – which was the Fed preemptively and dramatically cutting interest rates as the Nasdaq cracked in 2000. Interest rates around the world were extremely low and some fixed currency regimes kept some currencies weak. As a result, since 2003, we've seen all kinds of liquidity flow into risky assets, which have been going straight up – from real estate to commodities to equities. In general, that's not an environment where global macro managers tend to perform well. The fact that they are still putting up solid returns is a good sign. Macro usually performs best when the economy is falling apart, equities are getting trashed and the world looks dire. There is a reason why economics is called the dismal science.
CME: What are the characteristics of global macro funds that have enabled them to achieve such strong returns?
SD: Global macro hedge funds, by definition, are the least constrained, thus the most flexible. Macro managers can do anything at any time within the liquid global markets.
There are individual global macro managers that focus on certain markets or specialize in specific regions. For example, there are global macro hedge fund managers that are emerging market specialists and focus most of their risk outside of the G-10 markets. In general, you would expect a fund like this to underperform a long-only emerging market fund in a raging bull market for EM but outperform in a bear market, because the hedge fund manager is constantly looking for the hedge to limit the downside.
CME: We've seen the end of mega global macro funds like George Soros' Quantum Fund and Julian Robertson's Tiger Fund. Has the market changed fundamentally on a global scale or has competition within the markets just gotten tougher to make huge returns?
SD: The interesting thing about the current crop of global macro funds is that most of them were started after 2000. There is a regular rotation of old names and new names in hedge funds with many new managers coming out of the older, successful funds. So there's a constant reenergizing of global macro talent out there. Regarding your comment about the market changing, I think that's more driven by the investor base. The people investing in hedge funds today are not looking for 30 percent or 40 percent returns that were posted in the '80s and '90s. They are looking for more like 8 percent to 10 percent net returns with low correlation to other markets. Most pensions and endowments have an annual bogey of around 7 percent to meet their liabilities. So if they can get double-digit returns with low volatility and low risk, then an investment in hedge funds is a diversifier and additive to their portfolio construction process.
Today, if you try to open a global macro fund and say to investors, “I'm going to post 50 percent annual returns,” you are not going to get very far with most investors. But if you say you're going to target 10 percent to 15 percent net returns with low volatility, then you can attract investors. So the investor base has changed the game.
I also think investment opportunities aren't as large as they were. There are a lot of people and computers out there looking for unique ideas, which are becoming harder to come by.
CME: You often refer in your book to market shocks and major downturns such as the 1987 stock market crash, Black Wednesday 1992, the bond market rout in 1994, the Asia currency crisis in 1997, Long Term Capital Management in 1998 and the dot com bust. What do those events tell you about global macro investing?
SD: During market shocks, when there is a dramatic trend reversal, while it's often difficult to pick the exact top, macro managers have proven adept at jumping on that shift quicker than most other market participants. They can easily get long interest rates, futures, volatility positions and currency bets that take advantage of the new regime. That's where macro managers have made money in the past and, as a result, are somewhat pre-programmed to look for these types of opportunities. It's also what a lot of investors are looking for with their global macro allocation – to serve as a hedge when other parts of the portfolio aren't working.
CME: Can hedge funds do what Soros did – arguably the guy who brought down the Bank of England on Black Wednesday – or are central banks different today?
SD: I'd argue that Soros did not break the Bank of England. Instead, the Bank of England broke the Bank of England. The UK entered into a policy that was not healthy and that was recognized by the investment community, which took positions accordingly. Eventually, the British government realized that their policy was not in the best interest of their citizens and changed their policy. It wasn't just Soros that recognized the issue; it was the investment banks and prop desks and other hedge funds as well. That could still happen today. When governments make policy mistakes, market participants recognize it and take a position against it. The only difference is there are a lot more people looking for those opportunities, and with the constant news cycle from the Internet, these problems correct much faster. At the same time, governments have gotten much better at reading markets as a result of so many financial types going into treasury and central banking positions. Still, it is often government policy, politicians and bureaucrats that create the opportunities for hedge funds. The political cycle doesn't exactly correlate with the economic and business cycles.
CME: In your book, you also focus on the manager's best and worst trades. Interestingly, most of the hedge fund managers you spoke with were more willing to talk about their worst trades. Why is that and what can traders take from such information?
SD: The keys to longevity in financial markets are humility and flexibility. If you have a strong view that you're right and the market is wrong, eventually it is going to be proven either way. You'll either end up carried out or a star, but a star for a day. Humility and flexibility are very important because markets are constantly changing, and your view needs to be constantly changing.
If you ask good fund managers about their best trades, they'll say they've had a few home runs here and there but it's their bad trades where they've learned the most. We have a concept we call “scar tissue,” which means we like managers who have been taken through the wringer, blown up or had major problems in their trading history. As a result, they have a certain amount of scar tissue that will hopefully stop them from going to that deep, dark place in the future.
CME: So are the best traders the ones who are even-keeled and can strip emotion out of it?
SD: Yes, the best ones are those who think in terms of probabilities as opposed to monetary gains and losses. If you view everything in terms of probability, you're going to make money some days and lose some other days. And if you can skew those probabilities in your favor over time, you will generate alpha. If you wear your P&L on your sleeve, you'll burn out. Personal volatility is not sustainable.
CME: Of course, hedge funds take a variety of approaches to trading. In global macro investing, do you see too many firms trading the markets in the same way? If so, is that herd mentality harming returns?
SD: I disagree completely. Within global macro, you rarely find people doing the same thing. If you look at the fund managers in my book, you'll see one manager is a commodities specialist, another is an emerging market specialist, another is in equities and so on.
We hold a semi-annual conference where global macro fund managers stand up and present their best ideas in front of about 100 of their peers. Let's say one of those ideas is to go long Middle Eastern equities because of some macro fundamentals. You could have the entire room take the position, and in a year's time, their P&Ls would be completely different because some people would express their strategy in some countries but not others. Some would do it through equities while others would express the view in currencies or the bonds. Some would take profits or cut losses sooner than others, some would do it through swaps, some would hedge the position by shorting oil, others would do everything through options, etc. There is a tremendous amount of diversity because global macro has no definable mandate except to make money.
CME: Many global macro fund managers in your book have foreign exchange trading experience in their backgrounds. What does that knowledge base do for their trading or perspective as hedge fund managers?
SD: Foreign exchange is the largest market in the world in terms of daily turnover and daily liquidity. A lot of macro managers are running pretty big asset bases so they tend to gravitate toward the most liquid markets. Meanwhile, very few other hedge fund strategies utilize foreign exchange as an asset class, so that is a differentiator. Finally, foreign exchange is where a lot of macro managers made their money in the 1980s and 1990s, so there is a familiarity and comfort zone. FX really takes into account everything – interest rates, equity markets, commodity prices, geopolitics, central bank policy – it's the one market that sucks in all the variables in the world.
CME: You watch a lot of hedge funds and advise them. What are hedge funds doing differently today than they did a few years ago? What do they do that's the same in terms of trading and operations?
SD: They pretty much look the same. They have a portfolio manager looking at screens and prices, talking to counterparties while their research analysts are out there looking for ideas that are ahead of the market. The goal is to make a positive annual return although the focus has become a lot shorter from an investor standpoint.
It's slightly different in that the world has become much more quantitative and we've learned a lot more. The seat-of-your-pants style of “I feel this” or “I think I'm better at that” is going by the wayside. I don't think going pure quant is the answer, but having a certain amount of statistical analysis, coupled with experience and good judgment, is becoming the dominant approach for global macro managers.
CME: Are fees today in line with performance from hedge funds?
SD: The important thing about fees is net returns. Also, every hedge fund has to properly manage investors' expectations. But at the end of the day, if net returns are higher than the end investors' bogey and are uncorrelated to other markets, then a manager is providing the service they were hired to do.
CME: Should hedge funds be regulated?
SD: People talk about regulation like its going to save the planet, but we should stop and think about what the end goal is as opposed to just regulating for the sake of it.
If regulation of hedge funds served to keep fraud out of the hedge fund industry, it would be a good thing.
But at the end of the day, I doubt government regulation will be that effective. Meanwhile, most hedge funds, especially the large successful ones, are operating at a level well above and beyond what any regulator would require.
CME: Some in Congress are concerned because hedge funds hold huge positions in the markets today. Therefore, some feel they have to keep an eye on them.
SD: Do you think regulators in Washington could actually do anything even if they had the information? Could they help save the world if they knew a multistrategy hedge fund in Connecticut was taking a huge leveraged position in natural gas? No, they wouldn't because they wouldn't be able to act on the information. Yet that hedge fund did blow up and nothing happened despite the fact that many of its investors were SEC-regulated!
Maybe a hedge fund or two taking down the world was an issue when there were just a few hedge funds out there, as was the case in the 1990s. But now there are 10,000-plus hedge funds operating in much deeper global markets such that I don't believe it's an issue anymore.
CME: Some in the investment world worry hedge funds may be the cause of the next market collapse.
SD: The cause of the next market collapse will be something that nobody is talking about right now – an earthquake that knocks the seventh largest economy into the Pacific or something like that. The point is that a market shock is unpredictable. That's why it's a surprise. I'm not worried about hedge funds blowing up the world – the world is pretty resilient.
CME: What is the next hot sector space in terms of new contracts – e.g., credit derivative futures, event futures, emissions or weather?
SD: Climate, carbon, water, electricity, weather. These all seem to be at the beginning stages of something important. But you never know. It seems that nowadays, anything that can be quantified or counted will soon be tradable.
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