Systematic Macro Investing – Made Simple Guide by Pensions and Lifetime Savings Association
The central problem any pension scheme faces is how to ensure it has the funds to pay its liabilities as and when they are due.
A key aspect of this is ensuring the assets the scheme is investing are generating the necessary returns. There are many ways to approach this. If the behaviour of the underlying financial markets were more predictable then the job would be an easy one, and much less ink would have been spent on finding the ‘optimal solution’.
Accepted practice, though, is for pension schemes to divide the investment management problem down the middle, by separating decisions on how to allocate to a range of assets, such as shares, bonds and property, from those on how best to invest in each type of asset. At Winton, we have spent much of our 18-year existence consigned to the ‘alternatives’ allocation of the typical institutional portfolio, within which we are often labelled ‘systematic macro’. It is in this space we have built our reputation. However, we are not an asset class in the sense that other alternative investments such as property, forestry or distressed debt can be considered. Instead, it is our approach – rather than the markets we invest in – that is alternative.
While systematic macro can appear complex at first glance, many of the concepts that underpin it are intuitive and, in our view, it is well worth the effort in taking the time to understand. In the following guide, we endeavor to introduce how Winton and our peers approach investment management and, in turn, we hope to demonstrate how such an approach could benefit your pension scheme.
Chief Investment Officer, Winton Capital Management
What Is Systematic Macro?
In this guide we will be examining one of the most extensive applications of systematic investing, the systematic macro style of hedge fund.
A ‘hedge fund’ is a flexible investment vehicle that seeks to generate profits for investors, regardless of whether financial markets are rising. There are many types of hedge fund, and ‘global macro’ is a broad-brush label used to describe those that employ a range of global data in an attempt to predict and profit from rises and falls in markets around the world. The success and breadth of such an approach has turned some of its biggest fund managers into household names. George Soros, for example, gained fame (or notoriety) in the UK when his bets against the British pound “broke the Bank of England” and contributed to Britain leaving the European Exchange Rate Mechanism in 1992.
There are two fundamentally different approaches to global macro investing: ‘discretionary’ – that is, the likes of Soros, where investment decisions are based on the analysis and judgement of an investment manager or team – and ‘systematic’.
Even though it is now considered a subset of the global macro hedge fund genre, ‘systematic macro’ is a term used – often interchangeably with ‘managed futures’ or ‘commodity trading advisors (CTAs)’ – to describe an alternative investment approach with roots as far back as 1948; arguably predating global macro strategies and hedge funds themselves.2
Starting with speculators hand-drawing charts to identify simple trading patterns that can profit from trends in the value of commodity contracts, systematic macro has evolved, alongside financial markets and computers, into the global and digitalized industry it is today: a distinct and important alternatives allocation for many pension funds around the world.
The systematic macro industry currently manages around US$300 billion; involves over 500 different investment managers; and has provided pension funds, foundations, university endowments and individuals with annualized returns of 9.0% over the past 20 years.
In pursuing a systematic macro approach to investing, fund managers tend to follow a clear, three-stage investment process:
- Collect huge datasets from a diverse range of sources;
- Analyze the data to find persistent patterns; and finally
- Encode trading rules into a computer-based program to profit from the identified patterns.
These rules can then be used to trade financial securities around the world, 24 hours a day. The most common example of a pattern that systematic macro funds seek to exploit is the price trend, which we will discuss in more detail later on.
Typically, such an approach invests in futures and forwards, which are contracts that derive their value from an underlying asset, often a commodity, market index, bond or currency. Some systematic macro funds invest directly in company shares, or ‘equities’, as well. The global nature of these markets means that there is a large number of hedgers, speculators and investors willing to take the opposite side of transactions. Altogether, this deep and easily-traded choice of investments helps with liquidity – that is, being able to open or close a position when desired – and provides huge datasets on which trading systems can be researched, built and tested.
Back To The Futures: An Introduction To Derivatives
The majority of systematic macro investments are made through derivatives such as futures and forwards. These are contractual agreements between two parties that involve buying or selling set amounts of commodities, financial instruments or currencies in the future. They are called ‘derivatives’ because they derive their value from an underlying commodity, financial instrument or currency.
Derivatives contracts go back as far as ancient Babylon. However, the first formal trading is believed to have started in 1710 on the Dojima Rice Exchange in Osaka, Japan. In 1865, standardized futures contracts were introduced on commodities in the US by the Chicago Board of Trade as a way to help farmers and merchants shelter themselves from fluctuations in the price of their goods. They were later introduced on financial instruments such as stocks, market indices and bonds from the 1970s, which dramatically increased the investment universe for systematic approaches.
Futures are contracts where a buyer or seller agrees to exchange an asset at a fixed price at a fixed expiry date in the future. They are traded on exchanges and, on the expiry date, the contract is settled by delivering or receiving the underlying asset or by paying the difference between the contract price and the asset price. Futures buyers profit if the underlying asset price is above the contract price at expiration; futures sellers profit if the underlying asset price is below the contract price at expiration.
Forwards are similar to futures but are customized as they are a private transaction between two parties; they are not exchange-traded and are primarily used by systematic macro funds for taking positions in currencies.
Systematic Versus Discretionary
Discretionary investing is – and continues to be – more widely used than systematic investing.
Intuitively, trusting a trained individual to invest on behalf of beneficiaries might feel more comfortable than using an automated program. However, there are clear benefits of a systematic approach, highlighted in the table below.
Many Pension Funds Already Use Systematic Investing
In addition, it could be argued that nearly 10% of the world’s estimated US$87 trillion assets under management are already invested systematically: the US$8 trillion invested in index-tracking or ‘passive’ products.
An index by its very nature is a system, governed by a set of trading rules. A FTSE 100 Index tracker, for example, invests in the shares of the hundred largest companies listed on the London Stock Exchange, and it weights each position by a company’s free-float market capitalization. Whether a stock is bought or sold by the fund is based on these predefined criteria.
Systematic macro funds are similar in that they take a rules-based approach to investing. But rather than simply attempt to replicate the performance and makeup of a market index, managers use dynamic, research-based strategies and rigorous risk management processes in their search for consistent investment returns.
How Do Systematic Macro Funds Generate Returns?
Given that pre-defined, rules-based investments can be replicated by competitors, systematic macro fund managers often need to be secretive about their trading systems to prevent them being copied by other market participants and to stop returns being eroded for their investors.
This often leads to the misconception that systematic macro funds are highly complex. It is true that the identification and application of successful systems is challenging, but the principles underpinning many of the main strategies are fairly straightforward.
Systematic macro funds are also not constrained to the traditional equity and fixed income asset classes and can profit from price movements across a truly multi-asset investment universe: this can range from increases in livestock and crop prices to falls in major stockmarket indices around the world such as the S&P 500 and the Nikkei 225, which follow the most valuable companies listed in the US and Japan, respectively.
The esoteric nature of some of the markets in which systematic macro funds trade, while unfamiliar to some investors, can add compelling diversification benefits, as can the range of investment strategies they operate.
Trend following is one of the most common strategies pursued by systematic macro funds. Put simply, trend following involves buying (selling) an asset when its price starts to rise (fall) in the hope that it continues to rise (fall). Trend followers can benefit from both rising and falling prices by buying and selling futures contracts on assets, respectively.
There is a great deal of empirical evidence that suggests trends in financial markets exist, and even some of the most prominent markets have exhibited this behavior; for example, the US stock-market over the past 15 years, represented by the S&P 500 Index.
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