There are certain alternative fund managers and derivatives analysts that take an unconventional look at the world. They express a desire for the deep understanding of risk, often looking at the ugly from the inside out. Eclectica Absolute Macro Fund manager Hugh Hendry, in an April letter to investors reviewed by ValueWalk, looks back at the French election and sees the bigger “fat tail” risk that was little discussed in the mainstream: What would happen if the wheels on the euro currency fell off.
Eclectica Absolute Macro Fund manager Hugh Hendry says society sighed in relief at French election, but establishment win was far from certain
After the French election, stock markets in Europe celebrated as “political risk” subsided.
While the French election and populist revolt has “passed without contention,” Hendry remains wary of the market risk just below the tranquil surface seen in historically low volatility.
Hendry considered the establishment the likely winner. And former investment banker Emmanuel Macron did perform as expected amid voters potentially witnessing the results of a populist candidate’s election across the Atlantic.
The stakes were high and most equity portfolios might have seen significant loss sizes if populist Marine Le Pen won the French presidency the euro currency subsequently folded. Such an event would require many of the “risk contracts” that underlie the economic system to be renegotiated, a topic on the minds of certain systematic risk managers but definitively not in the mainstream.
This is a situation many have been watching behind the scenes, as some analysts look at a short volatility strategy with a high win percentage that could find a dramatic loss size depending if the derivatives contracts that insured risk under the financial system are required to pay out.
A disintegration or meaningful structural change of the euro currency is but one worry and even that victory was too close for comfort.
The establishment victory in the French election “was by no means pre-ordained,” Hendry says, roily observing that “nastier outcomes could have derailed the entire euro project.” The man who claims not to have an infatuation with market crisis trades notes it could have been much worse.
Eclectica Absolute Macro Fund manager Hugh Hendry made a “Michael Burry Big Short” bet on populism and fat tail risk if the euro currency folds
Hendry had the Eclectica Absolute Macro Fund positioned for a hedge trade on a disaster, much like the positioning of The Big Short’s reluctant hero Michael Burry. Both bet the unquestioned derivatives exposure was wrong-footed and fought off cynical investors as their bearish thesis was playing out before their eyes.
This disaster trade is one of several types of hedge trades for which Hendry pines, even if he doesn’t admit to this guilty obsession.
From numerous risk management standpoints, it is what the collapse of the euro currency might do to interest rates and related risk contracts that matter. These contracts are essentially based on the concept that the smooth economic trend persists, interest rates don’t rise in dramatic fashion and the euro currency remains the basis for risk contract designation.
If any of these components don’t play out as planned, Hendry’s trade could have paid off under a market crash situation with interest rate divergences.
Hendry maps the risk and waits for the whale of a trade to emerge.
There is typically a cost to hedging, it is just a matter of risk and reward calculations. Hendry says his risk “tails” were “covered” by our positioning in European sovereign bond spreads that had a relatively unbalanced relative value tilt which favored receiving senior financial credit while shorting bank equity futures.
To some derivatives analysts, this might sound a bit like a short volatility strategy with an undefined “senior financial credit” in a relative value spread with a contract on future prices of a bank stock, but a contract of unknown duration.
Hendry, for his part, didn’t detail trade logistics as much as opine on the attractive modeling of the risk profile. “Such was the attractive pricing of this zero carry, convex combination at the time of origination that even after the benign election result played out we had recorded a 1% NAV gain for the year on that trade package.”
While Hendry didn’t specifically state the potential payout, it was likely “asymmetric,” meaning it had a risk / reward ratio that would have paid off handsomely if relative tragedy struck.
“Our trade could have produced sizeable gains should Le Pen have won,” Hendry says in understated fashion. Sounding somewhat like a volatility play, he also notes the strategy could have “even made a little bit with a Macron victory.”
A key for a professional trader is to define clear risk parameters and accept a loss when it occurs. Hendry doesn’t lament what could have been.
“Le Pen didn’t win and it is time to move on,” he says, looking at a -1.9% loss in April for his Absolute Macro Fund. Hendry’s investment thesis is still alive, but this time horizon execution has been proven wrong. “The trade has been closed,” he told investors.
So what now? Eclectica Absolute Macro Fund has a huge stake in four positions. The letter notes:
So what next? Well, since the French election we have re-assessed our view of where the world stands and gradually built the portfolio back up accordingly. As of the time of writing in late May our four largest positions make up around 70% of the risk in the book so are likely to be the main drivers of returns over the next few weeks and months.
What are these four positions?
The letter states:
We have built up a 20 bps DVO1 position short the two-year Schatz futures in the days following the Macron victory; if two year yields were to revert to 0%, the trade has the potential to generate a gross return of around 14%.
Our second major European trade is a long position in German residential property stocks.
Eclectica Absolute Macro Fund letter states:
In the short term, these listed property stocks trade with a high correlation to German 10-year bonds. Over a longer time frame we would argue that this is a bit counterintuitive: property is a real asset not a nominal one, and one that should benefit from higher price inflation across the German economy. Nevertheless, listed equities are subject to the vagaries of the market: plunging Bund yields last year led to the stocks being bid up to a 30% premium to book, but the subsequent sharp rise in longer term yields late last year led to 25% drawdowns and we were able to load up on these stocks at valuations close to book value.
In effect you could say the combination of our two European trades gives us a book which is short nominal assets (Schatz) and long real assets (property) but expressed