In the 46-page Omega Advisors October 17 letter to investors is an issue that hits a raw nerve among many alternative asset managers. How is it that hedge fund managers, which in large part feast off an understanding of how the macro environment works and where mispricing was located, could find such an unprecedented string of underperformance? Steven Einhorn, a partner at the firm, looks in part to the central bank balance sheet as he correlates the two to consider the issue that dates back to 2009.
Central banks should not be criticized but they are involved in creating a low volatility global environment
There is an attention-grabbing chart on page 4 of the third quarter Omega letter to investors. It shows that in the wake of the 2008 financial crisis, hedge fund returns have faltered as the size of the US Central Bank balance sheet has ballooned. The S&P 500 has more than doubled the returns of hedge funds since 2009, the investor letter revealed.
Einhorn doesn’t necessarily blame central banks nor is he a reflexive critic. “The Fed did what it had to do to stabilize the economy,” he told ValueWalk in an interview Friday. Given the challenging economic market environment that was created in the wake of the 2008 market crash, “It was the right policy and it should not be criticized.”
The repression of global volatility and the lack of stock price dispersion that resulted from quantitative easing are part of the issues in lackluster hedge fund returns. It’s not only the Fed that is causing low volatility. The ECB and BoJ play a role, but it’s a global phenomenon involving lower volatility of economic growth and inflation for structural reasons.
“Well below-average equity market volatility/well-below average dispersion in individual security returns/a high correlation between shares/ below-average bond market volatility/less breadth in market leadership, all are the enemies of active management,” he wrote.
The influence of central bank bond buying moves past bond macro environment
The increase in the Fed balance sheet resulting in central bank bond buying and tranquil volatility has transcended the bond market and is influencing the broader macro environment, including the stock market. Prior to 2008, the notion that a central bank might tip the scales of a free market might have seen unusual. Could Einhorn see central banks buying government and corporate bonds to this extent? “No,” he said, “but I could not prior to 2008 envision an economic and credit capital market landscape that we experienced.”
But the good news for active managers is that things are about to change.
To see active management outperform passive, “one has to believe that: asset price volatility will lift over time, dispersion of individual security returns within the equity market will increase, the correlation between securities will decline further, bond market volatility will increase, and leadership within the equity market will broaden,” he wrote. “We anticipate all of these items.”
The return of a positive macro environment for active managers is coming because the Fed is beginning to tighten policy and shrink the size of their balance sheet at a time monetary policy outside the US is “turning a bit less expansive” and fiscal stimulus might be on the horizon. Add to this the likelihood of tax reform and a mean reversion for US economic growth – plus the potential for geopolitical tensions to create a buying opportunity – and the macro environment for active managers is looking strong.
“The developing shift in U.S. and global monetary policies, uncertainty surrounding U.S. tax initiatives, a severe lack of bipartisan cooperation in Congress, an aging U.S. economic expansion, and global geopolitical challenges, all suggest greater volatility in U.S. equity shares/greater dispersion in individual security returns/less correlation of individual security returns,” he wrote. "If correct, active money management should begin to fare better relative to passive indices,” a situation he says is already underway.