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The Case for Macro

Our Dynamic Allocation Strategies team explains why global macro investing offers many potential benefits when included in an investment portfolio. Read More (PDF)

Emerging Markets Outlook for 2017

The past 12 months have been fairly turbulent in emerging markets, but a number of factors support emerging market performance.  Read More (PDF)

Our Approach to Global Macro Investing

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In a previous post, my colleague explained some of the characteristics and potential benefits of global macro investing; here, I explain our investment process in terms of three stages: Where, Why, and How.

As background, the William Blair Dynamic Allocation Strategies team employs a discretionary global macro approach that has a long-term, fundamental value foundation; views fundamental opportunities through thematic and geopolitical risk lenses, among others; actively manages currency; and dynamically manages risk.

To understand our investment process, it helps to think in terms of three stages: Where, Why, and How.

  • Identification of value/price discrepancies: Where do prices differ from fundamental value?
  • Assessment of opportunities: Why do prices differ from fundamental value?
  • Designing the portfolio: How do we best capture value/price discrepancies?

Let's look at each stage in more detail.

       1. Where: Identify Value-to-Price Discrepancies

Focusing on top-down fundamentals, our team seeks to identify, evaluate, and benefit from the correction of discrepancies between fundamental value and price.

Investment opportunities exist when we observe large discrepancies between our estimate of a market's or currency's fundamental value and its current price.

We determine value using proprietary discounted cash flow models for equity and bond markets and a relative purchasing power parity framework for currencies. We then compare value to current price.

Investment opportunities exist when we observe large discrepancies between our estimate of a market's or currency's fundamental value and its current price.

Since we view our investments from a macro perspective, we are often asked how we can determine fundamental value for an index differently from how an analyst might determine the same for an individual company. Just as a specific company's cash flows respond to certain drivers, such as an energy company's to the variation of the price of oil, cash flows for a diversified collection of companies respond to other, broader drivers, such as economic growth.

Often these influences are more easily understood when looking at longer time horizons as individual companies are prone to company-specific risks, which can alter expected cash flows. These idiosyncrasies, however, can be diversified away when evaluating a collection of companies that instead respond to broad economic themes.

Currencies: The “Forgotten” Alpha

One of the differentiators of our approach is the extent to which active currency management—which we believe is one of the most misunderstood and unrecognized components in investment management—is used.

Conventional wisdom asserts that it is difficult, if not impossible to establish fundamental value for exchange rates and/or consistently earn a positive return using fundamental value as a point of orientation. Naturally, that keeps the exploitation of fundamental currency opportunities a relatively rare phenomenon within the competitive landscape.

Scarcity in this realm helps promote inefficiencies—and we are happy to operate in inefficient areas where we believe we have uncommon expertise.

To wit, empirical evidence not only shows the previously referenced conventional wisdom is incorrect, but also demonstrates that the pull of fundamental value is actually stronger and quicker for exchange rates (with a three- to five-year reversion horizon) than for equities or bonds (with a five- to eight-year horizon).

Currencies also have little to no correlation with equities and bonds, so they are a powerful diversifier. The combination of their strong value-reversion and diversification characteristics is why we, on average, take a relatively large amount of currency risk within our strategies.

Why We Avoid Commodities

We do not directly invest in commodities. Because commodities do not generate cash flows (or yield), they lack a true fundamental value. Instead, commodity prices are driven by supply and demand forces, which in turn can be affected by trends in demographics, weather patterns, and production deals orchestrated by small numbers of major players, such as OPEC. That said, the direction and volatility of commodity prices is important to the size and type of exposures we may choose to take in markets and currencies.

       2. Why: Assess Opportunities

Although fundamental value is the foundation of our investment process, relying on it alone as a means of investing is insufficient. The Why stage of our investment process involves the evaluation of non-fundamental influences that can materially affect the path that prices take to converge on value—influences that can act as short- to medium-term tailwinds or headwinds. To evaluate Why prices differ from value, we currently use three main frameworks:

  • Conventional Wisdom is a multi-dimensional assessment of recent economic activity, monetary policy, and the degree of risk aversion across a number of geographical regions. This provides insight into the sentiment of the market and an idea of what is already being “priced in” by other investors.
  • Macro Themes are identified that cut across asset classes and geographies. These themes, which typically last for a few years, are modeled as risk factors than can alter compensation, risk, or correlations in our near-term (Outlook) risk model. These themes can evolve over time, changing in both their intensity and in how they directionally influence certain markets and currencies.
  • Geopolitical Analysis is used to understand global political situations, such as conflicts and elections, and negotiations. Here, we use Game Theory, which involves identifying key players, their objectives, and the different powers they can wield to achieve these objectives. The purpose of this analysis is not necessarily to predict outcomes, but rather to better understand the consequences of such outcomes. This framework helps ensure that we are not surprised by developments as they occur, and this approach can help either avoid risks that the market underappreciates or take compensated risks where the market is overly cautious.

       3. How: Design the Portfolio

The final stage of our process is the merging of the Where and the Why into an integrated, calibrated portfolio of risk exposures pursuant to the specified risk budgets.

Here, we use two proprietary, forward-looking risk models to guide portfolio construction.

  • Equilibrium risk model. This risk model encompasses a long-term view that can be thought of as a “normal” state of risk.
  • Outlook risk model. However, because a true normal state of risk rarely exists, we also view our exposures through a shorter-term model that originates with the Equilibrium risk model and is then “distorted” by non-fundamental influences such as themes and game theaters to arrive at a framework we believe is consistent with the current risk environment.

One of our forward-looking assessments is that equities and bonds have a small positive correlation over the long term, based on our Equilibrium risk model. However, in the near term, in our Outlook risk model, these asset classes actually have a negative correlation.

Aspects of the Why stage of our process are modeled into our Outlook risk model and directly influence the extent to which it differs from our Equilibrium risk model.

In my next post, I will take a deeper look at the How part of our investment process—constructing a portfolio and dynamically taking risk over time.