What’s Scarier—Inflation or Interest Rates?

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Scott Minerd, the global CIO of Guggenheim Partners, recently tweeted his thoughts on two of the biggest risks facing institutional investors. He predicted “US inflation problems are years away,” adding that US interest rates will likelier fall than rise because of current market turbulence.

For many CIOs, the two risks cannot be separated. “Interest rate risk will only become an issue if inflation risk rises sharply,” says Stefan Dunatov, CIO of the UK’s Coal Pension Trustees Investment. “This can happen in two ways. Either inflation rises sharply and central banks are forced to raise rates, or the bond market anticipates inflation is likely to rise sharply and forces rates at the very short end higher. Either way, you can’t have rate risk without inflation risk.”

For the UK’s pension lifeboat fund—the Pension Protection Fund (PPF)—fast-rising rates are the biggest problem.

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According to CIO Barry Kenneth, if the fund has hedged effectively, it is essentially left with a cash-based benchmark. With the PPF’s high proportion of global bonds, credit, and other debt, rising rates potentially spark a duration problem.

A different perspective comes from America. Frank Ahimaz, CIO of the Museum of Modern Art in New York, says he’d be very surprised if investors were concerned about inflation over interest rates—but that a rising-rates market should worry investors, particularly if they’re investing in emerging markets. “We tackled our developed interest rate exposure by moving all our securities to floating rate notes,” he says. “Our gut feeling is it will be 12 to 18 months before the Fed does anything to rates, and then it will be little by little.” Ahimaz has no exposure to emerging market securities, but fears for those who do. “Let’s say you have some exposure to Turkey, where they’ve seen a 500 basis points increase to rates overnight. I can only imagine what impact that would have,” he says.

Deflation risk is also creeping up the agenda. Aviva pension CIO Ian McKinlay explains that he manages that risk by delta hedging as inflation expectations fall or the volatility of inflation rises. He also carries a reserve for deflation risk.

“The pricing of linkers suggests the market worries more about inflation than rates,” he adds.

He’s right: For many, inflation is the far scarier prospect. Centrica pension CIO Chetan Ghosh speaks for many pension funds when he highlights the added cost caused by inflation increases.

“If inflation is 10%, then we need to pay our pensioners 10% more,” he explains. “Interest rates and inflation expectations matter for the mark-to-market position, but as inflation also affects the benefit promise, we attach greater importance to our inflation risks.”

Pension funds that bought inflation hedges back in 2008 might be feeling the pain, given the low inflation environment we’ve endured for the past five years.

Low inflation levels have at least one benefit, however, in cheaper hedges. Yet the question remains: Should you buy insurance while it’s cheap, or ride it out for a couple more years?

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Two hedge fund strategies failed to keep up with their booming industry last year: macro and managed futures.

Both suffered weak overall performance in 2013, and not for the first time, according to eVestment data. Over the past five years, macro hedge funds have cumulative returns of roughly half the industry average. After fees, managed futures funds haven’t returned anything since October 2010.

But the experts, and more granular data, give strikingly different prognoses for these hedge fund fail-mates.

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“I think that what it boils down to is that 2013 was a very difficult year for both segments,” says Peter Laurelli, eVestment’s vice president of research. “Elevated redemptions at the end of the year showed a combination of money leaving the strategies and money rotating between different funds. For managed futures, it’s more like money leaving; but the macro side, I think, will probably see some investor capital start to come back.”

The hedge fund industry’s total assets under management (AUM) climbed nearly 10% last year. Macro funds’ AUM dropped by 1%, the net result of $9.8 billion in redemptions and $8 billion in investment gains. For managed futures, however, outflows not only surpassed those from macro strategies but were more than double the outflows of all other asset-losing strategies combined. At $143.8 billion, AUM for the struggling sector is at its lowest since 2007. Even the rare managed futures funds with positive performance in 2013 tended to lose investor capital. While investors dumped their commodity trading advisors (CTAs) across the board, they primarily pulled money from those macro managers who had underperformed—assets that may return to the strategy under new management.

“Macro hedge funds are not a homogenous group,” says Francis Frecentese, Lyxor Asset Management’s global head of hedge fund research. “Those who didn’t do well last year tended to have a fixed-income bias.” According to eVestment data, macro equity funds returned over 12% for the year, whereas bond and currency strategies lost 2%. The majority of losses—some later recouped—occurred in June, July, and August, amid a sharp shift in US real interest rates. Risk parity strategies, which fall under the macro umbrella, suffered an uncharacteristic quarter horribilis during this stretch. Several of the typically passive strategies rebalanced—a wise move, according to Frecentese. “The macro managers who really got hurt were not nimble enough or didn’t think that they needed to reposition themselves. The spike in correlations meant the impact spread beyond just the US: Europe felt it, and there was a fairly extreme move in foreign exchange markets. Managers who were positioned more in equities or who had a constructive view on global growth came out the best.”

The roaring stock market may in fact be sparking investor interest in a strategy it has clobbered over the last few years. “Macro hedge funds are a way to get certain exposures that diversify away from equities,” Frecentese explains. “Markets were up 30% last year. If asset owners want to move away from that, macro is one of the places to go. That’s what we’ve been hearing from our clients lately—interest has been healthy.” And how about interest in that other traditional equities safe-haven: managed futures strategies? “Non-healthy.”

CTAs and macro hedge fund strategies first gained traction during the financial crisis as strong performers in adverse markets. When the hedge fund industry as a whole was down nearly 15% in 2008, managed futures strategies were up 11%. Performance has dried up since then, and so too has the strategy’s primary asset base. Commingled funds-of-hedge-funds, once the largest source of capital for both managed futures and macro, have lost their dominant position in the market to institutional funds themselves. While these asset owners continue funding macro strategies via direct investment, the largely systematic managed futures approaches are not proving popular.

For one, strictly quantitative hedge funds are black boxes amid a gathering trend of transparency. Josh Kaplan, head of hedge strategies for $27 billion health care investor Ascension Investment Management, won’t allocate to managed futures funds for that reason. “Managed futures, CTAs, systematic macros—it’s all quantitative and system-driven. When a manager has a bad month, I want to be able to pick up the phone, get an explanation, and understand why my manager is where he is. With quant funds, it’s just because the formula spat out this and that.”

Systematic funds also tend to perform as a herd, Kaplan says, suggesting that one managed futures strategy isn’t all that different from the next. “Every quant manager thinks that they’ve got an edge on everybody else. But the reality is, if you had the secret sauce, you’d have dispersion away from the group.” The three macro strategies in Kaplan’s book displayed serious dispersion last year: One returned nearly 20%, another 5%, and one gained 1%. He remains keen on the macro category.

As much as Kaplan doubts the wisdom of investing in systematic managed futures, he doesn’t see the recent outflows as a harbinger of death for the strategy. “I’d like to think that this really is the downfall of systematic strategies, but my instinct tells me it’s not. These things have ebbs and flows. Money leaves when the formulas are wrong, and it will come back when they start being right.”