Monday, November 23, 2009

Macro Bets: A general framework..

As many of you are aware, I am not a great believer in macro bets but I recognis4 that there are investors out there who not only like to make big bets on interest rates, currencies or commodities, but also make tons of money in the process. In fact, the subject of my last post, John Paulson, made a macro bet on housing and it paid off big time for him. Consequently, I thought it would make sense for me to put down my thoughts on macro bets.

Should you make macro bets?
The old rule in investing applies. If you are going to make macro bets, you need to bring something unique to the table - a competitive advantage that sets you apart from the hordes of other investors. Here are some potential advantages that you may be able to build on:

a. Time: If you have a much longer time horizon than the rest of the market (remember that this requires that you have patience and that you can live with the loss of liquidity), you may be able to bet on macro mis-pricing that is expected to persist for the short term but not the long term.

b. Trading: The second skill set you can exploit is your capacity to trade on a macro bet that others may not possess. This will generally require that you either create your own securities (synthetic calls and puts, forwards) to make money on the macro bet or that you creatively exploit securities that already exist out there (as Paulson did with the CDS market)

c. Information: As with individual stocks, there are two ways in which you can exploit information. The first is short term, where you can get ahead of macro information announcements and game them for gain. Thus, you you can try to forecast how the next Federal Open Market Committee is going to vote (I cannot think of a way legally that you could get access to this information...but you never know). The second is long term. As an example, you may be able to collect information on copper production at individual mines globally and make judgments on copper supply (and prices) in future periods.

d. Behavioral: There is evidence that investors behave in quirky (notice that I did not say irrational) ways when making investing choices. You can try to take advantage of these behavioral quirks as long as you are immune from them and believe that they will be reversed in the future. Thus, the "herd behavior" of investors can cause short term momentum in currency markets before the same behavior creates a "big correction". To take advantage of this, though, you have to be less affected by the herd than the average investor (As a kid, did you fight peer pressure or did you bend to it?) and you have to be able to gauge when the herd will turn...

What is the best way to make a macro bet?
If you are going to make a macro bet, keep it simple and make it a focused bet. If you believe that gold prices will keep going up, the best investing strategy is to buy gold futures or options.

All too often, we hear of investors finding convoluted ways of making macro bets. Buying a gold mining company, say Barrick Resources, because you believe that gold prices will go up exposes you to all kinds of other risk. The stock price of a gold mining company reflects multiple other factors: its success at finding new gold reserves, whether it hedges against gold prices or not and whether its gold reserves are in an unstable country.

It is true that in some cases, a macro bet can be combined with a micro bet. Thus, if you like Petrobras as a company (because you like its management and investment strategy), you could buy Petrobras and also make bullish bets on Brazil and oil. You should be clear, though, as to which factor is front and center in your investment decision, i.e., Are you buying Petrobras because you like the company? Like Brazil? Think oil prices are going to go up?

What are the risks of macro bets?
The risk with macro bets as with any investment strategy is that your underlying premise may be wrong and/or that the rest of the market does not buy into it. My skepticism about macro bets is based upon the difficulty I see in establishing a competitive advantage. When there are literally millions of other playing the same game and "private" information is difficult to obtain (without breaking the law), the game is a much more difficult one to win. Obviously, it is not impossible, as John Paulson and others have shown over time, but the odds remain against you.


perpetual wonderer said...

Sir, I have always wondered if people like Paulson who have made a lot of money out of a single macro bet had made only that one bet? Or do they also use the principle of diversification even while placing macro bets?

Because I find it hard to believe that there are people who are so sure of the future that they are risking so much on events that are a function of several variables.
Is it likely that they macro bet on many events, make money only on a few and lose on some others? (like you said, the odds are stacked against you when you macro-bet)

And if that is true, is it only the bets which made them money that make it through to the media?

Aswath Damodaran said...

That remains the question. To be considered a great investor, you need to be a consistent winner. Will Paulson be as successful on his next macro bet and the next one? Only time will tell (and it has not been kind to other macro bettors in the past)

Henry Bee said...

Thanks for revisiting this issue. Does this mean your view on Soros has mellowed?

Immortal said...

@ perpetual...very good question on application of diversification principle in macro bets...

Prof...wats ur it possible to diversify ... if yes then how??


Compendium said...

Diversification should only work for loosely correlated investments.I am not an economist, but as a layman, think that macro economy related variables are so much interlinked that diversification is very hard to achieve. Overall, a good reminder article on marco investing. Thanks.

Unknown said...

Paulson was not going to lose anything regardless of how the bet went. in the "worst" case scenario, they would have held on to the securities if they had not defaulted and have made 1% spread on the interest payments. at least this is what he mentioned at a talk at NYU Stern.

perpetual wonderer said...

I referred to Paulson as just an example. Let me put my question in a different way. Hope the prof responds too. :)

Let us assume there is a Paulson who is sure that a particular rally is building up to a bubble that he expects to go bust after X months. So he takes on a risk by buying some security (CDS for example) hoping the bubble will burst and he will profit from holding the CDS. Now, is it likely that he is so sure of the future that he just invests in the one CDS? Or does he also diversify his risk by investing in a security that is likely to pay-off in case the bubble doesn't actually turn out to be a bubble (or even if it does, it doesn't burst when he expects it to)? Also, if he chooses to diversify and he does turn out to be right about the bubble bursting, he stands to lose a significant amount through the diversified security. Which then somewhat moderates his pay-off from his primary macro-bet.

So is this usually done? Do macro bettors just go ahead with an all-or-nothing strategy or do they place multiple macro-bets for different scenarios and we only notice the one bet that has paid off?

Patrick C said...

Could you describe the difference between a quirky decision and an irrational decision?

Aswath Damodaran said...

Two responses. The first is on whether or not to diversify your macro bets. On the one hand, going in all or nothing is not an option when you are uncertain about whether there is a mispricing in the first place and when it will be corrected (and one of these two conditions will almost always apply. Diversifying a macro bet is very difficult to do, because macro variables affect most asset classes. You can hedge a macro bet by doing one of two things - setting loss thresholds, where you unwind the bet and minimize losses or buying options, where you know what your maximum losses will be up front.

On the question of the difference between quirky and irrational, it is the same difference between calling someone crazy and calling them eccentric. The first has a negative connotation to it, whereas the latter is more an expression of puzzlement. For too long in finance, we have labeled those who do not behave the way our models dictate as irrational. What behavioral economists have pointed out is that just because we cannot explain a certain type of behavior does not mean that the people indulging in it are crazy (or stupid).