Hedge Funds Q&A: Michael Dicks, PGIM Wadhwani

2022 has, so far, not been a banner year for the hedge fund industry. Equity-based strategies in particular have suffered, but there has, so far, been more encouraging performance from strategies such as macro and managed futures. AlphaWeek’s Greg Winterton spoke to Michael Dicks, Chief Economist and Deputy Head of Research at quantitative multi-asset macro specialist PGIM Wadhwani in London, to get his views on the macroeconomic outlook and what types of strategies and exposures might smooth the choppy equity waters in the coming six months.

GW: Michael, let’s start with inflation. At the beginning of the year, the big question was whether higher inflation, particularly in the West, was transitory or semi-permanent. Now that we enter the home stretch of 2022, what’s your view here, and why?

MD: Both in 2021 and earlier this year, our models suggested that inflation would surprise the consensus on the high side & force policymakers to eat their words. Now, however, the models are adopting a more nuanced view; they still predict inflation to come down more slowly than generally expected and provide upward surprises to consensus expectations in the medium term, i.e., 2023 as a whole. However, in the short-term they forecast very slightly lower-than-expected inflation outturns.

GW: The threat of a global recession in the wake of ever higher energy and food costs is the current talk of the town in markets. It’s not a matter of if, but when, anymore, right?

MD: I would say “yes” if we’re talking about Europe. In the case of the United States, however, it is a closer call. We envisage a number of different scenarios being feasible – with recession avoidance (a softish landing) being one of them. But our models put the odds at a little over 50% that we get one of the scenarios that do involve a recession – either soon or perhaps after a pause from the Fed and then a realisation that the pause wasn’t warranted (and a second dose of tightening is needed, leading to a recession further down the road).

GW: So, we’ve got what’s essentially stagflation coming down the pipe. How should investors be re-adjusting their portfolios to defend against such challenges?

MD: Traditional investors typically hold fixed income bonds as a hedge against their long positions in equities. So, they stand to be hit twice if we do see elements of stagflation. Consequently, strategies that hedge against tail risk, such as those that rely upon identifying down trends in equity and fixed income markets and taking advantage of these by going short the asset, have shown themselves able to perform well when both equites and bonds are performing poorly. Other strategies that work well in the current environment rely more upon macro-econometric models, such as those designed to try to beat the consensus at forecasting growth, inflation and policymakers’ decision-making, or other common features of markets at a time of stagflation – such as risk-appetite driven moves into “safe haven” currencies.

GW: PGIMW recently launched a new product, Macro Tail Risk, specifically designed for times like these. Tell us a little more about that.

MD: We created MTR as a more targeted risk-mitigation solution compared to our more unconstrained and all-weather Trend Plus strategy. The solution takes the components of Trend Plus that we believe are best suited to solve for the equity protection problem – namely, directional short equities, FX equity hedge, relative value equity sectors, directional commodities, directional fixed income strategies and relative value yield curve, to create a multi-asset. By emphasizing the models within Trend Plus that are more reliable on the downside, we believe we’ve achieved an effective targeted solution to equity protection.

What we are also trying to do is provide a more cost-efficient approach to equity drawdown protection compared to put-options-based strategies. Whilst these strategies will provide reliable equity downside protection, they come at a cost, which is paid out when equity markets perform well. Investors can use a trend following strategy that is applied only to equity markets instead, which also provides reliable protection, but this is mathematically akin to a put option, which again, comes at a cost. In MTR, we’ve added non-trend models such as macro and value strategies alongside the trend models in order to generate some alpha in periods when equities do well, which effectively pays for this cost.

GW: Lastly, Michael, the S&P 500 rallied in the summer, before falling off again. But it’ll likely bounce back at some point – stocks go up over time, so the theory goes. So, what’s the rationale for a permanent tail risk allocation?

MD: We, like everyone else, are unable to predict exactly when the next episode of sustained equity weakness will occur. So, we recommend some allocation to a Macro Tail Risk-type product even in what appear to be ‘good times.’ Recall, for example, just how fast the environment shifted when Covid-19 struck, or when Russia invaded Ukraine. Products like ours contain several strategies that are designed specifically to complement a long equities position, which tends to be the largest position an institutional investor has, whether that’s public or private equity exposures, or both. Tail risk strategies extract sources of returns from different underlying asset classes, so they have the diversifying aspect, as well as the hedging aspect. We would stress it is worth having an allocation to strategies like ours which can change when the world changes, because that flexibility is what enables tail risk protection both quickly at the point of initial shock, and on an ongoing basis, whether equity markets continue to fall, or whether they move sideways, before eventually recovering – which could take years.

Michael Dicks is Chief Economist and Deputy Head of Research at PGIM Wadhwani