Saturday, October 21, 2017

Risk parity with strong performance, yet global macro - managed futures may be a better choice to offset mispricing risk

The positive performance of risk parity products has been sneaking up on clients after poor returns in 2015. This long-only product have done much better than many other multi-asset hedge fund strategies in the last year with the HFR 12% vol institutional index being up 9.46% through September; however, it has been riding the wave of asset price mispricing or overvaluation.

Risk parity, in a very stripped down version divides the investment world into a simple set of asset classes which are given equal risk allocations. There are no return estimations or expectations so the portfolio can be considered a naive or no-information set of allocations solely based on volatility (or covariance depending on structure). It will compete against other macro approaches that have embedded expectations of relative performance. This naive approach has proved to be superior to more sophisticated approaches in the last two years. In simple terms, the forecasting skills of embedded in macro traders has underperformed the no forecasting skill of risk parity.

It makes sense to review a simple stylized model to describe what is going on. Let's take four assets consisting of stocks, bonds credit, and commodities. Generally, stocks are more volatile than bonds, so a risk parity product will give more money to bonds over stocks. Credit and commodities are diversifying assets.

To understand recent performance, we have to look at the relative allocations when there is a change in volatility across asset classes. Assume first, that volatility declines. In this case, if the risk parity product has a fixed volatility target, there will be an increase in leverage to meet the target. The leverage effect in a falling vol higher returning environment is a significant positive. It has been a strong contributor to performance. If the volatility of equities has fallen relative to fixed income or other sectors, this will cause an increase in equity exposure in a rising return environment. Again this has been a positive effect.

The combination of higher returns in a lower volatility environment generates a positive leverage effect and a change in relative volatility with changing return patterns, specifically higher returns in lower volatility sectors has been a second strong effect. Volatility targeted managers may get a similar effect, but the drag may be forecasting skill. 

If there is a reversal in market performance such that long-only will underperform as the markets move back to fair valuation, we should expect to see stronger global macro and managed futures performance. In the current environment, global macro managed futures may be a better choice if an investor believes mispricing risk will be reversed. 

Understanding investor preferences is not easy - just ask them

The line between recent "exotic preferences" and "behavioral finance" is so blurred that it describes academic politics better than anything substantive. 
- John Cochrane University of Chicago 

John Cochrane, as well as others in finance, has focused on the academic issue of defining preferences for investors at an abstract level, but the issue becomes a reality when trying to extract preferences from investors to help build a portfolios. 

Recently working with some institutional investors, the greatest amount of time was spent not picking the strategy or portfolio elements but defining their preferences. How much upside did they want? How much downside were they willing to take? What is the chance of a tail risk event and how much protection did they want for these rare events? How are their performance preferences measured, holistically, by sector, or by market? How much regret are they willing to suffer from tracking error versus benchmarks? This list could go on. 

Many investors have an intuitive feel for what they want from their portfolio but the exercise of asking for precision in their preferences is very useful. Is it a behavior bias to have more regret or disutility for loses over gains? Is it wrong to focus on recent performance or tracking error on an individual manager? Is the concern about "poor" performance from negative or low correlated assets to equities when stocks go up justified? This are real issues that ned to be discussed with investors.

These preference orderings are not academic questions but the core for understanding investor needs, asset allocation, and recommendations for portfolio construction.

Wednesday, October 18, 2017

Time series or cross sectional momentum - which is better? Your choice may matter

The marketplace is abuzz with the value of momentum trading, but a closer inspection shows that it is packaged in two major strains, time series and cross-sectional momentum. The traditional trend-following CTA focuses on time series momentum while the most of the equity research and implementation is conducted through the cross-sectional approach. There is similarity between these approaches, but there are also enough differences so that the return profile for each will not be the same.  

Many CTA's now have a hybrid approach between times series and cross-sectional momentum, so it is critical for investors to know the differences. Times series momentum will focus on absolute performance while cross-sectional momentum will focus on relative performance. The times series is only focused on whether a specific market is moving up or down while cross-sectional work will rank markets to buy the best momentum markets and sell the worst. The cross-sectional work attempts to generate a momentum alpha while the times series approach mixes alpha and beta

A recent paper called "Time-series and cross-sectional momentum strategies under alternative implementation strategies" suggests that times series is actually superior because it does not place constraints on the winner and loser portfolio. This research is focused on a portfolio of stock indices, but the intuition can be used to help describe different managed futures approaches. 

Think about this issue through a simple example. Assume that a manager is trading 20 commodity markets. The times series approach will look at each market separately so that if there are 12 markets that are showing positive momentum, there will be twelve long positions. If eight markets are showing negative momentum, then eight would be the number of short positions. The long or short mix in the portfolio is independent of the number of markets traded.  In a cross-sectional momentum model, all the markets will be ranked and if there is a cut-off of say 20%, the top four would be long and the bottom 4 would be short. The rest would be ignored. There would be fewer positions to manage and the number would be set by a cut-off based on the number of markets in the sample. 

The time series approach will have variable diversification given the long and short positions would be dynamic; however, the size of each may be smaller since every market may be traded. The cross-sectional approach will focus on a limited set of markets based on relative signals.  The long and short positions will always be equal.  Hence, there will be less "beta" risk. Nevertheless, the approach that is better will change with market conditions based on the strength of market direction across the set of markets traded. 

An initial reaction would be that you get the best longs and best shorts through the cross-sectional approach, yet there is a problem if the market has a strong up or down bias.  The profitability of momentum strategies may be market dependent. If there is a strong long (short) bias, it will be harder to find short (long) positions. This market tilt makes the times series approach more attractive. Similarly, if the extremes have a greater tendency for reversal, the times series approach may do better. 

The preference for times series or cross-sectional momentum may be a function of the diversification and directional bias within an asset class. There may be diversification benefits form using both approaches. This may be the reason for many CTA's now choosing to blend time series and cross-sectional. However, the research does show that regardless of approach momentum is still a factor worth pursuing. 

Monday, October 16, 2017

If you take away the Fed balance sheet, should the bond premium be negative? Term premium reality

The Wall Street talk is that all markets are over-valued, yet any valuation has to be placed in context. For fixed income, this is not easy given you have to make a judgment on both the real rate of return and expected inflation. Additionally, there is a need to measure the term premium associated with bonds. The premium measures the compensation necessary for investors to hold longer duration bonds versus a series of successive short bonds given the volatility and uncertainty associated with real rates and inflation. The term premium is not directly observable and is difficult to measure but has intuitive appeal.

The Fed of New York provides their estimate of the term premium on a daily basis for different maturities along the yield curve. The premium will change with market conditions but it has been falling since the period of maximum uncertainty in the early 1980's. The term premium has really been declining since the Fed bond buying in their QE programs. Now all of the term premiums are negative. Granted volatility is lower and the Fed has controlled short rates, but a key driver is the expanding balance sheet of the Fed. The Fed as a marginal buyer and one of the top holders of Treasuries has led to the abnormal premium condition.

Given the long-term average and current levels, it would not be unheard of to see term premiums increase well over 100 basis points not including any change in expectations on the real rate and inflation. A slow Fed unwind should minimize any dramatic changes in the term, but that does not change the fact that this risk premium in on the wrong side of expectations. 

Forget the sophisticated models and take a simple Bayesian approach to bond risk. Assume less Fed activity to stabilize the market through constant buying to hold balance sheet levels stable; even if you get the forecast for inflation right which over the next year could be in a range of 100 basis points and you get real rates right which also could be in the range of 100 basis points over the next year, your forecasts could be spoiled by an increase in the term premium as it moves back to normal. 

Term premium adjustment is a headwind against any bondholder. Only bondholders who are short can turn this into a tailwind. A simple investment rule should be - Do not fight headwinds and don't add to markets that may have natural reasons to go down unless your forecasts are extremely strong