Tuesday, September 17, 2019

Are Alternative Risk Premia Effective Hedge Fund Replacements?

Are alternative risk premia (ARP) portfolios a good replacement for hedge funds? A recent ai-cio.com article "Oft-Touted Risk Premia Strategies Show Their Weak Side" commented on the lagging performance of risk premia over the last few quarters and questioned whether ARPs have lived up to expectations as a hedge fund replacement. Hedge funds have fared well in 2019, but many risk premia strategies have also shown a pick-up in performance this year. Similarly, some ARPs have correlated with poorer performance with some focused hedge fund styles.

The real comparison is not between a single ARP and a hedge fund style but a bundle of ARPs and a hedge funds. Hedge funds are usually not monolithic strategies but rather a combination of different strategies weighted by risk exposures. There will be hedge funds that specialize with a single strategy or with the majority of risk exposure in single strategy but most will be described by more than one factor.

There will be performance differences between ARP portfolios executed through bank swaps and hedge fund returns because they are fundamentally different views on how portfolios and investments should be structured and managed. These distinctions are important whether you want to use ARP as complement or as a substitute for hedge funds. 

ARPs should be viewed as factor building blocks that can be bundled into portfolios with well-defined risks. Hedge funds are managed investments that have factor risk exposures that can be categorized through alternative risk premia. One is a direct expression of risk factors while the other is a manager's representation of risk factors with the potential addition of skill. In the case of hedge funds, these representations may do better or worse than a specific weighted set of factors. The relative outperformance may be skill or may be caused by a poor measure of the risk taken. ARPs, on the other had can be bundled in any combination desired; however, the underlying ARP swaps are restricted by the rules used for construction.

Our table provides some of the distinctions between an ARP swap portfolios and hedge funds and offers insights on which investment choice has an advantage. An investor can run through this list and determine their preferences.   

We view that ARPs can be compared with hedge funds on a number of different dimensions: strategy, portfolio, flexibility, alpha generation, cost, transparency, and liquidity. In most cases ARP structures will have an advantage over hedge funds. The key difference is manager skill, yet in many cases, when properly measured, alpha is limited. Hedge fund managers may have a slight advantage with the dynamic adjustment of strategy exposure, yet even in this case there are systematic and inexpensive ways to adjust exposures that can give ARP an edge. 

Alternative risk premia will have dynamic returns which will not always be positive, but when properly compared with hedge funds, ARP will have clearly measured advantages.

Negativzin is a strafzin and investors are not happy with rates

The ECB has a solution for economic growth in Europe, more pain for savers. Germans don't refer to rates as negative but as a punishment, "straf". You will be punished until you are willing to consumer more and stop this silly idea of savings for future uncertainty. 

As a final act, president Draghi reopened their QE program and lowered rates to inflict more savings pain. Of course, in Rube Goldberg fashion, the ECB idea is to lower rates but actually not have the impact felt too much by depositors. This is a policy of selective pain. Can the policy-makers nudge the banks to lend without hurting the banks through crushing the earnings of financial institutions.

This rate policy does not change government spending behavior so there is no coordination between monetary and fiscal policy. There is no end is sight for negative rates. These expectations means that investors haver to either buy riskier assets for yield or save more not less. Capital flows will move to those places that have higher relative rates. Negative rates will be exported around the world with no solution 

Monday, September 16, 2019

Momentum meltdown not a trend-following meltdown

Trend-following is not momentum investing. They are similar and have many of the same characteristics and have been often described as being the same, but investors should not be confused. There has been a momentum meltdown this month, but there has not been a trend-following meltdown. 

Trend-following looks at times series behavior for a wide range of markets and will buy (sell) those that are moving higher (lower) based on some absolute criteria. There is not the expectation that the long trends will be matched against short trends Momentum strategies often applied to equity markets are cross-sectional. Market momentum is measured and ranked with the portfolio going long the highest momentum stocks and short the lowest momentum. The portfolio will be a long/short match based on these relative ranking.   

There has been a positive change in the macro environment which has hurt the strong bond trends seen since spring. This increase in bond yields has shocked many trend-followers who have been long the global bonds, but this move is independent of the momentum crash in equities which have seen a rotation from momentum growth to value stocks. There may be similar causes but the factor styles are different. 

Trend-followers generally focus on futures markets and not individual equities, hence the reference to managed futures. There can be further revisions from  changes in macro markets but this is not the same as a style factor rotation in equities.

Using CSAIX as a managed futures trend-following proxy and MOM as momentum proxy, we can see that they are related but the trend-following is more closely related to bond positioning and behavior. The trend-following program is less likely to have crash effects given its diversification. During this same time, there has been a positive shock to the value style. Herding behavior is often captured in the momentum strategy and will be subject to crashes when there is a major change in expectations. Trend-following may also be subject to trend revisions but the drivers will be associated with broader market changes.

Saturday, September 14, 2019

The end of Chimerica and the end of world order liberalism

The 21st century has been the era of Chimerica. The symbiotic relationship between China and US drove global growth and brought these two countries (two systems) into a close relationship of trade and finance. In 2018, China was the number three goods export market for the US and the number one goods importer. The two countries had overall goods and services trade exceeding $730 billion and a trade deficit of just under $400 billion. The US is running a trade and savings deficit with goods coming to America and dollars building up in China.

These trade numbers have not been higher, yet philosophically there is a now a sea change in thinking about link between the two countries. There has been the belief that trade and cooperation would lead to change in China with deeper cooperation instead of rivalry like superpowers in the 20th century.

The reality and dream of Chimerica was not perfect and was not all together healthy, but it was a trade and financial flow reality. Niall Ferguson, the historian, coined the phase a little over decade ago as an apt description of the times, but the Chimerica of the past is done regardless of any trade deal or the actual trade numbers. (See "Make Chimerica Great Again" by Ferguesen and Xu of the Hoover Institute to get their view on Chimerica.) There is now a political skepticism between the two countries coupled with super-power competition that is unlikely to reverse to anything we saw even three years ago. Trade may continue but in a wary form different from classic libertarian trade. China is now a strategic competitor not a strategic partner. 

There may not be a reversal of financial deals but the world has to find a new framework because the dual power structure of west and east is not sustainable. Perhaps there is a new darker Chimerica. The framework of looking at China as another large economy for investing is in flux regardless of index inclusion or market capitalization. A world of rivalry is less efficient with trade and capital flow driven by new criteria independent of comparative advantage or return on investment. 

Idea, culture, and people flows will dwindle in this darker world. Cooperative optimism has turned into mercantilistic pessimism. There will a new search for global partners in other countries. There is no room for a new order of liberalism for all countries. This will have a further spillover for all emerging market investing with greater instability and uncertainty. It is a headwind that cannot be ignored.