Friday, April 21, 2017

Follow the world business cycle - Economies are integrated

Globalization is a critical part of macro investing. There can be talk of separation politics, but for investors, you have to focus on the global economic cycle because the world is highly integrated. What is very interesting is that globalization has been fairly stable between the current environment and the Bretton Woods period as discussed by the recent work of Eric Monnet and Damien Puy who studied long horizon data available from the IMF. They find that there were two common shock periods which caused a highly synchronous global behavior. The first was oil shock period of the 70's and the second was the Great Financial Crisis. You could say that these were the two periods when "correlations went to one" across asset classes. There was no international diversification benefit. 

However, the output variance will vary across countries and time. If you want international diversification, you should focus on the countries that have the lowest variance explained by the world factor. The authors also found that which seems counter intuitive is that during normal times deeper financial integration tends to desynchronize national output with the world cycle.

What does this mean from a practical sense for investors? For US investors, following the US business cycle and the Fed is not enough. This may seem obvious, but it has to be a point of focus given this new data. When there is a common global shock, there is no safety with diversification, the global business cycle will explain more than half of country variation. There is also no reversal to the old days. The era of capital controls and fixed exchange rates still had a high degree of business cycle integration. Financial integration and output integration are not the same thing and they may be negatively correlated. Finally, the data says that you should know your shocks. When there is a common global shock, the world can get exceedingly small. 

Preparing for market risk - stay diversified across asset classes, factors, and strategies

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready – you won’t do well in the markets. If you go to Minnesota in January, you should know that it’s gonna be cold. You don’t panic when the thermometer falls below zero.
-Peter Lynch 

Simple advice for any investor. Accept that bad things will happen to markets. You may not know when, where, or how much it will affect markets but it will occur. There will be tail risk. The question is how you deal with it. Simple preparation can come through three dimensions:

1. Asset Class Diversification - The only free lunch of finance. Since you may not have any idea when bad times will come, the easiest solution is to diversify across asset classes that behave different across the business cycle. If a portfolio is concentrated, don't be surprised if there are periods when it will do poorly.

2. Factor Diversification - Look at the factors and structure or diversify. There are macro and micro risk factors. For example, some portfolios will be more sensitive to inflation. Others will be sensitive to the market capitalization. Small cap stocks will have more extreme moves around the business cycle. If you are not sure what you want with respect to factors, then diversify.

3. Strategy Diversification - Since many asset classes will often correlate to one during a crisis, asset class diversification may not be enough or the only solution. A second tier of diversification is through different investment strategies. Managed futures will perform differently during risk-off regimes as opposed to risk-on. Credit strategies will perform differently during different point in the liquidity cycle. Strategy correlations will generally stay lower than asset class correlations when there is a change in the business cycle; however, this may not be the case if there is a financial crisis. 

The performance cost from diversification may be less than the cost of specific tail risk strategies, so it seems as though diversification should always be the first line of defense against a negative market move.

Thursday, April 20, 2017

"Winner-Take-All" Dynamics and hedge fund investing

A growing stream of thinking in microeconomics is the concept of "winner-take-all" dynamics. The idea seems simple. A combination of networking economics and classic economies of scale creates situations where there are just a few dominant firms or economic agents who are able to capture significant market share in a given industry. With the advances in technology over the last decade, many industries are seeing the impact of winner-take-all dynamics leading to the result of greater concentration.

There have always been economies of scale with a firm, but there were limits based on geography, distribution, or just the ability to gain broad exposure. However, with the internet and the ability to communicate information broadly and quickly, the power of networking generates further economies of scale. 

There are some classic winner-take-all markets. For example, the music industry is dominated by a few singers who capture all of the market. Software, search engines, operating systems, or social media have all become winner-take-all markets. The first mover or close followers are able to gain strong market positions that cannot be broken by new entrants. 

We may now be seeing the beginning of winner-take-all dynamics with hedge fund investing. The combination of scale for investing with wide distribution has caused large hedge funds to get larger and more dominant regardless of performance. Think of winner-take-all networking and scale and you can see the how size matters more with hedge funds. We are moving from a highly competitive fragmented industry to one that is more concentrated. This will not happen overnight, but the signs of growing concentration are starting to be seen. Start-ups are slowing and smaller funds are closing.

Size allows for:
  • Economies of scale for passing due diligence - Passing due diligence for large investors requires more infrastructure from independent due diligence to redundant systems and independent trading. To gain money from large pensions, more scale is needed. 
  • Economies of scale with compliance - Regulation requires more compliance which is a large fixed cost. Scale spreads this fixed cost.
  • Broader distribution - The costs of marketing are high. This is not just visiting investors but providing investor relations and answering questionnaires. 
  • Platform access - More hedge funds need to be on platforms which have barriers to entry. Additionally, prime brokers want to only deal with larger firms.
  • Multiple products - Given the cost with reviewing firms, there is a desire for more products from the same firm. One stop shopping is gaining acceptance.
  • Matching with large investors - Concentration in banking and brokerage means that large firms will deal with other large firms. 
Is this good for investors? Scale will allow for the lowering of costs and allow for better infrastructure development. These lower costs can be passed onto investors. The better infrastructure developments in compliance, risk management, transparency, and investor relations all reduce business risk and provide benefits to investors, but the larger firms may not always perform better. Performance is just one aspect with the decision to invest. Now small have to perform better with excess returns to offset the higher business risks.

The idea that a smart manager can open a shop and attract investors to their new business may be ending. Performance as the key driver for new entrants may be ending.

Saturday, April 15, 2017

Factors, smart beta, and global macro

What has been at the vanguard of thinking in finance is the breakdown of returns into its constituent parts or risk factors. Finance has moved well beyond market beta. The primal breakdown for a portfolio is not returns by asset class but returns by risk factors. Some have criticized the current situation a factor zoo; however, even factor excesses does not change the fact that factorization is the paradigm used more and more by investors. 

There are many factors and many assets to map with factor weighting. The shear size of the problem lends itself to computerization and data mining. The role of the analyst as story-teller is diminished when a stock can be described through a set of modeled factor. Investors now buy risk premia not stories or names. Individual names are just the means to the end of gathering beta risks. Smart beta is just the realization that if factors can be used to describe stocks they can also be used to weight stock portfolios. This may be smart or it could just be the outgrowth from how the finance world is being viewed. 

Factors can be classified into two main categories: micro factors which are asset specific and macro factors which are related to macro events like the business cycle or changes in rates and credit availability. Hence, the type of hedge funds chosen by investors is bases on whether the manager focuses on micro or macro factors.

So what is the essence or purpose of global macro? In this new factor world view, global macro investing is a focus on economic wide factors which can be dynamically adjusted to generate excess return. Since factors move in and out of style or importance, the macro investor tries to find ways to exploit these changing weights. 

The issue is which factors are relevant for global macro investing. We are aware of the criticism of factor timing, so we have to be precise for what factors we are discussing.   Global macro has the overarching theme that the manager is trying to identify global business cycles or growth recessions which spill-over to the behavior of specific asset classes. Along with business cycle are credit and financial cycles which impact asset classes around the globe differently. The growth/inflation mix impacts policy choice which feed back on asset classes. What makes global macro so difficult is the low predictive skill by managers at forecasting these macro factors.

The difficulty with forecasting macro factors calls for managers to stay diversified, follow market trends, and take high probability tilts to specific factor opportunities. The poor performance for global macro is a function of the high uncertainty associated with the major macro factors. There is no smart beta in global macro if the macro factor directions cannot be identified. Global macro returns will only improve if the degree of uncertainty concerning growth, inflation, and liquidity falls to levels that allow for bets to be identified and managed.

The relatively better performance with managed futures programs is based on the core focus toward momentum and diversification and not fundamental macro factors. Managed futures captures macro events through the movement in asset prices, yet if there are no string trends there will ne only limited opportunities.