Sunday, September 24, 2017

Drivers of commodities in the medium term - global growth and dollar - look positive

If you wanted to focus on three longer-term macro factors that will drive overall commodity prices, it will be global growth, the dollar, and liquidity. The determination of long-only allocations in any asset allocation should focus on these three. Trading issues will be driven by volatility and market shocks.

Growth impacts demand, the dollar level will impact the market-clearing price since so many commodities are priced in dollar, and liquidity will impact investments and speculative flows. 

If growth globally, increases, demand for raw materials like metals and oil will increase with the unanticipated portion of growth. The price elasticity will change with the level of inventory. As excess inventories come down and production tightens, growth shocks will be more significant. As the dollar goes up, the cost paid for any dollar denominated commodity will also go up. The supply side will often be determined by production shocks which by their very nature will be surprises, but liquidity will impact supply through financing. New investment, the cost of holding inventory, and demand will be affected by the price of liquidity/credit.

So what do you need to know for general commodity price movements? There is a positive relationship between growth and commodities, especially base metals and oil prices. Hence, more growth should be commodity positive. A falling dollar will be commodity positive by reducing cost of purchasing the commodity. Finally, the real rate of interest will impact investment decisions. 

So what are the cross-currents for commodities today? First, there is growing dispersion across commodity prices. The one factor world of a global growth slowdown and then pick-up is over with energy prices separating from metals and food. The impact is that there is more intra-sector diversification benefit from commodities and an increase in value from skill investing. We expect this trend to continue. 

The tight correlation between global commodity prices has fallen with the stabilization of global growth. The lead-lag relationship between growth and prices does change over time with the more recent surge in global prices preceding the pick-up in 2017 growth. Looking at OECD recession indicators suggests that commodity prices will weaken when recession indicators are heightened. Currently, there are no heightened indicators of global recession.

The long slide in the dollar matched the rise in commodity prices and the dollar gains over the last few years were matched by declines in commodity prices. The current dollar decline while significant over the short-run has a long way to go to match the lows in the dollar during the post-financial crisis period. Nevertheless, if the dollar slide continues, we will see increased commodity demand.

The extended period of low real rates has meant that liquidity changes have not been a significant driver in commodity trends.  While the Fed is raising rates, other central banks have continued to follow loose monetary policies that have made liquidity a non-issue in commodities at this time.

Given these relationships, we are positive on asset allocations to commodity opportunities. This may not come in the form of the traditional commodity indices but holding commodities as a diversifier and return generator has more forward-looking benefit. 

The business of hedge funds - dynamic choice beyond 2/20

The lifeblood of hedge funds as businesses is their performance pricing proposition through incentive fees, but the simple business model of 2% management fee and 20% incentive fees is fast becoming extinct. Pricing is coming down as well as becoming more complex with more pricing alternatives as the businesses become more competitive and investors become more sensitive to alpha production. 

New pricing alternatives are more closely focused on the skill of managers. Investors have shifted to  pricing models to take advantage of the growth in benchmarks to minimize paying high fees for beta. The new business proposition for both investor and manager is to align incentives so that the talent performs better as the incentives become more focused. These incentives are aligned if managers receive money for performance and not asset gathering and any incentive payments is tied to alpha production not beta risk-taking. 

Still, the fixed costs of hedge fund management have to be covered with some stable fees. Consequently, a model of squeezing management fees or providing no incentive fees does not help managers who may have limited capacity and may in the longer-run hurt investors who want to hold the best managers in their portfolio. Unfortunately, those hit with the trend to new pricing models are newer and smaller managers.

The choice set of fee structures has widened from flat low fixed fees for large allocations to more innovative fee structures like the "1 or 30" concept rolled out by Texas Teacher's pension plan. The 1 or 30 and similar variations reveal the preferences of both manager and investor. The manager who is willing to take the 30% incentive only deal places more weight on his ability to deliver strong consistent returns. Those managers that focus on fixed fees, especially after fixed costs are covered, shows a bias toward asset gathering and stability of cash flows not performance.

The pricing negotiations review the preferences and skill confidence of both parties. Using "or" choices, switching choices between fees and incentives, tiered pricing by AUM, hurdles, and benchmarks all provide insight on manager skill as well as their business savvy. This are all positive for the industry as long s the focus is on aligning incentives and not just extracting lower fees.

Friday, September 22, 2017

Tetlock - Political forecasting is a loser's game... So follow trends?

The talking heads in the media spend significant time making political predictions. Even many Wall Street economists fall into the trap of giving political forecasting advice instead of digesting the economic data. The outcomes and impact of elections; pundits usually don't know. The time of geopolitical risks and wars; pundits don't know. The cultural changes that will impact markets; pundits don't know. Unfortunately, the media does like the experts who are doubtful and equivocate.  Pundits, however, are not often stupid. They provide significant amounts of information, background, and data. It is just that their ability to make good forecasts is poor. The advice from the forecasting expert Phillip Tetlock, the author of Superforecasters and Expert Political Judgment: How Good is It? How Can We Know? is very simple, "Don't listen to them". Their overconfidence will cause investor decisions to go awry. They place too high a probability on their views.

This failure of "experts" is another reason for using systematic investing like trend-following. You avoid the poor forecasting of political pundits and focus on what the markets are actually telling you through the behavior in prices. If the weight of opinion as expressed through "dollar votes" suggests that a market should be lower, prices will trend lower. A more uncertain environment will have shallower trends and more volatility. These prices may be noisy and may use the inputs of political experts, but the average price from crowd is still a good guess of what may happen. In some sense, the volatility in prices and slope of the trend provides an indicator on the confident of market opinion. 

Of course some may argue that you will be too late if you follow market prices or that market direction can be plan wrong, but evidence over the long-run is that trend-following is effective. At the very least, the direction of market opinion through dollar votes may be more informative than the opinions of talking heads. Someone can point to when markets get it wrong and there is a sharp price change or reversal, but that can be contained through risk management and stop-loses. The important point is that the aggregate opinion of market participants will do better than the overconfident opinions of experts. 

Tuesday, September 19, 2017

Research and systematic investing can overcome motivated cognition

Motivated cognition - we believe what we want to believe. We will also believe based on who we are and who we want to be. Our goals and needs shape our thinking. Facts do not change our goals when we have motivated cognition. Investors rationalize and filter evidence presented to support their views. Motivated reasoning will generate confirmation biases. 

This type of cognition can actually be effortless and is pervasive with many. Following what we want to believe is not hard work. The hard work is looking at evidence without bias. Motivated cognition is also goal-orientated. We look for evidence to support our goals. It focuses on confirming what we already know and meeting current objectives.  It can be very impactful because it can lead to significant mistakes in judgment. If we have a large equity allocation, we will look for evidence that supports this position and dismiss information that contradicts this position. Our cognitive focus is driven by our desire to be right. It focuses our attention on information that supports what we want to happen not what will actually happen. 

The power of research is to break the motivated cognition of what may not be true. Evidence-based investing focuses on the likelihood of events and not the desire for events to occur. The key goal for research is to present likelihoods and support positions. It is easy to say that investors should break through their motivated cognition, but much harder to implement. 

The use of a systematic and disciplined investment and research process is an effective way of reducing the confirmation biases by making the decision process explicitly based on a set criteria that can be tested. Decisions rules can be tested against past data and reviewed against future performance. There may still be biases based on the weighting of the evidence, but a systematic process can allow for testable analysis. Systematic investing can eliminate one of the key psychological problems facing investors.