Tuesday, September 18, 2018

Carry - What To Watch With This Alternative Risk Premium

One of the core issues with alternative risk premia is not just determining whether they exist but how they will move through time. If alternative risk premia are time varying and associated with specific macro factors, it may be possible to tilt exposures based on current or future market conditions or avoid carry risk premia during those periods when expected returns will be lower. 

What can we say about carry alternative risk premia returns, one of the most basic of risk premia? We don't have significant amounts of live trading data across all asset classes from bank or money management providers, so we have to rely on evidence-based analysis. We can look at research concerning carry and make judgments on relative performance across asset classes and under different market conditions. Judgments based on academic evidence are not definitive, but they do provide a good guide on what to expect. 

The best overview paper is this area is simple-named "Carry" by Koijen, Moskowitz, Pedersen, and Vrugt. Foremost, this  paper provides a universal definition of carry and apply it across all the major asset classes. It brings together in one framework the research of many authors. As defined, carry is the stand-alone return not associated with a change in expected prices. Given this simple definition, carry strategies are just the combination of being long high carry assets and short low carry assets within an asset class. This simple definition can be applied to currencies, equities, fixed income, commodities, credit, and options.

Carry can also tell us something about future returns and price changes. For example, high equity carry or dividend yield has some predictive power about the future equity prices. In other cases, future price changes will take back carry returns. In still other asset classes there is no relationship between carry and expected price changes. Our table summarizes the research in the "Carry" paper. The impact of carry on total return will vary by asset class.

While carry is available in all major asset classes, these risk premia are not highly correlated to each other. There is benefit with building a diversified basket of carry trades. 

Global carry will be riskier during periods of economic stress. Using a global recession indicator, it is found that there will be greater drawdowns during recession periods. Although these  drawdowns may be less than those found with market beta exposures, loses are significant. Nevertheless, all carry strategies will not behave the same during a recession. Specifically, Treasury carry will provide a defensive return stream. There is some crash risk with carry strategies but it is not universal.
Research also finds that global carry factors will have a positive response to liquidity shocks and a negative response to volatility changes. There is still alpha during these times, but expectations for a negative liquidity shock or a positive volatility shock will have a significant negative impact on carry returns.

The evidence on carry suggests that it exists across all asset classes, but its ability to predict futures returns is highly variable. Cary returns are highly uncorrelated and can be bundled into diversified portfolios; however, carry is sensitive to recessions, liquidity shocks and volatility shocks. Overall, this well-defined macro evidence can help any investor with determining when to hold or avoid carry exposure. Carry  may be good today, but a recession or volatility shock may quickly change return opportunities.

Monday, September 17, 2018

Waffle House and Risk Management - It Is All About the Preparation

If you have been on the road looking for cheap food 24 hours a day in the South, you have likely been to Waffle House. It is not be best breakfast, but if you need a quick meal, this is a good place. You usually will not see a money manager or a Wall Street banker at a Waffle House counter and that may be an added appeal. 

It has gotten a reputation as a place that will stay open no matter what the disaster or open first after a hurricane. Some have talked about the Waffle House hurricane index. The worst damage is where the Waffle Houses are closed. Civilization begins where Waffle House is serving. 

So what can a money manager learn from Waffle House? Emergency preparedness. To be able to deliver on staying open and opening quickly after a hurricane, Waffle House spends a lot of time planning. It is a logistical and supply problem, but the important issue is that they plan for the worst every year. 

Hurricane season lasts from June until the end of October, yet no one knows where or how many hurricanes may hit in the US. Some years there is nothing and other years there can be multiple hurricanes. Waffle House does not accept that these are mere random acts, but every year plans for the worst. There are emergency preparedness manuals and training for every store. There is staging before a hurricane. There are contingencies plans for supply. This is all for a simple restaurant to ensure that victims and relief workers have a place to eat. No frills, but the assurance that if you want eggs, hash browns, and coffee you will be able to get it. 

Is there the same level of planning by hedge funds and money managers? They know there will be sell-offs, bubbles, crises, liquidity events, and failures, but how many managers can show investors their contingency plans or what they will do under different emergency scenarios. Firms are good with operational plans, but the real planning is with the investment portfolio. The identification of risks has been much improved in real time, but the actions to be taken under different risk scenarios are less clear. If the next financial crisis hits, there will be a lot of talk about it being an event that hurt everyone and could not be avoided, yet it is a core job of the portfolio manager to protect principle during these events. Every situation is not unique and different. Planning can be done.

Waffle House would not accept a market event standard that things sometimes happen. It works to higher standard based on the needs of their customers even if it is just serving breakfast. The same high standard should apply to money managers. 

Tuesday, September 11, 2018

Simple Alternative Risk Premia (ARP) Allocation - You get value

Investments in alternative risk premia (ARP) are way to access the important building blocks for returns and generate return streams that will not be highly correlated with market beta exposures. Through factors and styles like value, carry, momentum, and volatility, investors can generate unique return streams relative to asset class betas. To show the value of alternative risk premia, we have taken a broad based index constructed from HFR through bank swap products and compared against a standard 60/40 stock/bond index. The HFR index is new and represents only a portion of the growing ARP market and may not include the largest banks.  Still, it may provide some insight on what realistic value can be added through investing in a portfolio of risk premia. 

For a simple 60/40 stock/bond blend, we combined SPY and AGG rebalanced monthly. For an alternative risk premia portfolio, we used the HFR Bank Systematic Risk Premia Multi-Asset Index, which combines risk premia in credit, rates, equities, commodities and currencies. There is a suite of HFR risk premia indices, but we employed their broad-based asset class index to show proof of concept. These risk premia indices are relatively new and we have concerns of the breath of coverage with the index, but it serves as a first pass of what is possible.

We looked at four combinations: 1. A base case 60/40 stock/bond SPY/AGG portfolio; 2. An 80 percent 60/40 proportional portfolio with 20 percent in the HFR risk premia index; 3. A conservative 40/40/20 portfolio of equities/bond/risk premia; and 4. An equity focused 60/20/20 equity/bond/risk premia portfolio. We started the portfolios in May 2009 as the beginning of the post Financial Crisis period through July 2018.

The results show that alternative risk premia at very generic level are able enhance a portfolio relative to a base 60/40 stock/bond blend. The best performer was an allocation to stock and an alternative risk premia substitute for bond exposure, followed by a proportional allocation to alternative risk premia, and then a lower allocation to stocks. The high equity exposure should not be surprising given the strong performance of stocks since 2009.

While there is no guarantee that this performance can continue in the future, it is suggestive of the gains from alternative risk premia during a period of strong equity gains and strong bond diversification benefit. The alternative risk premia basket was able to generate better returns than a bond portfolio, good diversification relative to stocks and bonds, and performance that will not generate significant return drag. This is all without any special structuring of the portfolio.

Monday, September 10, 2018

Don't worry about investment consultant advice on manager performance - It does not exist

How many times have you gone to a pension fund or endowment and heard the phrase, "You will have to check with my consultant", or "If my consultant hasn't approved you, I will not invest". Pension consultants are powerful in the money management industry. Without their blessing, it is hard to grow an institutional money management business. There is the assumption by many that they have special investment powers that allow them to conduct due diligence and ferret information on managers that cannot be achieved my most others. 

It should be easy to prove their value added. Just look at the managers they pick versus the managers they reject. This should not be much harder to test than determining whether a manager is better than a benchmark. It is just an issue of collecting the information from the consultants and comparing against a set of benchmarks and peer groups. Some have done the work, and the results are available for all to see, (Investment Consultants’ Claims about Their Own Performance: What Lies Beneath? Gordon Cookson, Tim Jenkinson, Howard Jones, and Jose Vicente Martinez)

The answer is that their value added for picking managers is limited. Are their picks harmful? Perhaps not. But, paying them for their secret due diligence performance sauce is not going to get you much. Show them this study and just ask them to prove otherwise.

The study used a database of recommendations from the FCA for UK consultants some of which are the biggest in the world. This database has not been available to the public. The conclusions suggest that the consultant recommendations do not outperform non-recommended managers or benchmarks. These results are inconsistent with the claims of the consultants who show outperformance versus selected grouping for comparison. A close look at the methods used for consultant claims suggest that there may be biases in their methodologies. 

This work scratches the surface and needs closer analysis for US recommendations and through using alternative methods for comparison, but the simple conclusion is that performance value-added through consultant manager picks has limited value.

Do consultants provide other value-added services? Helping with standardization of practices, doing operational due diligence and background checks, helping with performance benchmarking, forming strategic allocations, and providing data on sets of managers are all useful services. But, pensions may want to be more suspect with respect to using their picks for finding the best performing managers. Savvy pensions may have known this for years, but buyers beware.