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. 

Sunday, September 10, 2017

Keeping it simple with explanations - An investment narrative needs to answer key questions

"Maybe you could tell me what is going on. And please speak as you might to a young child. Or a golden retriever. It wasn't brains that brought me here; I assure you that." - Margin Call (movie) 

There are two communication problems with global macro investing. First, the stories used to explain the global macro economy are confusing, contradictory, and haven't proved to be true. This is an outgrowth of the poor forecasting of macroeconomics in general. Second, the stories used to explain the investment process especially for quants goes over the head of most investors. A discussion of techniques is not an explanation for how returns can be generated. Managers need to work on their narratives to ensure that investors understand what they do and why they make money.

These two issues are more acute given the way these global macro and managed futures programs have been sold. Managed futures managers have presented the story that their strategies will do well during a financial crisis given past low or negative correlation, yet this correlation benefit is not a certainty. Investors do not really know what to expect from these managers given there have not been good narratives to explain why there are low correlation benefits. 

We will not present a general narrative for the benefit of managed futures or global macro at this time, but will suggests some questions that have to be answered to provide a good narrative for any firm. There is no magic formula for providing the right narrative but any story has to have a well-defined beginning, middle, and end. A firm's narrative is like a journey. The first part is how the manager got to the point of having a unique strategy, the middle is the challenge for how the investment problem faced will be solved, and the third part or end is the performance or the results from the strategy. 

Below is a list of some simple questions that should be included in any narrative. 

Whether discretionary or quant, a good narrative starts with a view of the economic world or environment. The worldview places decisions and modeling approaches into context. The worldview concerning the behavior of markets needs to then be expressed in trades and in a portfolio. An important question is whether trades represent multiple themes or variations on one theme. A good narrative also discusses how technology and research is used to generate returns, and will discuss when there is failure and how it is overcome. 

Without a good narrative investors cannot understand the firm's value-added and appreciate when a strategy will have benefit.  Unfortunately, even successful managers do not spend enough time developing their story and do not peak to their investors in ways that are clearly understandable.

Global macro in one page - Where is that inflation?

Where is that inflation? Central banks have this fixation on 2% inflation as both a goal and a signal. Policies have been structured for the magic 2% and signals for balance sheet action are based on the inflation hitting 2%, yet current inflation has not been able to reach this number. Growth expectations have been moved higher, yet there seems to be continued economic slack that will not allow product prices to push beyond 2%. Hence, central banks have held to current policies. (An exception was the Bank of Canada this month.) The result has been further asset price appreciation and more leverage. This combination will have to be adjusted, but not today. Nevertheless, markets are still hyper-sensitive to monetary policy musings. 

High valuations and leverage make for a more difficult environment when there is a more market uncertainty concerning geopolitical shocks. As noted in a recent post, (AllianzGI Risk Monitor survey - Geopolitical risk on the rise, requires special thinking), geopolitical risks is on the rise as the top risk with investors. These types of risks are especially difficult to hedge given the impact across many asset classes. Growth expectations can be reversed quickly on a negative geopolitical event and leverage will make economies more sensitive to any shock. Investors have to think about strategies that will be more nimble to a negative geopolitical shock.

Friday, September 8, 2017

AllianzGI Risk Monitor survey - Geopolitical risk on the rise, requires special thinking

If you tell me I have increased equity risk, I can adjust my asset allocation way from stocks and determine a good hedge strategy. If you tell me there is more interest rate risk, I can adjust my bond exposure and determine a hedge. But, if you tell me I have geopolitical risks, the choices or options become more complex. Geopolitical risks just don't happen often so we don't have a lot of countable events. Increased political risks will usually mean risk-off, but how this plays-out through a portfolio is less clear. It calls for more careful portfolio construction and diversification management.

The AllianzGI Risk Monitor survey is more important this year because it highlights a change in risk concerns. With over 750 respondents around the world, this year's survey, for the first time, places geopolitical risks at the top of the list with 40% viewing these as a concern.

The list of worries translates into equity market and event risks topping the polls. Both increased over last year. The geopolitical risks have made investors more wary of a tail risk event which can have a major impact on performance. Tail risk worries are up over 10% since last year's survey.

What are investors planning to do about these greater geopolitical risks? The survey suggests that there are two approaches for dealing with this market uncertainty. First, investors will continue to be active managers so options are open in order to nimbly react to change. Second, investors will continue to employ strategies to enhance diversification. When in doubt, hold a broad basket of asset classes and strategies that can be adjusted as needed.

What applies to the portfolio overall also applies to alternative investments. The survey emphasizes the important role of diversification from hedge funds. In an uncertain world, strategies that help maximize diversification should be in high demand. Global macro and managed futures fit this profile. These strategies have low overall diversification because they actively trade many asset classes. Additionally, managed futures has shown to generate crisis alpha or a crisis risk offset which will be extremely helpful if there is a geopolitical event that creates strong tail risks.  

HFR risk parity indices - A systematic alternative that is returning?

HFR has announced a new set of risk parity indices. The set of indices includes risk parity strategies at different volatility levels and for both institutional levels and smaller funds. These investable indices represent 25 different products with $110 billion in AUM. The risk parity portfolios are generally comprised of four sectors which are given equal risk weight: equities, credit, interest rates, and commodities. 

The result of equal risk weighting will be a stronger allocation to bonds versus stocks given the lower volatility of bonds versus equities. Clearly, periods of strong bond performance will lead to outperformance versus even an equal dollar-weighted stock/bond portfolio. Nevertheless, the last two years have shown strong positive returns after a disastrous 2015. These indices have done better than a broad-based equity hedge fund index and may again be worth looking at as a systematic investment alternative.

These indices may be another way of expressing a systematic approach to portfolio management relative to global macro and managed futures. You might initially think that risk parity and global macro or managed futures has little in common with risk parity, but there are some structural similarities which make a comparative analysis reasonable. 

Many global macro and managed futures programs use some form of volatility targeting which is consistent with risk parity approaches. Additionally, systematic managed futures will often risk weight sectors with exposures in equities, bonds, commodities, and foreign exchange. The largest differences is with the core holding of credit versus foreign exchange exposure as a sector and the active determination of directional positions either long or short versus passive risk exposures. 

The risk parity approach was discredited by many based on the poor 2015 performance but it actually did what was expected during that period, albeit not what was wanted. It is now doing what is expected, offering equal risk-weighting across a well-defined set of sectors. It may serve as an alternative for investors who want a systematic approach to risk management but without any directional market views.

Thursday, September 7, 2017

Hedge fund performance - Growth, Macro, and EM best strategies

While stocks were mixed with performance down for the month in with growth, value, and small cap benchmarks, there was a general increase in hedge fund returns for August. Equity-focused hedge funds gained from the added dispersion in returns across sectors and individual stocks. Evidence suggests that active management relative performance increases when the correlation across stocks decline. 

The biggest gains were in EM hedge funds which is in-line with the strong gains for benchmarks. Global macro and systematic CTA's also did well for the month on bond, currency, and selected commodity moves. 

All hedge fund strategy benchmarks are positive for the year except for systematic diversified CTA's. The best performer for the year has been the fundamental growth category followed by special situations. A test for hedge fund investing will come this fall if there is an increase in market volatility and an adjustment in valuations.

Wednesday, September 6, 2017

MiFID and managers as return factories - For whom is it an issue

MiFID II is coming with less than four months to go until the start date in January 2018, yet money mangers and hedge funds are scrabbling to find the right regulatory structure and the right way to manage the costs of the business. MiFID requires an unbundling of brokerage from research costs. Asset managers will either have to pay for research or bill clients. Many managers have yet to make or disclose their intentions on how research costs will be handled. A topic that has not been fully covered is an understanding of the cost generating the investment returns based on the process employed. 

We can start with a simple discussion model of return generation as the output from a factory. The money manager is the return factory that processes information inputs to generate returns. A key question is where do those inputs come from and who pays for the raw material. The raw material can be data and news. The data could be price feeds, fundamental macro information, or company income and balance sheets to name just a few sources. This raw material generally has to be processed inside the factory to generate ideas, form valuations, and create opportunities. 

Some raw material needs a lot of processing while others has already been refined and needs little or no processing. The value-added of the manager is his ability to process data and generate a better return output. The data coming into these return factories is the same, but different factories have varying skill at processing the data.

Returns can be generated through a disciplined quantitative investment process with inputs like price and macro fundamental data. This systematic process needs monitoring, but runs like a machine. (You can think of the modern factory which uses robotics on the shop floor. It needs limited human intervention.) The input is raw data with all of the fabrication done in the factory through statistical analysis. The cost of this data is relatively cheap with most of the value-added done through the refining process. 

In this case, there is little need for research from brokers because the raw data are readily available from exchanges and the processing is done in-house. There is no deep link between research and execution because there are no research services from the Street that are used in quant programs. 

An alternative factory approach is a discretionary investment process which is more akin to an artisan or craftsman. The emphasis is not on bulk processing of raw data but deeper analysis on specific information like firm details which may include company meetings. This work takes more time, and data that is refined or pre-processed is especially helpful. In this model, brokerage firms act like subcontractors or suppliers of research, ideas, and analysis. The efficiency of the discretionary process is in the link with subcontractors or the outsourcing of research. Here the street may provide important contracting services and is a supplier to the hedge fund factory of preprocessed or semi-finished data. This preprocessed information is then used by the fund manager to generate a final product which are the portfolio returns of the fund. 

The core issue is the value of subcontracting relative to the price that is paid for this service. The money manger gets this subcontracting though a bundled price with execution. More execution should go to subcontractors who provide more value-added, but the cost of this contracting arrangement is not always clear, direct, or transparent. Good managers should be able to track the quality of subcontracts, poor managers will not. If the subcontractor provides high quality work, then a price will be found for the services. If the quality is poor, then the return factory may reject the input and not use the poor quality or pay for the contracting. Quality assurance may say that the preprocessed data from street research is not useful; however, contracting saves the factory from doing on the data processing in-house. 

Unbundling will mean that managers will not accept poor quality research that was given as part of execution fees. This is a positive welfare benefit, but still leaves the question of how to pay for good subcontracting. It is a service that is used to enhance the return factory overall product output. It is not just data, but prefabricated analysis usually done inside the firm. Should investors have to pay for this processing? Is the value of the manager his ability to process raw data or his ability to make decisions on processed data?

Clearly, all in-house processing firms like quantitative shops will not be greatly affected by this. Fundamental shops focused firm-specific analysis could be hit harder if the work now has to be done in-house. Thinking about money manager as a factory firm no different than other industries makes some these questions easier to address.

Monday, September 4, 2017

Positive gains for month on bonds and currencies - Strength to continue

Many of our trend indicators were mixed coming into last month but continued gains in currencies and a strong bond rally positively contributed to performance for many CTA's. The current trend indicators suggest continuation of these existing price moves. We  take a representative sample of markets in a sector and count how many have up or down trends to form a sector estimate. The sector estimates can be strongly up or down or more neutral with a bias up or down as indicated by our arrows. 

Stock indices sold-off earlier in the month only to rally during the second half on positive sentiment concerning tax reform and less aggressive Fed talk concerning its balance sheet. Bonds continue to move higher albeit with weaker slope. Currencies also continue their trends, yet the momentum against the dollar has slowed. Precious metal moves have been tied with currency trends. Energy markets have been affected by hurricane volatility and commodities are biased lower.

While some of the strongest trends last month may reverse, our general view is that trends often last longer than expected and without a policy or economic surprise, there is little reason to see a change.

Sector dispersion on the rise - A sign of active management on the rise

August showed growing dispersion across styles, sectors, countries, and bonds. For example, there was almost a 5% difference between holding the emerging market and value ETF's (EEM-IWN) For sectors, there was an 8 percent differential between energy and technology (XLE - XLK) and a 3.5% difference in bonds between long-term Treasuries and high yield (TLT - HYG). 

The major theme coming out of August was the mixed message of holding bonds and emerging market stocks as opposed to risky US stocks. You could think of the EM stock bond combination as a barbell around large cap US stocks. Nevertheless, these mixed messages are unlikely to continue. The pessimism embedded in bond investors versus global optimism cannot hold for long. The central bank policy meetings in September may clear up these issues.

Global equity markets, especially emerging markets, again added value to portfolios while the more domestic sensitive styles like small cap and value continue to lag. The diversification benefit of holding a global portfolio has proved to also be an excess return generator. 

 Sector dispersion has increased significantly which we believe will have a positive impact on active managers. The differential between energy and technology sectors is now over 35 percent. The differential between health care and finance is over 12 percent. There has been significant return value with choosing the right sector allocation.

 The country return differentials are also large. The returns have been benefited by currency gains. Although this month was negative, South Korea has still generated strong gains in 2017 in spite of all the geopolitical risks from North Korea. 

Holding duration in bonds has been a winner for the month; however, the combination of foreign duration risk with currency gains have been especially favorable for this year. High yield showed the largest underperformance for the month and has underperformed closely aligned Treasury duration portfolios. 

Trend and breakout signals across a number of time scales still show value with holding country and bond risks which can be accessed in futures and ETF markets.

Saturday, September 2, 2017

Managed futures post gains on bond and currency trends

Many CTA managers posted gains for August based on strong bond moves in the US and up trends in European fixe income. Currencies continued to add to profitability albeit the decline in the dollar has a flatter slope than previous months. Gold trading was profitable for those who traded it in tandem with currencies. Equity index trading was a more difficult sector given mid-month spikes in volatility and a reversal in direction during the second half of the month. Commodity trading was mixed for many managers with profitability associated with market allocation and style of trading employed. Oil trended lower while refined products and natural gas were slightly up for the month. Hurricane Harvey volatility affected position-taking at the end of the month. Industrial metals have continued their summer upward trends which has caused renewed interest in this sector.

Managers with bond heavy allocations were stand-outs this month.  There are perfect conditions for managed futures when a major market sector shows a strong trend with little volatility surrounding it.  Hence, the strong gains. This was only further enhanced with currency trends that have showed similar characteristics. A core sector gain can be further enhanced through satellite positions in less liquid sectors. 

September news and policy issues suggest that one of these trends may be reversed, but right now there is not likely to be significant position changes. Trends last long then expected, but extremes are often reversed and sometimes trends die of old age. This is when the quality of managers are tested. 

Friday, September 1, 2017

Agent-based finance and investing - Exploiting more than price is important

The book, The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber touches on the important idea that markets are driven by a diverse set of agents who have different objectives, levels of rationality, rules for making decision, and market power. The book makes a strong case for throwing out the existing theories that often rely on representative agents in order to more effectively explain the messy business of modeling financial markets. 

I am sympathetic to the main points presented by Bookstaber, and hearken back to the older age industrial organization work that focused on the dynamics and structure of players in a given industry. The description of the environment and how institutions enact is critical to understanding the dynamics of markets. Changes in regulation, adjustments in market practices, and the employment of market power all lead to situations which could not even be imagined in a world with atomistic similar agents. The representative agent approach, by assuming everyone is the same, naturally leads to market efficiency stories. There is no room for diverse behavior. An agent-based approach allow for ebbs and flows in efficiency based on the weight of different market players. 

More important for quant modeling, an agent-based view of markets focuses on more than just prices to help make better investment decisions. I have always been of the view that "prices are primal" and this is the best starting point for any market analysis. Price analysis can often be enough for finding market trends and making investment decisions, but secondary sources of information may be helpful for reinforcing price signals and identifying turning points. 

A classic example of using an agent-based approach to help with investment decisions is using the commitment of traders from the CFTC. The quality of the data has improved over the years with a finer breakdown of users categories and less delay in reporting. It is still not real time and there is significant noise in the data, but strong changes and extremes  in positioning is a good reinforcing tool to price behavior. 

The soybean chart of managed funds positioning provides a good story of when money was getting short and when it was reversing in response to a price increase. By itself it is not a good signal but with price, positioning information can reinforce what is happening in the market. This is especially true at extremes. Of course, given the availability of the data, many simple filter tools like the commitment of traders have to be recast in order to create an edge. 

The agent approach can be used to generate market context and color and can be further refined to include large trades, volume, and open interest. Given the success rate for trend trades is usually less than 50%, tools that condition or filter signals are extremely useful. 

August performance - Living in a bipolar world of safety and EM risk-taking

Global returns in August were unusual because of the bipolar behavior across market sectors. The strong performance on the long-end of the Treasury curve coupled with the negative returns for small cap and value suggests there was a flight to safety by investors, yet one the best performing sectors was the riskier emerging markets sector.

While there was an upward revision for US growth in the second quarter, the greater uncertainty concerning tax reform or cuts has weighed heavy on gains in equities. The switch from sell-off to return improvement during the month could be linked to a change in sentiment on this key issue. Negative sentiment concerning tax reform sinks the market while stories about a consensus for tax reform pushes the market higher. This issue focus uncertainty is not present in emerging market equities where good growth continues. International investments generally performed better on the dollar decline; nevertheless, as the currencies like the Euro move higher and seem especially stretched, there is a concern that it will negatively feedback on sales for these foreign companies.

With the end of summer, the focus is going to be on monetary policy with key meetings at the Fed and ECB in September. The Jackson Hole conference was a bust with respect to newsworthy announcements. The investment themes developed during the summer concerning overvaluation and policy direction will continue to be front and center for the fall. Still, the markets have shown a surprisingly level of stability given geopolitical and economic risks.

Wednesday, August 30, 2017

Downside analysis to the next level - look at partial moments for an edge

A close look at the VIX index shows a very skewed distribution as low levels push against a barrier. There is more risk that the VIX will rise versus fall. The same can be said for many other asset prices.  Normality is out; non-normality with respect to distributions is in. The value of looking beyond standard deviation is all the more important in the current environment.

These distribution tilts are all the more important impact in any discussion of asset allocation, but does not change the fact that risk management is still about the downside of any distribution. The lower partial movements can capture the deviations from normality and is a generalization of semi-variance that was discussed in a previous post, "Measuring Risk - Working Against the Downside".  The semi-variance is just the lower partial second moment, so there should be little problem looking at the lower partial moment of higher degrees like skew, the third moment. There is simplicity with semi-variance as an extension of risk measurement of the standard deviation, but the work on lower and upper partial moments is not hard to implement in a spreadsheet. 

Why not just look at volatility? Because volatility is too restrictive in a more complex price and return world where normality is the exception. The cost of skew and fat tails are real for those who ignore them. A simple example is shown with two managed futures funds and two managed futures indices. We looked at the standard deviation for each over the last three years as well as the omega, or upside versus downside returns, and the upside return versus downside risk. The fund that has the highest standard deviation or risk also has the highest upside to downside capture and the highest upside return to downside risk. The "riskiest" fund has the best upside opportunity and this applies to different threshold levels beyond zero. 

This work on partial moments can be extended to comparisons with the market portfolio. The covariance/variance (beta) of a stock to the market will be same as the conditional lower partial movement to lower partial moment of the market when the distribution is normal. If returns are not normal, there will be greater deviations between the normally calculated beta and a partial moments beta based on the distance from the average market exposure. This means that your beta measure for alternative assets which may have low market betas will have greater measurement error when there is non-normality. Your measure of risk to the market will deviate from normal beta calculations as the partial moments start to deviate from normal.

Lower partial moments like semi-variance splits the distribution between good and bad volatility as measured by a target that in most cases is set to zero or the mean return, but investors can look beyond symmetric distributions. We have found that downside risk measures relative to a target return are especially useful for pensions. Their interest are whether returns will be below their expected return not the around the average return of the manager. 

Don't be fooled by standard deviation when a little extra effort can generate useful information on downside risk. “Risky” managers, based on standard deviation, may actually be winners as measured by downside risk or lower partial moments.