Friday, November 17, 2017

Ivy league performance - Competing with top tier endowments can be done

The latest performance numbers of Ivy League endowments have been nicely displayed in the chart below along with the 60/40 stock/bond portfolio. Since the development of the "endowment" model associated with Yale and the attention on Harvard, the largest endowment, there has been an unusual focus on these funds. There is a fair amount of dispersion between the best and worst managers in the group.

Nevertheless, investors can compete against these more sophisticated funds by even just holding some variation on the 60/40 stock/bond mix. Three of the last ten years have seen the 60/40 mix at the top of the rankings. Twice the 60/40 mix has been at the bottom of the grouping. 

A large portion of the Ivy endowments has been associated with illiquid private equity investments. The 60/40 stock/bond investment blend is a liquid portfolio. It is possible that adding liquid assets that have higher returns than bonds or further diversification characteristics can generate more competitive returns to a simple 60/40 mix.    A liquid investment strategy approach can compete with more sophisticated managers.

Monday, November 13, 2017

Being short volatility is risky in a crisis - Do you know your volatility premium exposure?

Implied volatility is usually higher than realized volatility so there is a positive volatility risk premium, except when there is a crisis or volatility spike at which time the volatility premium turns negative. A recent CBOE seminar presented a chart on the volatility premium to illustrate the risk.  

The numbers suggest that being short volatility gave you a positive premium in a stable world, but when the world is less stable, (higher realized volatility), you do not want to be a vol seller. The chart suggests that there can still be a positive risk premium when realized volatility is high, but the odds work against you. It is a way to get to a realized volatility of more than 20% at current levels, but that world can become a reality quickly if there is an equity sell-off.

It is important to measure your short volatility where you may have been picking up vol premium. If you have too much, now is the time to cut that exposure. 

Saturday, November 11, 2017

The growing danger from a market that is complacent of risk - A variation on Minksy

Investors should be concerned about the unintended behavior from low volatility. Low volatility will lead to higher volatility in the future when investors become complacent about risk, the "Volatility Paradox". This paradox has been discussed by Richard Bookstaber as early as 2011 and recently referred to in a post on his blog, Our low risk (low volatility) world

Low volatility is a variation on the prosperity argument used by Minksy to start the cycle of speculative excess. Low volatility lulls investors into thinking risk is actually lower than reality just like prosperity or no economic downturn will cause bankers to change lending practices. Because perceived risk is lower, there is a willingness to increase leverage and increase investment in riskier assets. Risky assets are bid higher which are then used as collateral for further leverage. This volatility argument is separate from the reach for yield because of low interest rates. Risk-taking on low volatility makes the financial system more fragile.

The problem of misperception by investors with respect to measured risk and actual risk is real. Investors may be placing too much stock in recent volatility and too much emphasis on standard deviation as the right proxy for risk. Low volatility today does not mean low volatility tomorrow. Low volatility today will create behaviors that will lead to more risk tomorrow. The smart investor should be looking for long vol or divergent strategies that will profit from an increase in volatility.

Friday, November 10, 2017

Dan Fuss's 4 "P's" for global fixed income - Watch out if you are a bond holder

Dan Fuss, the Loomis Sayles bond guru, has been working in fixed income for decades. He has developed a set of four "P's" with central bank behavior for looking at the macro fixed income environment and his read is suggesting that caution should be applied to any forecast that believes bonds are safe. 

Many of the P factors are longer-term and associated with shocks, so it may not be trade worthy, but for investors who are looking at longer-term asset allocation, this type of checklist is valuable. We have made our own assessment and believe the tilt is away from the credit sector and should be focused on global diversification or strategies that can perform better if there is a global economic shock.

Thursday, November 9, 2017

Are you honest with your investment intellect? Avoid biases and follow the data

And not only the pride of intellect, but the stupidity of intellect. And, above all, the dishonesty, yes, the dishonesty of intellect. Yes, indeed, the dishonesty and trickery of intellect.
-Leo Tolstoy

Can intellect be dishonest? Not accepting behavioral biases is one form of intellectual dishonesty. We have to accept our decision biases before we can change them. Part of the behavioral revolution is the acknowledgment of our decision flaws. Intellectual honesty requires discipline with decision-making.

Another interpretation is that there can be dishonesty to data. When data do not support a narrative, there is no truth. Ignorance is not knowing the data. Dishonesty is stating or believing a story that is not grounded in the data when you actually have looked at the data.  Not accepting data is dishonest; nevertheless, there also has to be room for alternative interpretations of data. We are dishonest to the truth when we do not accept alternative arguments that better fit evidence. 

Why follow this line of reasoning? Are those who are not quants or data driven, less honest? Do quants or systematic traders have the moral high ground by being data focused and less biased? We are not proposing answers; rather we are proposing more self-reflection in an industry that is long on ego and opinions. Money management is humbling and financial painful if we are not honest with our knowledge and limitations. The movement to passive investing, the increased use of quantitative tools, the stronger focus on risk management, and the acceptance of behavioral biases are all indicators that we are learning to be more honest with our intellect.

Tuesday, November 7, 2017

Spider chart tells managed futures story differently

The spider chart is an alternative way of displaying data that may be useful at showing the strong diversification benefits versus different asset classes and alternatives. Correlations are looked at through a matrix form but the spider or radar graph may better display the most relevant information. Each node on the web may represent a different asset class and show the correlation of each to a single strategy.

The spider graph provides a simple holistic picture of diversification benefits for a single strategy as well as a group. In the graph above we should the correlation of the SocGen management futures against a battery of other asset classes. Any other alternative can be overlaid on top of managed futures to show the relative performance. We have taken the spider graph which looks at managed futures across different asset classes and enhanced it through running a comparison with a general hedge fund exposure through using the HFRI composite fund of funds index. 

The spider shows that managed futures provide a great deal of diversification against equities and less against bonds. The HFRI composite does just the opposite. This shows the relative important of managed futures even within a hedge fund portfolio.

Monday, November 6, 2017

Will hedging not speculation be the driver of a financial disaster? Is VaR hedging like portfolio insurance?

Unlike earlier financial disasters, this one will emerge not because of too much speculation, but because of the inverse - too much hedging.

-William Silber on stock market in August 1987

Could this be the problem we are facing with the next financial crisis? There has a significant amount of talk about over-valuation in equities and the reach for yield in fixed income, but there has been less focus on how a financial crisis will evolve. It may not be from speculators changing their views on the market although this could be a catalyst. Selling could be driven by those investors who are trying to hedge or mitigate their risk exposures.

One of the contributors to the financial crash in 1987 was the impact of positive feedback strategies that reinforced the market decline. In particular, there was a strong link between portfolio insurance selling and the market decline. When employing portfolio insurance, as the market declined, there had to be more selling of equities and buying of bonds by those following this hedging strategy. Because the amount of portfolio insurance was so large, their selling activity dominated the market during the crash of October 1987. We have referred to this is a previous posts on the "paradox of prudence" and VaR - good for a manager, but bad for the markets as a whole - Call it the "Paradox of VaR Risk Management". It was hedging not speculation which drove the crash through waves of selling. Certainly, it was a feedback loop that needed to sell more as the market declined.

We can see a similar problem with the current risk management techniques that employ a form of hedging through cutting exposure on volatility increases. The feedback loop will add to selling when there is a volatility shock. An increase in VaR will cause investors to reduce their risk by selling the risky asset and buying the safe asset, similar to a portfolio insurance scheme. What is different is that investors will not sell just those assets that may be falling. There could be downward pressure on any markets that are seeing upward pressure on volatility. Positive feedback will actually place downward pressure on many markets.

The upside-downside risk embedded in options - Lower but less balanced than earlier in the year

From the Minneapolis Fed we have market-based probabilities of a large up or down market move embedded in 12-month options. This is a good market-based view of a large up or down stock market move.

If we look at the numbers from a year ago, the probability of a 20% or more down move was more than double the risk of a 20% up move over the next year; (13% versus 5%). Now, the chance of a 20% down move is approximately 8% and the chance of an up move is about 2%. The market has a tighter range but the change of a down move is still much higher than an up move. There is still skew to the downside but likelihoods have fallen. 

These volatility numbers will be tied with market moves, but right now it is hard to argue that there will be a large market moves given the chance of 20% down move has declined by close to 40% and a chance of an 20% up move has dropped by over 50% 

Sunday, November 5, 2017

The "Paradox of Prudence" - It is real and needs your attention

Our thinking of systematic risk has to be in two dimensions; one, the time series impact and two, the cross-sectional impact. These financial insights are coming from Markus Brunnermeier in his piece "Paradox of Prudence". The time series component focuses with the build-up of risks, and the cross-sectional component focuses with the transfer of risks. This leads to two paradoxes. 

  • The "volatility paradox" - Low volatility today leads to more risk-taking and higher leverage which will lead to more volatility tomorrow. Low volatility causes more risk-taking which makes the economy more sensitive to any shock. The seeds of future risk tomorrow are found in the low volatility of today. 
  • The "Paradox of Prudence" - Each firm tries to reduce risk exposure and be micro-prudent, but this leads to more systematic risk and is macro-imprudent. While some behavior can be market risk tampering, risk management can also be risk amplifying for the economy as a whole. Attempting to control your risk will spill-over to other firm. 
We usually focus on the times series, but the actual risk will be in the networks between firms and the behavior of firms to specific risk shock. A shock to any firm will propagate through the economy through firm linkages. 

The potential advantage of global macro and managed futures comes from their ability to take advantage of cross asset class spill-over of risks. An equity shock may spill-over to bonds which can impact currencies. The global macro manager can trade these differences.

Saturday, November 4, 2017

Predicting managed futures returns - Follow the mean reversion

Managed futures have been in a significant drawdown with poor Sharpe ratios over the last two years albeit October has been a good performance month. Many investors have talked about throwing in the towel and getting out of this hedge fund strategy. New investors have focused on other strategies and not waste their time with CTA’s. A simple approach of looking at recent performance would not be compelling, yet a closer examination shows that this may be one of the best times to invest with managed futures. Forget the recent performance or more specifically, do the opposite of momentum investors and buy on the dips in risk-adjusted performance.

The investment people at Steben and Company have published a good piece of research on market-timing of managed futures called, "Can you Time Managed Futures?". Their results suggest that there is mean reversion or negative autocorrelation with 12-month Sharpe ratios. Periods of very low Sharpe ratios are followed by strong risk-adjusted returns. 

Simply put, buy the dips if you are interested in increasing your allocation or investing for the first time. This mean reversion is present in every decade for the Barclays CTA index.

This does not address the question of what manager should you buy if you want to increase your allocation, but it is a good start at looking at timing this hedge fund strategy space. We are currently conducting some research on how to choose which manager using a similar methodology of timing risk-adjusted returns.

The decision for investing in any one manager is more complex, but the general timing decision may be easier to address. When the investment committee likes management futures the least may be the period when you should love it the most. If you are holding managed futures and ready to divest, think again, it may be worth waiting for the reversal. 

How many biases dragged down your performance last month?

The behavioral finance revolution has been well noted by both academics and practitioners. Multiple Nobel Prizes have gone to economists who have studied in this area, yet investment decision-makers still make the same behavioral mistakes. We have noted our biases but often we have not changed our behavior. Perhaps it is too ingrained, but good has to be reinforced. 

The following info graph does a nice job of listing the possible mistakes (screw-ups) that can be made. Only 20? Without a review or inventory of your mistakes, there is little chance for decision improvement. If there is a performance review for a portfolio, it seems as though a performance review of decisions should also be made. 

How many decisions were made in the last month? How many were good ones? A good decision does not have to be profitable. It does have to be rational. In many ways the decision-making review for a quant system is so much easier because the behavior is hard-coded in the action. Nevertheless, discretionary decisions can still be made more rational and address a unique set of problems. A decision review system will help.

Friday, November 3, 2017

Trend continuation in currencies, energy, and equities will be good for managed futures

You could call it the second reflation trade. Based on economic data trends which suggest stronger global growth coupled with tax reform/cut talk, we are seeing major sectors show increasing trends and opportunities. The good October trends seem to be carrying over to November. The reflation trades has driven stock indices, energy, and base metals prices higher. The differential between monetary policy in the US and the rest of the world also suggests dollar strengthening. The rate differential is in favor of the the dollar. This dollar strength places downward pressure on precious metals. Bond price behavior has been a little surprising with some recent gains in spite of the the strong growth story.

Our general view is that October trends will continue given current price action relative to different trend timeframes and break-out models. 

October hedge fund performance led by CTA's - all hedge fund strategies positive for the year

CTA's showed their strongest performance of the year in October. Only the fundamental growth strategy came close to generating the returns seen in managed futures for the month. Some strategies actually posted losses for October even with the continued increase in equity returns. 

Managed futures will do best when there are trends outside the normal equity bond mix. With increases in the dollar, energy complex, and selected commodities, CTA's were able to find profitable opportunities.

All hedge fund strategies are now posting positive returns for the year. The best returning strategies are fundamental growth, special situations, and emerging markets. Most strategies have some combination of beta and alpha generation; consequently, the strong absolute gains in equities help hedge funds with performance.

Thursday, November 2, 2017

Investors show rational selectivity in an overvalued world

A review of style performance shows that risk-taking is still occurring across all equity sectors; nevertheless, small cap, dividend, and value returns have fallen behind global and emerging market equity returns for year to date returns.  Global and emerging market indices still show the best returns for the year. Our trend indicators show little change in longer-term up trends.

The bond sectors have behaved as expected for a defensive asset class. Money has flowed out of bond ETF's and show general down trends except for credit sensitive indices. The best performers for 2017 have been in international and emerging market bonds given the general appreciation in currencies. Trends are generally down except for corporates and high yield.

Equity sector performance was lead by the technology sector while energy is still a laggard even with the increase in oil prices. Consumer stables and real estate show down trends as money seems to be chasing the higher beta performing sectors. There is less interest in the more defensive sectors.
Sovereign ETF's continue to show good performance with the exception for this month being with Mexico. Both European and Asian exposure continues to do well; however, there are pockets of sovereign risk with those countries that have fiscal and trade imbalances. 

While market talk has been focused on bubble discussions, there is enough differentiation between styles, sectors, and classes to suggest that investors are making relative performance judgments. This may not change the story of a market that is overvalued, but investors still show regional selectivity.

Wednesday, November 1, 2017

Thoughts of managed futures death were premature

Managed futures returns exploded to the upside with index returns showing big gains relative to alternative asset classes. The positive skew for some managers was even more surprising.  We saw some October returns as large as 14%. Every major index we track was close to 3% or higher. For example, the October return using the Morningstar managed futures category was positive 3.45 and the year to date return was up 1.85 percent.

So what was the cause for these strong gains?
  • There was no volatility spike. 
  • No financial crisis.
  • No equity meltdown.
  • No explosive set of market break-outs. 
  • No strong market predictions realized.
  • Just some good intermediate trends.
  • Strong signal to noise allowing for larger position sizing to take advantage of market divergences 
The performance drivers were clear. Strong dollar uptrends and oil price increases coupled with continued equity gains. Add to these trends a slight bond decline with bund increases as well as some selected commodity moves and you have a strong month. The size of the gain was surprising in the context that there was no large market dislocation, but multiple market gains can accumulate.

These types of moves should not be discounted given the structure of managed futures to sell losers through strong stop-loss management and holding onto winners longer than what behavior finance would suggest. This combination always for positive skew which was the hallmark of this month's performance.

Tuesday, October 31, 2017

Natural gas market - Elasticities are changing and that means more volatility

Natural gas has always been a volatile market and subject to weather shocks; however, over the last few years the volatility and weather shocks have been dampened because of the high storage inventory levels. Monthly volatility has declined by at least 1/3 over the last three years as inventories remained high.  

Inventories serve as a cushion for any shock, but this may be changing according to Matt Piselli who manages a commodity fund (MJP Strategy) for Launchpad Capital Management. Matt has been running money for the Tudor organization and prior as the head trader for Gresham, so he has a good perspective on commodity issues. 

His view is that LNG exports is starting to weigh on the excess inventory now that natural gas is leaving the country at a quickening pace. LNG exports from Sabine Pass have increased from zero to 12% of the region's production in the just 18 months. For these flows to reverse, domestic prices have to reach global rates. Coupled with combined-cycle gas turbines (CCGT) replacing coal as base-load for utilities, there may be a shift in gas elasticities. This will generate a greater price impact for any demand shock.

The important of this change should not be underestimated even with current low prices and inventories within five-year ranges. Research consistently shows that lower inventory levels are coupled with more volatility and whippiness in spreads. A weather shock will create more trading opportunities. This higher natural gas volatility will allow skilled traders to be better rewarded this winter.

Risky assets up and safe assets flat - Investors look beyond any political rhetoric

Talk of tax cuts floating through the halls of Congress coupled with stronger consumer confidence allowed risky assets to continue marching higher. Warnings of overvalued equities, concerns over leverage, and higher geopolitical risks, have not stopped stocks from stronger gains around the globe. For US companies in the third quarter, 76% have shown positive earnings surprises and 67% have had positive sales surprises. The earnings growth rate is 4.7% for the third quarter according to Factset. Positive economics, good company performance, and low volatility all contributed to this continued rally. 

Bonds were generally flat with some positive performance in the credit area and a decline in international bonds after accounting for dollar returns. With further dovish behavior from the ECB and a Fed that is cautious about quickening any pace for rate rates, there is still good liquidity in the markets. Inflation is still below 2% as measured by the PCE even though other selected measures show stronger numbers. Controlled inflation has limited any bond sell-off.

The message from October is the same one we have been hearing for most of the year. Beta investing is in style. There has been little reason to look for diversification or localized opportunities. Investors are being paid to follow market direction and not focus on manager skill to control risk. This will change and the reversal may be swift, but right now there is no clear catalyst for a market reversal.

Sunday, October 29, 2017

Interest rates for the ages - "Winter is coming" for bonds but it can take a number of forms

The Bank of England research piece, Eight centuries of the risk-free rate: bond market reversals from the Venetians to the ‘VaR shock’ by Paul Schmelzing, is important reading for any investor. It places the current bond rally which has been going on for over three decades in the long term context of the last 700 years. This bond bull movement is exceptional but not yet extraordinary when look at through history. Unfortunately, all bond rallies will end, but the reasons for ending may vary.

This Bank of England research suggests that bond bears are not just correlated to fundamentals like higher inflation but also underperformance in GDP and equity returns during the 20th century. The author conducts case studies for some of the most recent large bond bear markets in the post-WWII period. He finds that while fundamentals like inflation are a key reason for a bond bear market as in the case of the '65-'70 sell-off, there have been other cases which are not related to fundamentals like the '94 bond massacre or the '03 Japanese VaR shock. The author suggests that central miscommunication or non-fundamentals can also trigger a bond bear market. 

Inflation does not currently seem to be a potential driver for a bond bear market, although the author believes that the '65-'70 fundamental (inflation) reversal may be a likely scenario. Bond bull market trends may last longer than what many expect, but divergences will occur and the reasons may be unexpected.