Friday, April 20, 2018

The yield curve is flattening - What is it telling investors and what should you do about it?

There has been a litany of stories on yield curve flatness as if this is the signal that will provide the investment secret to success for 2018. Investors should watch the yield curve closely, but it is important to focus on what it is and is not signaling. There is a cost with trying to be preemptive to what is being signaled in the yield curve. 

Flat or inverted yield curves tell us something about:
  • Recessions - Inverted yield curves precede recessions although flat curves can last for a long time before becoming inverted or showing a recession signal. All recessions are preceded by inversions but not all inversions lead to recessions.
  • Fed behavior - Flattening and inverted yield curve are associated with tightening of Fed policy, but tightening does not mean that a market sell-off or recession is around the corner. The link between the beginning of the tightening cycle and the impact on financial markets is loose. 
  • Term premium risk - Flat yield curves tell investors there is no compensation for taking duration risk. There is limited reason to take marginal duration risk. We find that flat curves signal future increases in yield. It is a negative signal for bonds.
  • Equity markets - Flatter yield curve do not mean lower stock returns. Flattening curves are not associated with market sell-offs. 

Now, there is a truism that you have to get flat to go inverted; however, there can be a long lag between showing flatness of inside 100 bps and moving to an inverted curve. Watch the slope of the curve, but be careful about trying to be early with the portfolio changes. Adjusting intra asset class allocations is different from allocation changes across asset classes. Reducing duration risk or equity sector exposures does not mean switching from risk-on to risk-off allocations at a macro portfolio level. 

Tuesday, April 17, 2018

The "3 by 5 index card" on "Divergent" and "Convergent" hedge fund strategies

This is the second in our series; all you need to know about a topic should fit on a "3 by 5" index card. We think the complexity of hedge fund investing can be simplified if the simple dichotomy of divergent and convergent trading is used as a primary method of describing potential return pay-offs. 

If you strip away all of the activities and the just get down to basics, strategies are based on the world view of the manager and will either make money when prices move away from the mean or equilibrium price or prices revert to the mean or equilibrium price. If a manager believes the world is knowable, stable, and rational, he will be comfortable taking relative value arbitrage risks. If a manager believes the world its unknowable, dynamic, and subject to mistakes and biases, he will be comfortable with strategies that make money from market dislocations. 

Investors will be rewarded from convergent trading when prices are stable and times are normal. You will be rewarded with holding divergent strategies when there are large market dislocation and price movement away from the mean. This is not the end of the story on hedge fund investing but a good start for any discussion.

See: Mark Rzepczynski "Market Vision and Investment Styles: Convergent and Divergent Trading" Journal of Alternative Investments (Winter 1999).

Long/short commodities - Adds value to equity and bond portfolios

Static investments in long-only commodity indices have had a checkered past since the financial crisis. With the end of the commodity super-cycle, there has been a long commodity unwind and passive investing in commodities has generated negative annualized returns for investors for years. There has not been any bounce to pre-crisis level like we seen in equities. The interest in commodities as an inflation hedge has waned with this poor performance.

Of course, the dynamics of commodity prices are different from other asset classes where value is determined by discounted future cash flows. Commodities indices, as constructed through futures contracts, are driven by current demand, production, and inventory changes and not long-term future cash flows. Nevertheless, the investment environment may be changing in favor of commodities. See:

Over the past decade, there have been a explosion of commodity alternatives often referred to as second and third generation indices that have reduced risk and provided positive returns independent of the long commodity cycle and long-only indices. These long/short indices have focused on commodity risk premium and have included momentum, carry and fundamental focused rules-based investments. Expressing commodity exposure through the underlying risk premium in these markets allows investors to capture the behavior of commodities but in a way that is not as sensitive to the long swings in price and can exploit the unique differences across markets include in a commodity basket. See:

Recent research from Tom Erik Sonsteng Henriksen, "Properties of Long/Short Commodity Indices in Stock and Bond Portfolios" in the Spring 2018 Journal of Alternative Investments further confirms the distinctive features and value of long/short commodity investing through analyzing some existing investment funds available to investors. There has been a significant decline in performance since the launch of these funds, which corresponds to the post-Financial Crisis period, but the shortfalls relative to the pre-crisis periods are significantly lower the what has been seen with long-only investing. When added to portfolios of stocks and bonds using a variety of portfolio allocation methods including variations on risk parity, the author finds that returns are lowered especially in the post-crisis period, but there also is significant risk reduction and a general improvement in the return to risk ratio.

Our take-away is that employing long/short commodities indices comprised of risk premiums have diversification benefit but the potential for return enhancement is mixed and affected by the time period analyzed. Since the study looked at funds that have singular purpose like momentum or carry, there is still room for further analysis on the impact of bundled risk premium portfolios. Nevertheless, there is value in looking at enhanced commodity allocations at this time given the higher potential for inflation, better overall commodity environment, and the continued global economic growth.

Monday, April 16, 2018

Option strategies over hedge funds - Why not? The number tell a good story

There has been a consistent drumbeat that investors should use hedge funds as a core means of portfolio diversification. This has been at the expense of other methods of hedging. A diversification strategy makes sense when there is no investor information advantage or no view on the direction of markets, but in reality, investors often have some view on market direction or risks at the extreme. However, given the uncertainty on market direction and the inability to form conditional hedges, the investor focus is usually on strategy diversification through hedge funds. 

Nevertheless, option strategies can be effective alternatives to hedge funds especially if there is a market view. We mention the issue of market view because low cost option strategies will often buy puts to protect a percentage of the portfolio or protect against a specific sized move and selling calls is used to generate premium to pay for the puts. The call selling is based on either a market view or a willingness to limit upside. 

There is a close link between hedge fund pay-offs and option pay-offs. A number of researchers have used options pay-offs to describe hedge fund returns. For example, managed futures have often been described as being long a straddle. Some relative value strategies have been described as being short options. Given this link between the non-linear pay-off of options and hedge fund strategies, it would seem natural to compare the two to see which actually perform better when equalized on volatility or market exposure. 

On the one hand, investors access the skill of the hedge fund manager versus the direct pay-off from options which do not include all the fees associated with a hedge fund. Given that option should be cheaper, a simple question is whether hedge fund skill can cover their costs and also outperform an option strategy. 

We think this work has been under-researched, yet that is changing with a recent paper in the Journal of Alternative Investments. (See "alternatives to Alternative Assets: Assessing S&P 500 Index Option Strategies as Hedge Fund Replacements" by Wei Ge.) The author compares seven different option strategies on an equity index against 14 different Credit Suisse hedge fund indices that cover all of the major hedge fund strategies. The comparison is done through either beta volatility matching.  

The results show that the combined option strategies of buying puts and selling calls against the index generated higher returns and have better return to risk characteristics. The numbers are economically significant and should be persuasive even to motivate any investor to take a closer look at the value of these strategies as a hedge fund alternative. 

There are a host of management issues with trying to implement options strategies as well as regulatory barriers, but all of these can be effectively addressed. Why limit diversification alternatives to hedge funds when there are option strategies that can provide better choices?

Sunday, April 15, 2018

Morningstar star prediction - Signal to noise is low

Morningstar star ratings - Do they really work or are they a dangerous tool? This is important to revisit given the increased number of hedge funds that now have '40 Act fund structures that are ranked by Morningstar.

Like most tools, if they are used inappropriately, there will be problems. There is an ongoing controversy between Morningstar and others on the signaling value of a 5-star rating or for that matter any ranking. The ranking today may not provide predictive power on future ranking or performance. Our view is that their ranking system is a good start for analysis but should not be used as a definitive measure. Some of the problem with the ranking are associated with just understanding what is being measured.  

The ratings are a risk adjusted ranking of funds within a defined investment category. While the approach accounts for downside risk, the stars are nothing more than a ranking system. A 5-star fund will be in the top 10 percent of the funds within the category. Morningstar grades on a curve, it is hard to maintain a 5-star rating. It is backward-looking based on performance and says nothing about the quality of the manager, their philosophy, or what the fund will do in the future other than to say for the sample periods it has a high ranking. Morningstar also has analyst rating which are forward-looking and rank by a colored shield but this approach is not as popular as the risk rating. The ranking is also weighted by the time outstanding for the fund. 

We think the ranking value may have less signaling in alternative investments for two reasons. One, the sizes of the categories has changed significantly over the last few years with the growth in alternative investment funds. Two, the categorization of alternative investments is not as precise as in some of the more traditional categories. Hence, there may be noisier investor information in these ranking measures.

Predictability comes with a positive correlation between ranking today and the performance tomorrow. The research on predictability is mixed. A ranking could still remain high but there can be a decline in returns. A ranking could fall and there be better risk-adjusted performance next period. The risk ranking does to account for any changes in the fund structure. Hence, it is hard to place too much emphasis in the ranking until you define carefully what is being measured. 

  • Do you want to predict return? 
  • Do you want to predict future rankings? 
  • Do you want to predict absolute return to risk? 
  • Do you want to make a prediction about return or ranking versus other categories?
There needs to be more research on the value of rankings for alternative investments in order to provide investors with better advise on allocation to these growing categories of funds.

Speculators and commodity markets - The data does not support a bias in prices

Do speculators drive prices away from commodity fundamentals? This is one of the core commodity futures markets questions. One approach to answering this question is through looking at the price dynamics, but the advantage of futures is that we have reporting of position information by specific traders groups. Trade flows can be divided into producers, money managers (speculators), swaps dealers, and indexers. The relative balance between these groups can tell us about the market structure, a dynamic agent-based analysis.

The questions was tackled by Aaron Smith of the UC Davis at the Protecting America's Agricultural Markets: An Agricultural Commodity Futures Conference in his presentation, "Do speculators drive commodity prices away from supply and demand fundamentals?". This provides good answers to some very basic commodity futures questions. On average producers (hedgers) are net short and managed money is net long. Swaps dealers are also generally net long. This numbers are consistent with the traditional stories that speculators are needed to take the other side of risk from hedgers. Speculators receive a risk premiums for that the other side of hedger activity.

This work can be extended by looking at the relationship between price and agent behavior. Across a board set of commodities, the data show that changes in producer positions have a negative relationship with changes in futures prices while managed money has a positive relationship with price changes, This is consistent with the story that speculators follow trends in prices while hedgers will be behaving in manner to offset price risk. 

Swap dealers, in general, are price independent except in the metals markets given more directional hedging against OTC positions. 

Index traders are also price indifferent. Their activities are more likely associated with diversification trades like what would be seen in risk parity programs.

The key piece of Smith's research is to relate the changes in positions of managed money with price corrections. He finds that managed money will be positively related price changes, but there will not be a price reversal in the subsequent weeks. There is not evidence that managed money will push prices away from fundamentals in a manner that would lead to future adjustments.

This work on the decomposition of futures traders adds to our understanding of price dynamics and speculation in futures markets. It also helps us appreciate the dynamics of different players in futures markets. There is still a symbiotic relationship between hedgers and speculations where each is needed to have an effective market. 

Saturday, April 14, 2018

What should you get with complexity in beta strategies - Smoother return to risk

There has been an explosion of alternative measures and methods to access market betas and risk premiums, yet it is not always easy to explain what this added complexity should give investors.  We want to simplify the discussion to a simple trade-off - added beta "complexity" through either decomposing, diversifying, or managing the set of betas should reduce the range of return to risk. 

The managing of beta risks will not always outperform the return to risk of a passive traditional beta portfolio in, for example, a classic market cap stock index, but a sample of return to risk ratios or the rolling return to risks ratios of a portfolio of risk premiums through time should be more stable. Complexity or the management of the beta risks will buy you stability, diversification, and potential long-term return to risk advantages. Added value will come if the manager has skill at bundling and adjusting beta exposures.

In the simplest case, investors allocate to a traditional asset class benchmark which will return the market risk premium. It will vary with the business cycle and pay investors for the risk of loss during "bad times".  From that simple case investors may buy a diversified portfolio of asset class betas  that will have more stable return to risk. Within an asset class, the portfolio can be adjusted based on alternative risk premiums or betas such as size, value, momentum. This portfolio could represent different smart betas.

An added level of complexity beyond asset class or smart betas is gained through alternative risk premium where strategies combine long/short positions. This could be, for example, momentum/trend managers like what is seen in managed futures. It could also be a long/short equity trading based on value. An even more complex case would the bundling of alternative risk premium in a portfolio or through a must-strategy hedge fund.

The decomposition of risk into different factors or risk premium has allowed for more reordering of the risk within a portfolio. The reordering of risk premium should result in smoother return to risk trade-offs. 

Wednesday, April 11, 2018

The evolution of trend-following firms to alternative risk premiums and quant shops

Trend-following CTAs and managed futures has evolved over the years. Many of the largest firms today would not be recognizable from those who were the largest during the 1980s and 90s. Some of this change in leadership is due to business decisions, but it also has to do with the evolution of the investment process. CTAs have evolved with research trends in finance, the changing focus of overall money management, technological developments, and structural changes in markets. 

We provide three highly stylized themes that have changed managed futures trend-followers: structural, finance research and risk research. These can serve as a point of departure for further discussion on how firms and strategies evolve. 

Managed futures have moved from the focused intermediate to long-term trend-following of the 80s and early 90s to more mixed strategies of more markets traded, more styles employed, and alternative timeframes for trading. These mixing of style, timing, and markets serve as mechanisms for smoothing returns, improving return to risk ratios, and finding ways to maintain fees as simpler quantitative strategies become commoditized.

Trend-following was traditionally focused on finding opportunities within time series with market diversification added in order to offset the mixed quality of the times series signals. Risk management was a core component of programs through the use of stop-loses for each position. Sizing was usually based on a contracts per million basis and not volatility. 

With cheaper costs for execution and markets to trade around the world, trend-followers increase the range of timeframes for trading and the set of opportunities. Changes in market structured has allowed for time and market diversification. 

Times series work to determine the trends for each market has been coupled with the momentum revolution, so that cross-sectional work of ranking markets is now a core part of trend-following diversification.

Strategy diversification has started to include carry type trades and position adjustment based on risk-on/risk-off indicators. The movement to quant approaches beyond trend opened up program development on two fronts; first, the diversification of programs to take advantage of different risk premiums outside of momentum and second, the development of explicit risk premium programs to have business alternatives to the more concentrated return profile of trend-following.

Given the uncorrelated nature of risk premiums and potential issues of liquidity, it is a natural business extension to develop research in uncorrelated models that will business diversification. As prices with core trend-following have further declined, the speed of on new product development has intensified. 

With the development in VaR and advancements in risk thinking, trend-following managers moved from dollar-weighted positions to volatility positioning as a standard. Volatility position-sizing has also been coupled with volatility weighted sectors, and targeted program volatility. All of these techniques are a means of supporting risk management beyond stops to individual positions. The development of risk parity models are consistent this volatility work by CTAs. It could be viewed that risk parity is the no-information, no view portfolio while trend-following is a price-based view. 

Firms have now formed a range of program offerings from pure trend-following, to alternative risk premiums, to diversified blends or multi-alternative offerings. The concept of single strategy trend-following firms has been essentially dropped to a more general approach of quantitative asset management employing different strategies. 

Saturday, April 7, 2018

Mutual funds versus ETF liquidations - Their market impact may not be the same

There has been a significant capital switch from mutual fund investing to ETFs, from active to passive investing. This has been a significant positive for many investors because there are many "active" managers who are closet indexers and active managers who do not show skill. 

It is often easier and cheaper to gain exposure through ETFs but the active to passive debate is not the same as the active to buy and hold debate. There will come a time when equities go into a bear market and interest rates start to climb quickly. Investors will have to make choices, stay with a diversified buy and hold portfolio and weather the performance storm or make some asset allocation adjustment. There should be concern that the dynamics of a new bear market will be different from the past. 

We have to think through scenarios of what will happen if there is a downturn with the current market  structure. In particular, active money management of a fund in a market downturn gives trading authority, within investment guidelines, to the manager who may be able to adjust quickly, cut risk exposures, raise cash, and adjust the portfolio mix based on available liquidity. An investment in a passive investment is a blunt instrument when making buy or sell decisions.

Passive managers has no authority to adjust risk in a portfolio since the allocations and guidelines are set. There are rules and passive funds will not adjust behavior to market conditions. A sell order in an ETF will trigger orders across a spectrum of markets without concern for liquidity or nuances across markets. The market adjustments will implicitly be in the hands of the investor with respect to holding the ETF, but there will be no buffer from an active manager to reduce market impact.

This may not seem like a large problem when ETF allocations were small, but it could be a real problem now. It is compounded if the ETF portfolios invest in assets that may be less liquid in a market downturn. The significant amount invested in LQD and HYG, two of the largest credit and high yield ETF, could make this problem a reality. Investors should be checking for the exits before an investment fire begins.

Friday, April 6, 2018

Inflation is here - Now focus on the next question, where is it going

Inflation is here. There is no doubt, but that number will be around 2%. The only question that is unclear is whether there will be overshoot beyond the 2% level. Clearly inflation in the Eurozone is still not near 2%, but all inflation placed bets seem to surround the target level that have set by central banks. Investors have to ask the simple question of whether the beyond 2% is realistic. 

A place to help answer that question is the NY Fed Underlying Inflation Gauge (UIG) which looks at disaggregated data of price and prices plus fundamentals using a dynamic factor model. The latest numbers below show a growing gap between the two UIGs and the CPI.

The price based UIG shows stability around 2% but the full data set measure has accelerated to above 3 which is highest levels we have seen since before the Financial Crisis. The current gap between the full and prices measure is also at the highest level in over a decade and a half. 

Putting stock in these number should cause any investor to think about their bond duration exposure and whether they should be holding more commodity exposure.

Thursday, April 5, 2018

Hedge fund performance mixed for month

The reversal in equity performance in March proved to be a difficult challenge for hedge funds with most HFR strategy index returns negative for the month. On a relative basis, macro and managed futures index returns were better than many equity focused hedge fund strategies. The first quarter returns were dispersed across strategies with a clear negative skew with both February and March being difficult performance months. 

Regardless of strategy, directional choppiness and volatility transition were not good for most hedge fund manager. After a good start, February was hit with a volatility spike and repricing event. March was slightly calmer with lower extremes in volatility, but the general volatility level is now almost double from end of 2017 levels. The market was also hit with  price transition spikes in both February and March as sentiment changed with concerns about trade wars, growth, and Fed changes. 

Few managers were able to exploit these macro directional trends in both equities and fixed income. Nevertheless, higher volatility or return dispersion is good for most hedge fund strategies which are based on security or market selection skill. Skill is usually displayed when there is more market differentiation. 

Wednesday, April 4, 2018

Decomposition of credit markets - Simple but important conclusions

Should investors be worried about credit spread return expectations or expectations of credit default losses in the current environment? Before we answer the credit questions about the current environment,  investors may need a framework for weighting the types of risks in the credit markets. This is the fundamental question concerning holding any credit exposure, and an exhaustive research using variance decomposition of a large dataset shows that you should be worried about both. See "What Drives the Cross‐Section of Credit Spreads?: A Variance Decomposition Approach", by Yoshiio Nozawa in the October 2017 Journal of Finance

This work which follows a similar approach used to analyze variance decomposition on stocks shows that  risk can be decomposed into an expectations comment and a default component. At the portfolio level the credit default risk is diversified away and the majority of risk is with changing expectations of risk premium. There are, however, differences in the weighting based on the credit ratings - the importance of credit loss is inversely rated to the credit rating.

The author focuses on the dynamic between stocks and bonds and finds that there is a distressed effect whereby firms with higher risk bonds closer to default actually have lower equity returns. There is a significant inverse relationship between credit loss risk and profitability but there is no relationship between bond and stock risk premiums. 

This work is important when applied to current events. Credit default risk can be diversified away and time varying risk premiums can be the key driver of spreads which means that macro effects will likely drive credit spreads. Credit allocation decisions at the portfolio level are still a macro bet which may be closely tied to business cycle analysis. Spreads may move higher even if there are limited signs of greater credit defaults. Investors may face spread risk even if default rates are low.

Tuesday, April 3, 2018

Trends tilt to bonds over equities

Global equity index signals suggest short positions while bonds are showing stronger long trend signals. The repricing of risk usually is associated with movement from more risky to less risky assets. Short rates suggest more uncertainty on Fed making good on rate rise promises. Metals are signaling a growth slowdown. The general tenor is that trends in most liquid markets more likely.

Managed futures slightly down for month - Better than equites

Managed futures index returns were slightly negative for the month with the SocGen CTA index down 26 bps and the SocGen CTA mutual fund index down 62 bps. The BTOP 50 index gained 26 bps for the month. This compared favorably against many equity indices, but was less than the fixed income indices. Trend-following managers were not able to catch the early rotations from equities to bonds during the second half of the month.

The flat performance for managed futures was consistent with the higher volatility environment and relative flat price slopes in many asset classes. Equities rebounded during the first half of the month only to decline once talk of "trade wars" accelerated. Similarly, the bond prices were range-bound until the up trend in the second half of the month. Trend rotation now has short equity and long bond positions for April. 

Monday, April 2, 2018

Sector differences increased during month - Rotation to bonds from equities

2018 has surprised many investors with a change in focus from economic growth and increased earnings from tax cuts to an emphasis on volatility repricing.  Most equity factor and sector styles generated negative returns for the first quarter with the only exception being emerging markets and growth. The only positive price-based signals are within the growth sector. 

Equity sectors were also generally negative with technology and consumer discretionary as the only two sectors that have generated year to date positive returns. Our moving average and breakout signals only show positive signals in utilities and real estate as bond markets rallied in the second half of the month.

Country equity ETFs showed some large dislocations with Brazil, Taiwan, and Italy being strong performers. Canada and Australia were negative outliers with poor performance. Surprisingly, the best potential trends are with strong global trade countries such as Mexico, South Korea, and Taiwan.

Bond sectors in March showed a strong turnaround in performance relative to last month. Most of the moving average and breakout indicators point to strong bond returns; nevertheless, long duration and credit have underperformed in the first quarter and the only positive sector for the year has been developed international bonds. 

The first quarter of the year has generated poor return performance across all asset classes as higher volatility forced a repricing of risk by investors. Markets are seeing a rotation from risky assets to less risky with bonds looking more attractive this month.

Sunday, April 1, 2018

Change in mood reflected in asset markets

Markets have seen a significant change in economic sentiment over the first quarter of 2018. Market views have moved from euphoria concerning tax cuts and global growth,  to the fear of a volatility shock, to a revised view of growth,  and finally to growth fears under the concern that a trade war is around the corner. Overall, major assets, both equities and fixed income were negative for the quarter. Large cap firms that engage in global trade were hurt in March while bonds rallied as the safe asset. US small cap equities did better given their focus on domestic growth. Emerging markets gained on the dollar decline and the continued belief that EM markets have room for independent growth. 

As we start the second quarter, the economic growth picture looks more mixed and earnings may be under pressure if there is no further growth beyond tax cut adjustment. The continued high volatility with the VIX index, albeit lower than the early February extremes, is averaging between 18-20% and putting further pressure on repricing of risk. With higher short-term interest rates, the value of discounted cash flows has fallen and there is less demand for risky assets. While the growth and liquidity signs are not flashing a strong exit from risky assets, caution is required and any new savings is best positioned in safe assets.  The weight of the evidence is signaling portfolio positioning toward low risk or uncorrelated assets. Any risky asset over-weights should be adjusted downwards.

Saturday, March 31, 2018

Failures With Information Usage - Competing Models and a Solution

Investors do not always use all the information that is available to them; however this is a not a unique problem to finance but an issue that runs the gamut for all consumer decisions. The explanations for the problem of information usage or non-usage has fallen into two major camps or models of behavior and described nicely in a recent Journal of Economic Perspective article, "Frictions or Mental Gaps: What's Behind the Information We (Don't) Use and When Do We Care?" by Benjamin Handel and Joshua Schwartzstein. We present their framework with our view on how the problem can be solved.

One view is that the lack of information usage is associated with market frictions, transaction costs. There is a cost of gathering and processing information so it is not done. This seems unlikely for sophisticated investors, but there is evidence that even simple differences in the costs of index funds are not fully explored by investors. Of course, the cost of processing information may be much higher than the cost of gathering information. If there is a friction, it is with effectively weighting all the information available.

The alternative view is the mental gaps school of thinking which focuses on behavior biases. Investors gather all of the information but they do not use it effectively. It is the poor processing  because of mental heuristics which could be the problem with information usage.

A little of both models can explain decision-making problems in finance. The question is whether there is an effective way to avoid frictions and mental gaps. The problem could be solved through the issue of disciplined systematic decision-making. 

For the friction explanation, disciplined investment decisions can use all of the information available and can increase processing through the use of quantitative models. There can be errors with the models, but their effectiveness can be measured and any errors can be adjusted. 

For the mental gap explanation, disciplined decision-making can eliminate the problems identified in behavioral finance. Whether anchoring or recency biases, a model or rules-based system can eliminate some obvious behavioral biases. 

Markets will always react to surprises in new information, but investors should not be disadvantaged through not using information that is already in the marketplace. Costs can be minimized through effective information gathering and processing which can be done through quantitative tools. Mental gaps can be closed by using rules to hardwire good behavior. There is no reason why information inefficiencies cannot be closed. 

Friday, March 30, 2018

Portfolio trust in mean reversion not momentum - The contradiction of investing in trend-followers

Most trend-follower will say that they are "non-predictive".  While I think this is true in the sense they do not form forecasts or expectations, trend-following is also based on the prediction that the price direction through some set of price weighting from yesterdays and today will continue into tomorrow. Trend-followers do not try and forecast expected returns rather they extract signals from past data under the assumption that price moves will have memory of at least direction. 

These managers find trends across a large diverse set of markets and then invest long or short based on these trends. If the markets are moving higher, they are a buyers, and if price move lower they are sellers. Buy high under the assumption that prices will move higher and sell low under the view that prices will move lower. 

The relative value of any trend manager comes from their ability to better extract a signal from the noise versus their peers. Nevertheless, the question for many investors is how to predict when this strategy as a whole will make money which may form a contradiction within the trend strategy. 

One investment approach is to not make any prediction. The trend-following properties of diversification should lead to a constant allocation. Some may take a more active approach and invest in a performance trend. Others will take the opposite approach. The best time to buy is when returns are low and the best time to sell is when performance is high. Be a trend-following contrarian. There is evidence that this approach works.

The contrarian view suggests that trends in any one direction do not last forever; consequently, there will come time when strong performance will be reversed or at least the return to risk will turn down. Similarly, there will periods when poor performance will be reversed because risk-taking is reduced or the period of no trends is finished. Investing in trend-followers through thinking like a mean-reverter while paradoxical does work.

Wednesday, March 28, 2018

Stock-Bond Correlation - An inflation regime change will push it higher

A recurring global macro theme has been how investors should think about stock bond correlation. The negative correlation between stocks and bonds has been the single best diversification provider for any portfolio. There are very few alternative investments that have offered the same amount of diversification and provided a significant amount of alpha. This simple diversification is why variations on the 60/40 stock/bond portfolio mix have been such winners since the Financial Crisis. But times change, or more specifically, regimes change. 

A UBS Asset Management piece "Investment Troubles" suggests that the stock/bond correlation is loosely tied to inflation regimes. The negative correlation of today has not been a given through history and an often overlooked fact is that the negative stock/bond correlation seen in the US is not a given in other countries. For example, the US stock/bond correlations in the 70's, 80's and 90's were positive.  Canada has seen positive correlation between stocks and bonds during the entire period when the US correlation has been negative. This asset class correlation is dynamic and situational.

A long-term look at the US stock/bond correlation shows that there have been long period of both positive and negative correlation. These dynamics exist even though a good working hypothesis is that this correlation should be positive. A change in short-term interest rates should impact the valuations for stocks and bonds in the same direction through present valuing of cash flows. In reality, the key issue affecting correlation is the level and volatility of inflation.

When inflation is high, the short-term discounting factor which includes expected inflation seems to dominate the stock/bond correlation. When inflation is low and thus short rates are low, other factors such as economic growth seem to dominate and growth will have an negatively impact on the stock/bond correlation. A further review suggests that these inflation regimes will be associated with monetary policy.

The monetary regimes will respond to inflation and create a   different correlation environment as measured by the Taylor Rule.

Extrapolating this historical information suggests that the combination of restrictive monetary policy in a higher volatility environment will tilt diversification risks to higher correlation. It is unlikely that there will be a significant inflation risk shift in the near-term, but our priors suggests that investors will not continue to receive the diversification tailwind that was the great portfolio risk reducer in the post Financial Crisis period.

Some past posts on the issue:

The stock-bond correlation curve - risks from the Fed?

Inflation Protection Trade - TIPS Are Not Enough

Inflation is rising and is likely to be centered around 2% in the current environment. This market view may be a good null hypothesis for what many investors believe they will face in the coming year. Consequently, investors have shown renewed interest in TIPS (Treasury inflation protected securities), but we have concerns that TIPS may not provide enough return to help many pensions. Alternative investments that have  return advantages should be carefully reviewed. There are some simple disadvantages with TIPS.

First, many pensions have discount rates that are still around 7 percent, so a CPI-linked investment is not going to help gain ground versus the expected discount rate. Pension funding gaps only grow if portfolio returns are less than the discount rate. Pensions may be concerned about inflation, but on a relative basis, the matching or exceeding the discount rate is a more critical problem.

Second, the inflation that is faced by pensioners is higher than what is being stated in the CPI. The CPI-E (experimental CPI weighted for seniors) is increasing at a slightly higher rate given the mix in their consumption basket. TIPS may offer inflation protection but not for the inflation that is being faced by pensioners. 

Third, many state pension funds have COLA provisions that are often set at a rate that is higher than the CPI. In the case of many states, it could be at 3%. Hence, if there is not a TIPS premium, a TIPS return will underperform the COLA provision if COLA is higher than CPI. Additionally, any TIPS premium is present to deal with the risk with the TIPS and not as a means of supporting higher COLAs.

Unfortunately, the use of long-only commodity indices has not helped pensions because these indices have been in an extended drawdown since the financial crisis. Using commodities has not helped pensions but actually caused a performance drag.

The solution to inflation protection is to think outside the immediate inflation securities box. Three alternatives come to mind, real estate, systematic trading, and commodity risk premium portfolios. Each offers a slightly different approach to providing inflation protection. 

Real estate is a classic inflation hedge, but there are issues of liquidity and current valuations at this point in the business cycle. Leases should increase with inflation but investors will lock-in funds with limited flexibility. 

Systematic investment strategies that could include risk parity that explicitly has commodity exposure or managed futures that actively trade commodities is another alternative. Investors will have significant liquidity. There also are implicit adjustments across asset classes through active management. Dynamic asset class adjustments could provide inflation protection as allocations are changed during an inflation shock.

A relatively new strategy would be to invest in a commodity portfolio that is based on commodity risk premiums. Instead of investing in a long-only basket with fixed commodity weights, investors would build a commodity portfolio based on well-defined risk premiums such as carry (backwardation/contango), momentum (trend), value, and volatility. This portfolio will be uncorrelated with core traditional assets and should be positioned to take advantage of inflation increases.

Thinking outside the TIPS box may allow pensions to have inflation protection but also receive a return that will not be a drag relative to the expected discount factor. This is a win in almost any environment.