Wednesday, August 15, 2018

Rivals take more risks - Is this a good thing for money management?


You might think some research is obvious after the fact, but in reality, good research can allow us to deepen our understanding on a topic and may provide subtle insights that were unexpected. One topic of interest is competition and rivalry.


Recent work finds that when there is competition between rivals there will be more risk-taking. See "Research: We Take More Risks When We Compete Against Rivals" in the Harvard Business Review. The idea that you can pit employees within a firm against a rival to get better work will actually lead to greater risk-taking. The same can be said for those who form rivalries with other firms. It may motivate people to work harder, but there will be the unintended result of greater risk-taking.


The researchers from the article study this problem in a number of novel ways. For example, they look at risky play calling in football between rivals. They track the incidence of two-point conversions after a touchdown or not punting on fourth down. Both are more likely when playing a rival team. They also created experiments in card playing where other players wore rival sportswear to see if risk-taking increased when playing against perceived rivals. It did. 

There is less prevention focus, avoidance of negative outcomes,  and more promotion focus, reaching for ideal outcomes when playing against rivals. We all know that the hedge fund and only management business is competitive and there are rivalries between firms and individuals. Any time spent in New York will tell you money manager not only want to win but beat their perceived rivals. (Perhaps this is why managing assets outside of New York is a good thing.) Most managers cannot help themselves, but if rivalries are not controlled there can be excessive risk-taking solely related to this competition. In competitive bidding like private equity, rivalries will cause excesses and the "winner's curse". Again, emotions can be the enemy of a money manager.

Risk management, the quantitative measure of risk-taking, is necessary to stop the excesses of rivalry. If risk can be measured, the emotional bias and baggage can be limited. Discipline will trump emotions.


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  • Tuesday, August 14, 2018

    Carry alternative risk premiums tied to macro market relationships


    The returns of alternative risk premium strategies and products developed by banks and investment managers will have close links with the underlying macro relationships that are modeled. In the case of credit carry risk premiums, investors will gain from the difference between high yield and investment grade spreads. In the case of rate carry risk premiums, returns will be tied to the term premium in the yield curve. 

    The credit carry HFR alternative risk index shows the strong returns generated since the end of the Financial Crisis. The rate carry risk premium shows positive gains albeit lower than credit carry.




    There has been a general decline in the spread between high yield and investment grade corporates since the Financial Crisis. There has been significant gains from carry positions in credit risk premium products since the high reach at the height of the crisis. There have also been gains in holding term premium in Treasuries since the Financial Crisis, but these gains have been more limited because the spread and change in the term premium has been less. 

    There has been a close relationship between the change in spreads and returns with the HFR carry risk premium indices. This exists for both credit and rates.




    There has been a view that investors should build diversified portfolio of risk premiums because you don't know where returns will be generated. Investors should hold carry, value, momentum, and volatility across all asset classes because this will give you the best risk-adjusted returns. This is a sound strategy, but we actually know a lot about the behavior of some risk premiums and this will help with building any portfolio.

    For example, credit carry will not be as attractive for the simple reason that as the spread between high yield and investment grade debt close, there will be less carry opportunity. The same can be said for rate or term premium carry trades. These carry spreads will change with the business cycle, so that as we move from recession to recovery and onto expansion there will be a change in the return opportunity set. The returns will be time varying but will be tied to business cycle performance. Hence, the strong returns associated with the performance of credit carry strategies will unlikely continue. Similarly, as the term premium (yield curve) flattens, there will be less return opportunity for rate carry. 

    A diversified strategy of holding different style risk premium makes perfect sense, but our knowledge about the relative and absolute performance of these strategies that can help with determining any portfolio mix.

    Monday, August 13, 2018

    Graphs worth thinking about for the week - Volatility, uncertainty, and contagion




    Volatility has fallen since the February vol-shock, but the vol-of-vol shock paints a deeper picture of the calm that has overtaken the equity markets. This same behavior is seen in other asset classes. Given the combination of geopolitical risks, economic uncertainty, and policy changes, should we expect this level of calm? It seems unlikely.


    The Turkey debt-currency crisis takes us back to the old policy problems of the 90's. Turkey is bigger and more closely aligned with the EU than some other EM countries that have had currency problems over the last decade, so the chance for a contagion is greater. This contagion effect is more likely if you look at bank exposures to Turkey. While a direct spill-over to other emerging markets is less imminent, expectations may change and reduce lending to other countries. This can be result in an EM liquidity shortage.


    While real rates are higher for many countries, the problem is whether DM banks will lend dollars to these countries and what will be the roll-over cost of existing dollar debt. 


    The equity rally is reaching old age and the business cycle has also aged and seems to be reaching a number of highs, but the real GDP gap is still significant. The cost of the Financial Crisis is still being felt in the GDP numbers. Nevertheless, the old adage applies; business and financial cycles don't die of old age, they are murdered by bad policy choices or a surprise shock. 

    The short-term link between policy uncertainty, economic data, and financial markets seems to be highly variable, but China policy uncertainty has not dampened but is actually on the rise. The China stock market reflects this uncertainty, but the rest of the world still does not seem to focus on the true impact of China on global financial markets.


    Investors are voting with their dollars. Markets are efficient albeit perhaps not as quickly as many would expect. Active managers have underperformed at higher fees and investors have concluded that this is unacceptable. 



    Saturday, August 11, 2018

    Alternative risk premium versus bonds - A choice of factor risks and diversification


    Investors want diversification from their equity exposure. This desire for diversification increases with uncertainty and with expectations of an equity decline. The big question is how or where are you going to get this diversification. The diversification winner for the post Financial Crisis period has been simple, US bonds. Bonds have been an asset that generated a good rate of return with lower volatility and a negative correlation with equities.  You could not ask for a better diversifier. Unfortunately, the investment environment is changing and the benefits from bonds may no longer be available, so there is an increased desire to find new diversifiers. 

    An effective alternative diversifier could be a portfolio of alternative style risk premiums. No investor should divest all of their bond exposure, but alternative risk premium (ARP) strategies may offer a different form of diversification safety. 

    Think about the cause of the core bond diversification boost. Bonds benefited from low inflation, declining risk premium, and central banks that wanted to push rates lower. This combination led to good returns that were uncorrelated with equities. Now inflation is higher, central banks are implementing or contemplating QT policies, and risk premia are expected to rise. The underlying bond factor environment is less favorable. 

    Diversification going forward can be achieved holding alternative risk premia across momentum, carry, value, and volatility to name a few. These alternative risk premiums can be executed through swaps which can be done as an overlay on bonds. 

    Will these style premiums perform better than bonds? It is not clear and looking at past performance may not provide a perfect answers. What we do know is that an investment in a style risk premium will be by definition uncorrelated with market betas. Investors would be switching the risk factors driving returns and that can help if market beta risk is a concern.   


    Friday, August 10, 2018

    New research on loss aversion is causing me to think deeper - Worth a closer look


    I have been a close follower of behavioral economics research. This broad research is insightful and has caused me to think deeper about how to make better decisions. It has certainly reinforced my belief that using algorithms to make decisions is better than discretionary judgment. However, I have read a series of recent papers that have caused me to take a closer look at some of the core behavioral beliefs that have been established in this area. See the work of Dan Gal and Derek Rucker in the Journal of Consumer Psychology and the recent article in the Observation Section of Scientific American, "Why the Most Important Idea in Behavioral Decision-Making Is a Fallacy: The popular idea that avoiding losses is a bigger motivator than achieving gains is not supported by the evidence".

    A core behavioral economics foundation concerning risky choices is the concept that loss aversion has a strong influence on behavior. As simply put by the original authors, Dan Kahneman and Amos Tversky "Losses loom larger than gains". The relative pain from a loss is greater than the gain from winners, and this asymmetric view is more than just a function of risk aversion. 


    The disposition effect, driven by loss aversion, states that investors will hold losers and sell winners. It has become a bedrock behavioral view about investors and is a core reason why many managers have stop-losses in models to counter-act this bias. 

    Now we have research that calls into question loss aversion as the core reason for these effects both from a theoretical and empirical point of view. There is clear evidence that contradicts loss aversion, but it has either been dismissed or ignored. Loss aversion is a description of behavior and not an explanation of behavior. This research is not offering an alternative to loss aversion but rather a commentary on its usefulness and explanatory power.

    This new research may not completely change minds on the importance of loss aversion, but it does tell us that loss aversion is a subtle concept and should be employed with more care. How we evaluate decision outcomes is very sensitive to a reference point that is often the status quo. The set-up of the problem influences results that suggests that any general conclusions concerning loss aversion may be suspect. 


    According to Gal and Rucker, 

    "In general, it can be stated that the name “loss aversion” represents exceptional branding from the perspective of enhancing the idea’s intuitive appeal as everyone is essentially averse to losses (just as everyone is attracted to gains). This good branding might have led researchers to identify phenomena as being supportive of loss aversion even though the phenomena, while involving losses, do not involve comparisons of the impact of losses relative to equivalent gains. As discussed in the previous section, examples include the sunk cost effect, the disposition effect, and others." 

    This research is subtle and may not change an investor's decision-making, but it is a testimony to careful thinking about problems. The obvious may not always be correct and a simple narrative is not always applicable to a wide set of problems. 

    Do I worry about the pain from trading loses? Yes. Should I take extra steps to reduce downside "pain" more than what would be the case given my level risk aversion (specifically account for loss aversion)? I am less sure. Accepting conceptual uncertainty may make for decision-making.

    Tuesday, August 7, 2018

    Prophets of Doom continue with negativity - Now what?


    Ben Bernanke, former chair of the Federal Reserve. “In 2020, Wile E. Coyote is going to go off the cliff and look down.”
    Alan Greenspan, also former head of the Fed. “There are two bubbles: a stock market bubble and a bond market bubble.”

    Scott Minerd, Guggenheim Partners chief investment officer. The market “is on a collision course with disaster” and the catastrophe will hit in late 2019, with stocks losing 40%.


    Jim Rogers, founder of the Quantum Fund. “When we have a bear market, and we are going to have a bear market, it will be the worst in our lifetime.”


    From Forbes 4 Financial Savants Warn About The Great Crash Of 2020 Larry Light


    These four experts are telling us doom is ahead. Call it Wile E. Coyote moments, double bubbles, bear of bears or a collision course with disaster, the prediction is the same - wealth destruction is coming. These are the usual doomsday stories. They may be right but there seems to be a natural bias to the dark side. We seem to like it and pundits keep feeding us these narratives. 

    "I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage." - John Stuart Mills 

    If you say the world has been getting better you may get away with being called na├»ve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad. If, on the other hand, you say catastrophe is imminent, you may expect a McArthur genius award or even the Nobel Peace Prize. - Matt Ridley


    "Only pessimism sounds profound. Optimism sounds superficial," - Teresa Amabile


    "For reasons I have never understood, people like to hear that the world is going to hell ...yet pessimism has consistently been a poor guide to the modern economic world.” historian Deirdre N. McCloskey


    "Optimism appears oblivious to risks, so by default pessimism looks more intelligent." -Mogan Housel

    Experts traffic in negativity, but this may not help the portfolio manager who has to make investment decisions to increase wealth and protect principle. Conservative investing to avoid these dark scenarios has cost investors real money. So what is the best course of action? 

    We offer some simple solutions.

    1. Discount the negativity. Realize there is a bias, so discount the general level of negative commentary and focus only on the change in negativity.


    2. Find the alternative story. For every negative story, there should be a well-defined positive alternative. Find that story and see if it counters the negative. The same can be said for positive stories and finding the negative.

    3. Diversify. Diversification is the only cheap alternative to protect against negative events. Diversification may come in the form of building portfolio with assets that have low correlation or forming barbelled portfolios between cash and risky assets. 

    4. Follow the trend. If there is high subjective uncertainty, follow the market trends that serve as a weighted average of investor opinions. You will be subject to reversals, but trend-following with some form of stop risk management creates option-like pay-offs that may serve investors well. This strategy should be tied with diversification.

    Read the doomsayers, prepare for the possibility, but don't be burdened with negativity.

    Sunday, August 5, 2018

    Charts that give me fear and calm this week


    What did we learn from the February volatility shock?Volatility has trended lower and the same trades are being put into play; short volatility. Looks like the market has a short memory.

    The signals for potential credit risk -
    Can we support the market debt if there is no slower GDP growth? 

    The growth in credit since 2008 is stunning -
    Latest research states that credit growth is key indicator of future financial crisis.

    Warren Buffet’s favorite macro measure -
    Total market cap to GDP is reaching all time high. Perhaps the global nature of US first can allow for high number.

    This recession risks low -
    Model is not at elevated level, but is actually declining.


    Yet, earnings numbers are attractive - 
    Forward looking - Can this get much better?

    China Reserves not keeping pace -
    This is the level necessary to support the economy under a currency crisis. It will grow with the size of the economy and current account.

    Strong decline in yuan -
    This offsets the effects of a tariff but not one for one.

    The flows tell the story - 
    Improvement in EM capital flows has had a positive impact on some currencies and risks.

    This has been a great trade but what is the upside -
    Spread tightening in July helpful for high yield but what is the return to risk going forward?

    Using principal components  as an asset allocation tool -
    Look at PC1 can tell you where there are common risks and places to gain diversification.

    Commodity gains existed over the last year, but it depended on the index used


    Commodities, as an asset class, have had exciting performance year; well maybe, if you had the right index. A quick look at returns over the last year shows that if you held the SPGSCI index through the GSG ETF, you would have gained a very attractive 19 percent return. If you held the broader-based Bloomberg commodity index (BCOMM) (DJP ETF) you would have received only 3.2%.  Both are well-defined indices, but the performance difference would have been in the double digits. This is all based on the weighting of the index.  SPGSCI has a 2/3rds weighting in energy while the BCOMM only has a 30 percent energy weighting. If you liked energy, you would have been a star. If you preferred diversity, you would have been made only a slightly positive gain. 

    More analysts have talked about commodities being a good bet versus equities, yet care is needed in finding the right vehicle. See the latest chart from Goehring and Rozencwajg.

    Nevertheless, there is a gap between picking the right or wrong index. There is still high dispersion between commodity indices. A better approach may be to hold an index with a portfolio of commodity risk premiums that will smooth out returns and provide added diversification by style through carry, value, momentum, and volatility strategies. There may not be the same strong gains but there is the opportunity for smoother returns the will be less correlated with any given commodity sector.

    Saturday, August 4, 2018

    What a difference a year makes - Credit spread sentiment is moving negative



    The survey from the International Association of Credit Portfolio Managers shows a significant change in the sentiment of credit managers on the direction of credit spreads. The diffusion index which ranges between 100 and -100 shows that the increase in negative sentiment has moved significantly downward. This decline is occurring even with corporate and high yield indices showing some tightening this last month. The survey was conducted in June, but the tilt is strong. This bias should be included in any portfolio adjustments.

    Think about credit risk premiums relative to other risk premium alternatives. If investors would like to acquire excess returns, they should be generated through investments in other risk premium that are not showing the same negative tilt.

    "Think outside the box" or "look more closely inside the box" - Start inside the box


    “We need to embrace the fact that we don’t know what the next bad outcome is. We need to think outside the box.”

    “The world is continuing to change, and we need to constantly reinvent ourselves in this revolving world.”

    -John Williams, President NYFRB

    Look outside the box! Everyone should look outside the box. Everyone wants to me the person looking outside the box. There is a desire for innovation, but are we sure that this is the best solution to any problem? 

    I want to be known as creative, but is attempting to be creative always the best use of our time. Perhaps it is better to look at the past and search for similarities or the obvious before moving outside the box. Let the data speak first before looking for odd alternatives. Exhaust the obvious first.


    Thinking out of the box originated as a solution to the "nine-dot problem" - using only four lines, pass through each dot without lifting the pencil off the paper. It is a great game for showing creativity.



    Yes, thinking out of the box provides the solution to the puzzle. The solution literally requires being outside the box. Still, the first order of business is learning to look inside the box and see whether we are missing what may be considered obvious. Someone who is trying to solve the nine dot problem should follow a process. The first may be to try simple solutions.

    With respect to NYFRB president Williams, we agree that we don't know what will be the next bad outcome, but the first thing is to focus on the bad outcome that may be potentially staring us in the face. Bad outcomes usually seem obvious after the fact, so a fist pass is to look at problems that are most likely before venturing into the less likely. 

    We don't have to think out of the box to realize there is a debt leverage problem. We don't know the catalyst for the problem but we do know that a change in cash flow expectations will lead to a financial failure. The yield curve inversion is another obvious place to look. A flattening curve affects financial markets, so you don't have to look outside the box. What is more important is thinking through the timing of inversion on market prices.

    You may not want to be the one who is looking inside the box, yet looking inward for better understanding has a higher likelihood of success. Conventional thinking or rather looking for the obvious from what is known is not a bad starting point. After all that is obvious is eliminated, then other solutions can be entertained. This is a simple conservation process for solution management.



    Friday, August 3, 2018

    Hedge fund performance mixed for July



    Hedge fund returns for July were generally negative with the only exceptions being equity hedge and fundamental value strategy indices. The class of uncorrelated hedge funds styles, event driven and special situations, under performed. Defensive styles like systematic CTA and global macro also posted negative returns. 

    With over half the year done, 10 strategy indices are negative and 7 are positive. The average for the negative strategies is just under 4 while the gaining strategy indices posted an average of 1.25 percent. For the negative strategies to move into positive territory, there will have to be at least a one to two standard deviation positive event over the next five months. This is possible but will require some market dislocations that can be capitalized  by hedge fund managers.  

    Switch to risk-on but dispersion in return shows mixed opportunities



    All equity style sectors generated gains for July. The EM index ETF is the only major style down for the year. Global markets outperformed more localized US markets as measured by mid and small cap indices. Growth has been the best style index this year with returns exceeding 11 percent. While performing well this month, global equities have still lagged for the year based on growth and earnings differentials versus the US. Nevertheless, there are some concerns about short-term trends in smaller cap indices as well as growth and value indices.
    All equity sectors also showed gains for July; however, the dispersion in performance is significantly greater for year to date returns. Consumer discretionary, health, and technology are the leaders for the year. Finance, materials, and utilities are laggards. Trend models are signaling some short-term concern for the technology sector.

    Country equity ETFs also produced strong gains for the month with double digit returns for Mexico and Brazil. Year to date returns show high variation in returns with the average country return being negative.


    Bond performance was negatively correlated with equity returns. Long duration Treasury bond ETFs generated the poorest performance while credit sensitive and EM bonds posted positive returns consistent with risk-on behavior. Trend models signal lower returns for duration sensitive sectors. The credit sectors show upward trend signals.

    The general signals for asset classes suggest being long risky asset classes and avoiding safe assets. Portfolios with equity tilts should perform well in August based on current price-based signals. Markets are looking through political noise and focusing on economic and earnings based fundamental signals.

    Thursday, August 2, 2018

    Sector trends show significant changes over last month



    Our tracking models for the end of July show that there have been changes in direction for all major sectors. This would usually suggest significant loses for trend managers but the relatively mild volatility and the slow reversals allowed for adjustment of signals to mitigate loses.

    Equity indices moved higher around globe while bonds reversed and sold-off. Between good economic numbers and the worst fears not being realized, the market moved to risk-on positioning. Rates suggest that quantitative tightening will continue. The dollar rally slowed which cause precious metals to move sideways. The energy rally also slowed albeit there is a large dispersion in market views. Commodity markets were mixed but the strong grain price declines in June have started to reverse, but soft prices are trending lower.

    Given the sector reversals between June and July, it is hard to say what will be the potential winners for August. With vacations for many this month, position changes will be limited without a major economic surprise.

    If there are no trends, there will be no gains - Managed futures slightly negative on range bound market behavior


    July  proved to be a classic reversal from less risk appetite to risk-on behavior. Global equities, which were weak in June, reversed on the expectations of stronger growth and earnings. This was bad news for trend-followers positioned for further market declines. The switch in risk appetite caused bonds to move lower. The strong growth, higher inflation, expected larger supplies, and expectations for continued Fed QT placed added pressure on Treasuries.  Credit markets moved in-line with equities. The range bound currencies helped international assets but did not allow for trading gains. Commodities were mixed with energy prices moving lower and grains seeing some buying pressure after large declines last month. All of these reversals did not help intermediate trend traders. 


    While it is a consolation that core portfolio holding have been positive this year, investors are expecting less pain from this defensive strategy. A long history suggests that the average return for this style will not see long periods of stress; however, any change in return patterns will be predicated by an economic dislocation which has yet to occur.

    Wednesday, August 1, 2018

    July performance shows risk-on appetite


    First look at the data to see what weighted market opinion is telling us. July marks a reversal to more risk-on behavior with strong gains in large cap US stocks as well as international and emerging market equities. While small cap, growth, and value indices all did well, the broader international concerns affecting risk behavior have abated. This positive global view was also seen in the international bond markets. The dollar rise from a desire for safety was contained and more range bound. Along with international bonds, credit markets improved with tightening spreads. The only losers for the bond sector were long-duration Treasuries and commodities. 

    Away from the headline grabbing FAANG stocks, the markets have responded to the higher economic growth story which culminated with a 4% second quarter growth announcement. The combination of continued good economic news and a dampening of trade war rhetoric led to a more hopeful market. While trade war discussions with China are still a market focus, the news with the EU is more suggestive of compromise or even a new trade deal with better terms. Of course, these trade discussions almost always exclude autos and agriculture which are industries that hold special appeal by the EU. 

    While the link between economic growth and equity prices is not always definitive, we can say that the announcements of tech firms like Facebook, Netflix, or Twitter do not represent signals for where earnings will go for the average firm. The growth story and its impact on wages and inflation will still be the key driver for the rest of 2018.

    Tuesday, July 31, 2018

    The correlation within the financial cycle - Not good for those looking for international diversification




    One of the core strategies for portfolio diversification is increasing exposure to international stocks and bonds. This risk reduction strategy is easy to achieve, yet the value of this asset class diversification has diminished over the last few years. The financial cycle has more commonality as measured through times series analysis, and it is harder to achieve the diversification benefits desired if there are more correlated financial cycles.

    There are a host of reason for this increase in financial cycle correlation, but no one explanation can do the job even after accounting for the Financial Crisis. There is a real economic reason for the higher financial correlation; bilateral GDP's are also increasing, but that does not nearly explain the more explosive increase in equity price bilateral correlations. There are structural reasons for bilateral correlation changes given the lower capital control, increased capital flows, and greater economic integration. However, most important may be the tighter financial links across countries between US monetary policy and global risk appetites.

    The paper, "Global Financial Cycles and Risk Premiums", provides a wealth of empirical information on this important topic. It shows a clear change in the response equity premiums to an interest rate shock over the last few decades.

    If this work is true, we should see equity price declines with the Fed's higher rate policy. Holding risky asset abroad will not provide safety as global risk appetites change with monetary policy tightening. Investors will have to look harder for diversification in their portfolios.

    Given less diversification from equity risk premiums, investors will have to look to alternative risk premium to gain diversification based on factors less sensitive to risk appetites. This may not be easy since attitudes to risk pervade all risk premiums.,