Saturday, June 30, 2018

Risk should not be determined by feelings of a past experience - Block the perceptions and focus on some numbers


Risk perception is often about pain and not probabilities. It is about the experience of risk not the mathematical chance or size of loss. I would like to say that everything about risk management is measurable and can be reviewed dispassionately, but that is not the case. There is often a difference between fear and facts and this is the perception gap which often leads to bad judgment. You may be a dispassionate risk assessor, but the market's perception of risk may be driven by its weighted perception of the risk.

We actually know a lot about the key factors impacting our risk perception, but they are usually not discussed in investment management. Reviewing these risk perception factors is helpful at pinpointing how investors may react to different risk situations. 

A number of these factors have been discussed in the writings of David Ropeik. His 14 factors influencing risk perceptions is a useful guide on how to dampen adverse risk perceptions and potential gaps with reality. These are factors are consistent with many of the behavioral biases we often discuss in finance.

Factors that affect our risk perceptions:

1. Is the source describing the risk trustworthy? - If the person or organization describing the risks is more trustworthy, our level of fear decreases.
2. Is the risk imposed versus voluntary? - Risks taken are perceived to be lower than those imposed upon an investor. I am more afraid of the driver next to me than I am of my own driving. This is a variation of the illusion of control. 
3. Is the risk natural or caused by humans? - We are afraid of each other. People are more afraid of risk from humans than from nature. We are more afraid of pesticides, chemical and those things perceived not to be natural.
4. Is it a catastrophic or chronic risk? - The risk of a catastrophic disaster is viewed as riskier than something that is more likely to be such as cancer. The talk of a crash is greater than a general decline in stocks. This is a vividness bias.
5. Is the risk dreaded? - Extremely bad outcomes are given greater risk. Being attacked by a bear on a camping trip is perceived as greater than breaking a leg.
6. Is the risk hard to understand? - Anything that is hard to understand is considered riskier. New technology is viewed as riskier than existing technology.
7. Is there a high degree of uncertainty? - Anything that seems hard to quantify or explain is viewed as riskier.
8. Is the risk new or familiar? - Anything that is new is perceived as riskier over that which is familiar.
9. Is there awareness of the risk? - It seems logical that we will always feel there is greater risk with those that are known, but heightened awareness of any risk will increase our perception of the risk.
10. Is there a known victim? - If someone has been affected by a risk, our perception is that it is more likely. If you know someone who got hit by lightening, you will perceive that it is more likely to occur. 
11. Will the risk affect future generations? - Risks that are associated with children are given heightened awareness. 
12. Will the risk affect me? - Call it selfishness, but if we think a risk may affect ourselves it will be perceived as more real.
13. Is there a benefit with this risk-taking? If a risk is associated with perceived benefits, it will be given less weight.
14. Am I in control of the risk? Similar to those risks that are voluntary versus imposed, if we think we are in control of the risk-taking, it will be given a lower weight. Those who undertake high risk behavior just assume that they can outwit and control the risks.

Risk is always the chance of something happening times the impact of that event. While this is easy to define, it is hard to measure in practice so we often use heuristics to judge risks. Investors are not immune to the use of heuristics. We just have to be aware of the problem, take a time-out, and objectively try to measure the probability and impact of an event.

Friday, June 29, 2018

The power law, 80/20 rule, and concentration of returns - What it means for money managers


The power law has been become a strong fascination to me. We have been trained to generally think about the normal distribution. The law of large numbers has been pounded into our psyche since our first class in statistics but as you look more closely, the more relevant the power law becomes. Now, a normal distribution will produce extreme values. However, in a power law the extremes follow certain characteristics such that the "top few" are unbundled or more likely to have an extreme, (as opposed to a normal distribution where the "top few" are exponential and bounded).  
  • Let's look at the construction and return performance of the leading equity indices:
    • There is the NASDAQ 100 but the top names represent a significant amount of the index. The FAAMG equals about 45%.
    • For the SPX, the FAAMG will equal 14.5% of the market capitalization. The performance will be skewed by the gains in these high market cap stocks.
    • Amazon has accounted for 7% of the SPX growth over the last five years.
    • The returns of the major equity indices have been influenced disproportionately given the weighting and actual returns. Performance data shows that over the long-run just a few names will have a meaningful impact on performance. See the seminal work of Hendrik Bessembinder.) 
    • Analysis suggests that large up days will make all of the difference in index gains. Miss a few days and you see a marked decline in performance. Missing the top ten days would have reduced returns by close to 40%.
  • Let's look at some numbers in venture capital:
    • A recent study shows that venture cap is like playing long shot bets. Most deals go bad with a few big winners. As quoted by Peter Their the tech venture capital leader, "We don't live in a normal world, we live under a power law".
  • Let's look at importance of key days in bond markets:
    • Studies have shown the high concentration of return around just a few days when the Fed makes an announcement. 
The power law and the short hand 80/20 phrase (Pareto Principle) is everywhere, yet we likely spend more time on the 80% than the 20% of the total.  So what  do we do about it?
  • Know the extremes and when the power law applies.
    • These extremes are everywhere.
    • These extremes will create significant return influence. 
    • These extremes are seen in all major indices; passive investors are subject to the power law.
    • However, the extremes are dynamic and change over time.
  • When you see these extremes, spend more time studying them.
    • Don't make the mistake of focusing on the average. The 80/20 rule requires 80/20 work effort.
    • Realize that the return patterns of indices or active managers are the same - concentrated in spite of their best efforts.
      • Trend followers, for example, see most of their returns concentrated in a few trades. 
      • Given this pattern, it is all the more important to act on the power law. Ride the profits and sell the losers.





Thursday, June 28, 2018

Ride the trend but remember what is possible



“I am not an optimist. I am a very serious possibilist.” - late statistician Hans Rosling

"I am a trend-follower for both price and fundamentals. I am also a very serious scenario realist."

How do investors reconcile potential storm clouds with optimistic trends in markets. There is ongoing information of long-term economic problems from a wide variety of sources today, yet many markets have continued to move higher and followed trends. There often seems to be disconnects between long-term peril or risks and shorter-term optimism. Some says this is the essence of a bubble market, a disconnect between price and fundamentals, yet avoiding trends based on yet to be realized threats can easily cause investors to avoid profitable opportunities.

It makes sense to follow trends in the short-run (weeks or months), but also realize that at some point long-term negative events will be brought forward into the present. The bringing forward of alternative possibilities that are counter to trends is the point when momentum crashes will occur. For example, excess credit and leverage are a macro problem, but trends can continue for a long-time before credit concerns are pushed forward and cause price adjustments.

To avoid momentum crashes the investor has three options for protection. One, diversify across assets so that any one momentum crash will not damage the portfolio. Two, use risk management stops to exit positions that reverse direction. When the momentum crash comes, there is a process for exit regardless of what are the market conditions. Three, track fundamental possibilities to determine when or if negative scenarios may become reality and use this for strategic allocation adjustments. 

The first two choices are strongly systematic. Diversification and portfolio structuring can done well before a negative event. Similarly, stop-loses can be added before any action is necessary albeit there is evidence that stop-loss triggers may be sub-optimal. Many systematic managers find the third option problematic. Engaging in scenario analysis can be disciplined but it is not a systematic activity. There is no easy way to add rules to account for scenarios, yet this can be a very effective exercise.

Why are scenarios relevant? The catalysts for any change in trends are usually, although not always, known or within our grasp. Prices are primal and condense all information, but their weighting of probabilities change through time. Past prices can be wrong about the future. 

Scenario analysis can tell us something about the potential correlation of risks. A Fed tightening shock will likely have an impact on all emerging market debt.   An oil shock will have an impact on the real economy and equity markets. Consequently, scenario analysis may help change the strategic weights or leverage within a portfolio. Although difficult, the mapping of scenarios to asset classes could be done systematically. Scenarios are a fundamental component of risk analysis. The biggest disconnects between trends and weighted scenarios are also likely the greatest risks. One can follow trends but still engage in scenario analysis to measure potential risks.


See also:

Using scenario analysis to help with asset allocation - A simple solution to a complex problem



Monday, June 25, 2018

Active management should work because active managers work hard!


Which is more likely? A manager who has successful returns, or a manager who has successful returns and gets up early, works hard all day, and spends half the night reading current research. Which one will you choose to run your money? 

A recent paper discusses the persistence of active management relative to passive in spite of their underperformance through using the conjunction fallacy, another behavioral bias. (See "How Active Management Survives" by JB Heaton and Ginger Pennington.) Their argument is that the persistence of money in active management is spite of the empirical evidence supporting passive investing is based on the view that hard work and successful active management go hand in hand. This is an error in simple probabilities.

The general idea is fairly simple and well documented. It has been referred to as the Linda Problem whereby it is assumed that a specific condition is more likely than a general one. This condition is false.
Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
Which is more probable?
  1. Linda is a bank teller.
  2. Linda is a bank teller and is active in the feminist movement.

The majority chose option 2 even though the probability of a joint result is less than the probability of the broader classification. This often is the basis for the representativeness bias. 


The authors in the paper conduct survey work to see if  investors engage in the conjunction fallacy through matching hard work with performance. There results are consistent with the cognitive error. We are not very good at simple probability rules.

We could call this the "work ethic" fallacy. Investors place more stock in hard work than luck. We want to believe that hard work will generate better returns. It could also be thought of as a "just world" view. Investors believe that higher returns are the just rewards for hard work. Certainly there may be a "peace of mind" view that managers who are working hard will better serve investors and generate higher returns and oversee successful portfolio performance. This is all consistent with the "feeling as information" theory in psychology. Many use their feelings as an effective form of judgment.


There are counter-arguments for the conjunction fallacy based on how the experiments are phrased based on the idea that framing and relevance matters. While adjusted language has diminished the cognitive error, it still proves to be consistent in testing. 

There have been many theories for the persistence of funds in active management in spite of underperformance. None seem to explain the persistence well except for some form of irrationality or bias. The conjunction fallacy provides another credible theory.

I like to invest with hard working managers. I like to see hard work rewarded. I believe that hard work will generate an edge although I accept that hard work is not the same as investment skill. I may try and avoid it, but I make the "feeling as information" and conjunction fallacy. The adage, "don't confuse hard work with results" is well known; however, we often cannot help ourselves with the confusion. Most in money management work hard, so forget effort sympathy and just look at the numbers and the process. 

Saturday, June 23, 2018

Tobin's separation theorem - It can be applied anywhere


One of the greater principles of investment finance is Tobin's separation theorem which is a powerful simple tool that can be used for any investment portfolio, but is especially useful when thinking about managed futures and alternative risk premiums. (Robin Powell reminded me of Tobin’s contribution in his essay, Can you really stomach the risk you’re taking?) There is a tremendous amount of useful investment advise through just applying the simplest of concepts. 


Tobin's Separation Theorem is elegant in its simplicity. Find the risky portfolio that maximizes the return to risk and then form a new portfolio that combines this risky portfolio with cash or leverage to find the level of risk that will make you comfortable. The new portfolio, set to the volatility you want, will be on the tangent line for the max return to risk. The new portfolio will be a combination of the risky portfolio and cash if you want less volatility. Similarly, the risky portfolio can be levered to a higher level of volatility. 

The Tobin Separation theorem is especially useful for thinking about managed futures portfolios or alternative risk premiums using total return swaps. Because both use margin at a low level, the risky portfolio can be set at any level desired by the investors through notional funding. 

For example, in managed futures, if the manager sets his base portfolio at a volatility target of 10%, the investor could fund a separate account for say $10 mm and set the notional exposure at twice the cash level or $20mm of notional exposure for 20% volatility on the $10 mm investment. The investor achieves the higher risk at the same return to risk trade-off. Managed futures managers understand the separation concept very well through their setting of volatility for their funds.

In the case of alternative risk premiums (ARPs), there may be a set of strategies that generate an information ratio of 2 but only has volatility of 2% and a return of 4%; however, a pension fund may have a discount rate of 7%. The ARPs may be a great investment but at a return of 4%, it will be significantly less than the expected return needed for the pension. The ARPs better be good diversifiers or there will be a return shortfall. In this case, the separation theorem tells us that we can view this as the risky portfolio that can be levered to a higher volatility that will be closer to the discount rate. Low volatility combinations of risk premiums can be levered through notional funding to a risk level more consistent with the desire of the investor.

Similarly, if an investor starts with a portfolio that has a beta of one but would like lower market exposure, it is easy to just reduce the beta exposure with an increase in cash to the level desired. It can be done through cash and the risky asset without resorting to greater complexity.

Find the best return to risk portfolio and then adjust to the volatility desired. If this can be done with investments which do not need to borrow such as swaps and futures, all the better. This approach is both elegant and simple. 

Friday, June 22, 2018

Commodity returns over the long-run - A good diversifier, so get back in with an asset allocation


Commodity index investing has not been very successful for investors as measured by leading index total returns since the Great Financial Crisis. The end of the super-cycle has been tough on most investors and only recently has there been a period of extended positive returns based on the rise in oil prices. Is there any relief for investors?

A look at long-term returns for commodity futures suggests that this period is not representative of what may happen in long run; however, long periods of negative performance are not unusual. The recent paper, "Commodities in the Long  Run", published in the Financial Analysts Journal studies commodities since almost the beginning of the Chicago Board of Trade, a period of 140 years. It finds that commodity futures indices have been significantly positive over the large time period, albeit with high volatility.

The work also shows that the key driver of commodity futures returns are the interest rate adjusted carry and not the spot price. Backwadation and contango do matter and this carry effect is different than the movement in short-term interest rates. Backwardation is a strong positive condition for commodity returns. Additionally, performance will differ on the macroeconomic conditions with high inflation and growth being two states that positively impact return performance. Notably, in an inflation up and expansion period commodity returns are positive regardless of the backwardation or contango.

Commodities will add value as a diversifier to a portfolio especially during certain economic states like higher inflation. Given the low correlation to stocks and bonds, volatility will be lowered with even a small allocation to commodities and there will be an increase in Sharpe ratio. The benefits from commodities can be achieved either through a long position or a long-short position through backwardation and contango.

Our view is that commodities should be incorporated as a core allocation for a well-diversified portfolio but this allocation should be dynamic. Periods of sharp economic downturn should call for lower allocations or exposure through long-short carry positions. More importantly, asset allocation decisions should not be skewed by the recent post financial crisis return performance but should be based on a longer-term view consistent with the data.

Thursday, June 21, 2018

Decision noise reduction - This is the one thing investment managers should get right


"There's a lot of noise when making a decision. Not in the decision itself, but in the making of the decision. It is possible that an algorithm, and even an unsophisticated algorithm, will do better because the main characteristic of algorithms is they're noise-free. You give them the same problem twice, you get the same result. People don't." 

- Daniel Kahneman keynote at the Morningstar Investment Conference in Chicago 2018



What is the one thing that investors want from a manager? Consistency in performance. There is value in the "smoothness" of returns. Smoothness is not the same as volatility. A manager can be volatile but still be consistent in that it applies the same reasoning to the same set of facts or market conditions. The smoothness comes from the fact that returns will match a set of factors that can describe the investment decision process.

Decision consistency or decision noise reduction is important across all professions. We want a radiologist to reach the same diagnosis for the same x-ray. We want a judge to rule in the same way for a similar crime. And, we want a money manager to behave the same when faced with the same economic conditions. 

Return consistency is achieved through the same application of decision-making. Having the same process for decisions should reduce performance noise in that the performance pattern will be similar given the same set of price behavior. It will not ensure protection from loses, but consistency may allow for longer-term success. Of course, if the wrong process is applied consistently, there will be a problem.

Of course, some will say all decisions are situational and cannot be placed into a neat framework. No situation is exactly the same, but we believe the odds are more favorable when a disciplined approach is applied. Consistency should be a fundamental issue for discussion during a due diligence.

Wednesday, June 20, 2018

The "Hedgehog and the Fox" revisited - Find managers with big ideas, but diversify





The Greek poet Archilochus wrote, "The fox knows many things, but the hedgehog knows one big thing."

The Oxford philosopher Isaiah Berlin used the fable of the hedgehog and fox as a metaphor for the writing of Leo Tolstoy in War and Peace. In "The Hedgehog and the Fox”. Berlin used the fable as a way to describe thinkers and writers. There are two types, those who define the world through a single idea versus those that have a variety of experiences and cannot be defined by a single idea but by many. Some writers are hedgehogs while others are like foxes. In the case of Tolstoy, he thought like fox and wrote about many ideas but desired to have one big idea. He could not be classified as a hedgehog or fox and this was a source of conflict, a "fox by nature but a hedgehog by conviction".  

Since the writing of Berlin in the 1950’s, the hedgehog and fox analogy has gone from a description of thinking to a more negative view on forecasting. Phil Tetlock used the fable to describe types of forecasters. The fox uses many sources of information and thinking to develop a prediction versus the hedgehog who has only a single idea that is less effective at explaining a dynamic or uncertain future.

We think that the original idea of Berlin coupled with the thinking of Tetlock is a useful for describing the thinking of hedge fund managers. There are those that have a single big idea or philosophy for how the investment world may work. The hedgehog could be the systematic trend-follower, the value manager, or the short specialist. The fox is the manager who is the diversifier. He does not have a guiding or unifying philosophy but rather is willing to combine different ideas to find the best strategy or idea to implement. There is no philosophy other than to use what works.

We respect the hedgehog that has the one big idea or can articulate the well-defined strategy but we also realize that a fox may protect us from the failure of the big idea through its flexibility. A key choice of the investor is to either find the fox manager or diversify across a set of hedgehogs. In either case, the single big idea can be costly, so there is value with running with the foxes of Tetlock or bundle a set of big ideas to stay diversified. Big ideas are critical, but it is important to have more than one of them in an uncertain world.

Wednesday, June 13, 2018

Go back to basics with the efficient market hypothesis – Think of it as a base or prior


The Efficient Market Hypothesis… has two components that I like to refer to with the terms No Free Lunch and The Price Is Right. The No Free Lunch component says that it is impossible to predict future stock prices and earn excess returns except by bearing more risk. The Price Is Right component says that asset prices are equal to their “intrinsic value,” somehow defined. 


Times have changed. Bashing the efficient market hypothesis has become a pastime within the academic and hedge fund communities. What was once a foundational principle in finance has been has been cut down to size by behavioral finance. In the marketplace, the premise of all hedge fund investing is that markets are inefficient and can be exploited by a manager's unique skill and edge. 

Nevertheless, the efficient markets hypothesis (EMH) should still be a starting point for any discussion about market behavior or the ability of managers to make money. The EMH should be an investor's base case or prior from which he look for exceptions or alternatives.    Start with the premise that there is no skill or edge and ask to be proved otherwise.

Richard Thaler does a nice job of providing a simple updated definition of EMH and how his thinking fits within this hypothesis in his Noble Prize lecture in 2017. For his two-part definition, the "no free lunch" component is simple. In a competitive market with no barriers to entry, it is hard to earn excess returns.  Any better "mousetrap" for finding profits will not be able to last before the market takes away the edge. Normal profits are zero beyond the return for bearing risk. Anyone who looks at the structure of markets should believe there are a lot of smart people trying to gain an edge and it is not easy. Information processing is very quick, so prices respond immediately to new information. The second part states that prices represent true value. All that competition is able to generate the intrinsic price. Prices have to equal intrinsic value otherwise excess returns can be exploited. Markets are able to process information efficiently. His career work finds that there are exceptions to these rules.

While this is a good working prior, it does not mean that markets are efficient at all times and prices will also equal intrinsic value. There can be free lunches and deviations from intrinsic value because of the limits of arbitrage and from behavior that does not process information effectively and makes errors in judgment. 

Our ability to define intrinsic value is compromised because the concept of value is hard to measure. There are simple example where investors are not able to do simple math for finding relative value and deeper example where value is just elusive.  Similarly, our behavior may generate consistent mistakes which can be exploited. There may exist an ebb and flow between true rationality and actual behavior. Markets will move away from intrinsic value only to return after being stretched to an extreme.

So how should an investor behave given this changing concept of efficiency?


  • Accept that markets are competitive, so an edge is hard to find.
  • It is difficult to generate excess returns after accounting for risk.
  • Accept that any manager skill like an edge is rare.  
  • If there is skill or edge, it may not last. 
  • Use the EMH as a prior or base case, but accept that anomalies can exist. However, these exceptions may only be identifiable ex post.
  • Behavioral biases exist which can generate repeatable opportunities. Competition may not drive out all of the investors who have biases and the biases that dominate may change over time.
  • Price will deviate from intrinsic value because there are limits to arbitrage. 
  • There will be noise around intrinsic value 
  • Prices may deviate from intrinsic value because there is not always agreement on value or beliefs. Price are weighting of opinions. 
  • Price deviations from intrinsic value may not last, but any closure of deviation may not be immediate.
The efficient market hypothesis may be out of fashion and has been proven not to hold as tightly as believed. Thaler and others have proved that market behavior is more complex than described by EMH, but the EMH should still be a good foundational guide for what can possibly be achieved through active management.  












Tuesday, June 12, 2018

Risk preferences are not stable - The major take-aways

An important problem in finance is trying to properly incorporate risk preferences when forming portfolios. This is especially true if risk preferences are not stable. Yet, we have increasing evidence that risk preferences do change over time. (See article "Are risk preferences stable?" by Hannah Schildberg-Horisch in the Journal of Economic Perspectives Spring 2018 and illustration below.)

First, individuals become more risk averse as they age. Older investors become more cautious and conservative. Second, there is an increase in risk aversion during an economic crisis or downturn. Risk aversion is countercyclical which can explain why the equity risk premium is higher in recessions. This can also explain why investors who lived through economic crises, like a depression, act more conservative than investors in the same age category who did not experience a depression. Third, stress, fear and cognitive load will elevate temporarily risk aversion. 

Risk aversion may not be stable through time, but it may be stable when measured by traits which is consistent with how psychology looks at risk aversion.

This idea of changing risk preferences can be very useful at explaining both investor and manager behavior. The change in risk aversion as we age is consistent with the target date products that become more conservative through time. The risk aversion from economic crisis suggests that many avoid holding risk portfolios at times when upset is best. The fear factor suggests that portfolios will become more conservative during stress. The impact of risk aversion on investors seems acceptable to our understanding of market behavior, but we should also accept that risk aversion impacts manager behavior.

Managers are likely to become more risk averse as they age. The gunslinger of yesterday will become more conservative with his grey hair. Managers are not immune to a crisis will become more conservative during a recession. Managers will increase their risk aversion when there is more stress. 

Given this time-varying pattern, there is a good reason to hold systematic strategies that will not show changing risk aversion. Disciplined rules-based approach can eliminate this behavior in managers. 

Monday, June 11, 2018

The power law and hedge funds - Power law in size may not equal power law in returns


The four biggest hedge fund launches of 2018 have attracted more than $17bn, according to figures compiled by the FT. That compares with the $13.7bn investors have put in existing funds, according to data from eVestment.  from FT 
Hedge fund stars rake in billions for new funds



Many may know the 80/20 rule-of-thumb for economics, the Pareto Principle. In businesses, 80% of the profits are generated from 20% of the customers. The power law is everywhere and the hedge fund industry is no different. A few firms hold a majority of the money.   The performance of managers is often positively skewed because poor performer close. Most firms fail.


Most new money goes to a few firms, as is the case in 2018. Behaviorally, investors want to be with smart money which is naturally supposed to be with new big start-ups. Money flows create a herding effect, which perpetuate the power law.

However, data on performance suggest that small firms do better than large firms. The power law with size or launches may not match the fat tails or power law in performance. This shows the complexity or non-linearity within the hedge fund industry. Following the flow or size crowd will not lead to riches in return. A power law in one dimension, size, does not strongly correlated with another dimension, return

Nevertheless, the dynamic nature of the hedge fund industry means there are constant launches and liquidations so that picking hedge funds is like venture capital investing.  A few winners are offset by a larger number of losers. A key process for due diligence and investing is finding the potential size/return trade-off maximum. Using managers that are too small, while potentially generating higher returns, may increase the exposure to firm failure. Using managers that are too large may reduce firm risk but may place a drag on performance. The power law in size may not signal quality.

Wednesday, June 6, 2018

Hedge fund performance - Not providing the investor benefits expected


Hedge fund indices, in general, showed positive albeit muted gains for the month. The biggest losers were EM and systematic CTAs on the sell-off in emerging market stocks and bonds and the large bond reversal. The largest gainer was fundamental growth which was consistent with growth indices. 

Hedge fund performance for the first five months of the year is tilted to the negative with event, distressed, and special situations underperforming. The largest winners are the relative value and multi-strategy indices. 

Investors should be underwhelmed with average hedge fund behavior this year. Volatility spikes, some country specific risks, and some choppy markets conditions served not as trading opportunities but as drags on performance. Some of these events could be viewed as true surprises, but the benefit from holding hedge funds has been limited for the year even though the markets have not been directional.

Tuesday, June 5, 2018

What affects my sleep this week - DB, Brazil, and CMBS

Historian Deirdre McCloskey says, “For reasons I have never understood, people like to hear that the world is going to hell.”
John Stuart Mill wrote in the 1840s: “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.” from Morgan Housel "The Psychology of Money"

Yet, here I am talking about what may cause me to lose sleep. Am I falling into the same trap described in the quotes above? Yes, but I would like to believe that focusing on the possible extremes or dangers help protection wealth. The cost of complacency is high. A lose of principal requires more future return to reach breakeven. This is the drag of volatility. 

This week here are three issues of concern. One, Deutsche Bank. The decline in a global bank has systemic risks which are hard to unravel. Reduction in lending for one bank cannot be immediately replaced with another bank. Governments do get involved, and financial plumbing is important. Second, the Brazil turmoil is can lead to unintended future policy consequences with a election coming up. Forecasts have actually increased growth for 2018 to 2.0% from 1.6%, but the strike impact looks to be more far-reaching. It should cause concern for any EM investing. Third, the quality of loan portfolios in CMBS should be a concern. Interest only loans never are a good sign of quality.

Nevertheless, good macro data in the US lifts the global boat. With employment still improving, it is harder to bring any localized negative concerns forward in time as global issues 

Monday, June 4, 2018

Trends dominated by bond reversal but not clear the shock rally will continue

I have always thought that the simple physics analogy that a market at rest will stay at rest and a market in motion will stay in motion is apt for trend-following. Trends will change when there is a shock or catalyst that will change the underlying fundamentals. Trend-following does not require knowing all of the reasons for why a trend is happening or why it may stop. Trend-following only requires that a signal is extracted and followed until price dynamics tell you otherwise. The success with trend-following is driven by the fact that trends last longer than expected. They last longer because most new information is trend reinforcing. Fundamentals do not generally change quickly. Nevertheless, loses will occur when new information causes an expectations reversal. Expectations may change more frequently than fundamentals. 

Bond markets faced a large reversal from their rising rate trend when markets switched to risk-off over the forming of the new government in Italy. EU exit risk is back. This causes revisions in equity, bond, and rate trends. The shocks were strong, but it is not clear whether this change in sentiment will be reinforced by additional new information. Political risk is hard to handicap and even harder to exploit as a trend-follower. 

While we have seen trends change in a number of sectors, currencies and energy sectors have continued to follow existing market price action. Our view of sector trend behavior is that June will offer good return opportunities albeit the size of the gains may be muted. 

Managed futures hurt by bond reversals - Surprises shock major trend-followers

Managed futures performance for May was driven by one sector, global bonds. The surprise events in Italian politics led to a flight to quality move into safe bonds around the world. This sharp reversal caught most short trend-follower flat-footed. The commitment of traders reports have shown a strong short tilt in managed money. The size of the move over less than 10 trading days ensured stops would be hit and positions changed. The question was just how much pain managers took in this sector. Notably, the markets sold-off on the good economic employments numbers to further hurt managers who switched to longs earlier in the week. A similar set of events followed the rates markets. Expectations for fewer Fed hikes given the political turmoil only reversed again after the US employment number.

Stock index performance was mixed on shallow trends or reversals in stock markets. Trading increased in difficultly with a spike in market volatility. Nevertheless, a bright spot for many traders were continued sell-off in many currencies. The dollar rally has continued with well-developed trends. Energy markets moved higher, yet there has been an increase in volatility based on discussion of production increases. Gold has sold-off like currencies; however, there were more limited opportunities in base metals. Commodity markets were mixed with grains starting to trend lower now that US planting is done for corn and soybeans. Sugar and coffee, while showing trends, offered limited opportunities given the size of positioning for most managers.

Managed futures have been hurt by the February volatility shock and now the May bond shock from political risks. Economic surprises generally hurt managed futures especially if it comes in global bond market sector which is usually the largest sector of risk exposure. 

Sunday, June 3, 2018

Painful May performance for international equity and bond investing requires more caution with diversification


May saw a set of return reversals with bonds posting gains on flight to quality while international markets saw strong return declines. Selected country equity declines were very strong based on increased political risks. It was a good month for those cautious and focused on US smaller cap names.


The style gainers for the month were in US centric names, small cap, growth and value. International and emerging market performance declined on dollar strength and capital flight away from political risks focused in specific EU and Latin American countries.

The finance sector declined with the higher rate uncertainty. Rate sensitive sectors like utilities and real estate continue to lag other market sectors. Consumer stables declined again with double digit loses for the year. Technology continues to be the strong sector winner for the year.


Selected country ETFs were strong losers with double digit loses in Mexico and Brazil. Mexico is facing an important presidential election which may significantly change the business climate regardless of any trade issues with the US. Brazil has been facing strikes that have crippled the economy. Strong declines were posted in Spain and Italy. Italy is facing the problems of forming a coalition government while Spain has dropped on Italy contagion given the poor macroeconomic position of the country.


Bonds saw a strong reversal from the flight to quality associated with the Italian problem; however, a strong employment report reversed some of this positive bond euphoria. Sector loses were concentrated in the international and emerging market bonds. Bonds are still negative for the year across sectors.

Our moving average and break-out models point to a few key trends. First, hold US stocks and avoid international sectors. Second, avoid international and emerging market bonds. Third, avoid poor performing countries that are facing political uncertainty. Fourth, maintain or increase real estate, technology and consumer durable sectors. In general, while volatility has fallen since the February shock, there is still significant uncertainty that should mitigate excessive risk-taking.

Friday, June 1, 2018

Monthly performance does not follow an expected return script - Improvisation in value, growth, and small cap indices

One way to measure market uncertainty is to run a simple thought experiment. A well-behaved market should match performance with events in a well-defined manner. An uncertain complex market environment would behave in an ill-defined manner. Close your eyes and assume you have knowledge of the news highlights for the month of May. For example:

  • Political turmoil in Italy and the EU
  • Off-again/on-again North Korea talks 
  • Good economic data albeit with lower momentum
  • EM problems in Turkey and Argentina 
  • Trade war discussions

What would you expect?

The results for May were quite different from what many would expect for some asset classes. A flight to quality and a Treasury rally seems consistent with the news. Similarly, a decline in developed equity and emerging markets also seem consistent. However, the strong showing with small cap, value, and growth are out of character in the current environment.

Small cap, growth, and value indices all had gains of over 5 percent for the month even with higher volatility in the last week. Core domestic equities did better than global, emerging, and large cap stocks. These numbers are inconsistent with a flight to quality or risk-off behavior by some international investors. Unfortunately, the key drivers for May are political headline risks which are difficult to handicap. There is little evidence that can be used to provide likelihood for further momentum or mean reversion.