Tuesday, June 18, 2019

Factor portfolio construction - All alternative risk premia are not the same


An investor could say, "I would like to have exposure to risk premium X." However, there is no one single definition or consensus for how to implement a risk premia portfolio. First, there has to be agreement on what it means to say you want a specific factor exposure. There may be agreement from an academic definition, but once you start getting into the investment details, there can be a lot of differences in how to access this premium. 

Here are some of the choice issues for investing in a risk premium:
  • Universe for application of the risk premia. This universe could be, in the case of equities, a large cap set of stocks or a much broader universe which includes mid and small cap stocks. There also has to be the decision whether to include global equities and emerging markets.
  • Monthly or daily reset or rebalancing. The timing for when to rebalance will matter both for performance, risk, and costs.
  • Long-only or some variation of short exposure with constraints. Performance will differ markedly when you include short positions.
  • A pure factor exposure or controlling exposure to other factors matter because over-exposure to one factor may be driven by other risks.
  • Equal weighted, risk weighted, or cap-weighted allocations will impact risk exposures. 
  • Constrained or unconstrained with respect to tracking error or exposures will impact concentration risks. 
The construction issues are relevant for all asset classes. A recent thought piece from the Axioma Group examined one risk factor, profitability, and compared the return results using different portfolio assumptions. The range of performance and correlations are startling. (See "What exactly is a factor? How factor portfolio construction impacts exposures, returns and attributions" from Axioma)

Table 1 shows the definitions for the choice set analyzed. Table 2 shows that the correlations between the factor and different implementation strategies can vary between .83 and .21 over a thirteen-year period. You may not get what you think you paid for with this risk premium.


The performance differences are significant with a spread in the cumulative gain of over 50 percent. The scaled performance differences are over 15 percent. Now, on an annual basis this may only a little more than 1 percent, but these differences add up.  The weighting scheme will also generate significant differences both in the short and long-term. if you made the "wrong" weighting choice, you would have likely exited this risk premium even though it would have generated strong gains.

Implementation matters, which means that knowing the details will also matter for any risk premia choice. This requirement for understanding the details is no different than knowing the differences in manager strategies. There is value with doing a deep due diligence.

Monday, June 17, 2019

Inflation - It is still about minding the gap


There has been so much discussion about hitting the 2 percent inflation target that it is often good to go back to basics. Investors should keep in mind the simple rule that inflation cannot really rise above expectations unless the output gap is closed, not just for the US, but for the global economy. This goes back to classic macro and an expectations-augmented Phillips curve model. If inflation is below inflation expectations, it suggests that there is still an output gap. (See "Is Inflation Just Around the Corner? The Phillips Curve and Global Inflationary Pressures" by Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate in the 2019 AER Papers and Proceedings)

Close the output gap and there will likely be more inflation upside. If the gap is not closed, upward pressure will be limited. Additionally, the US will be hard pressed to see higher inflation if global inflation and output still languishing. The US is not an inflation island separate from the rest of the world.
If inflation is below the expectations, the output gap has likely not been closed. There is still slack in the economy. While capacity utilization is higher, it has taken a long time to close the employment gap which has dampened any possible surge in inflation.

The inflation gap is closing so there is a smaller difference between actual and expected inflation; however, there is still a problem that inflation expectations are low. Economic agents just do not believe that the combination of growth and monetary policy will lead to inflation strongly consistent with inflation targets.



The decline in the output gap and the closing of the inflation gap all suggests that Fed tightening made sense over the last few years. A close look at inflation expectations and CPI percentage changes tell us that the gap was closed. There may be concern that the gap may again increase, but the data, while switching sign, has does not suggest a change in the economic environment. Inflation is not that has to be addressed.  


Sunday, June 16, 2019

Russell survey on smart beta - A mainstream investment choice


More than 50% of the institutional investors polled in the new 2019 FTSE Russell smart beta global survey now have exposure to smart beta products. Smart beta is now a normal part of the normal investment choice set. The key reason for employing smart beta investment is not to provide another passive asset allocation choice but to serve as an alternative to active management. Smart beta, the investing in long-only risk premia, is serving as rules-based method of gaining specific risk exposures without the use of an active manager. 


Investors are not buying unbundled smart beta strategies, but focusing on portfolios of factors. There is a desire to have an investment product that balances between a few risk factors.  Investors still want help with the asset allocation process.

These smart beta allocations are not viewed as short-run allocation decisions but as part of strategic long-term allocations. This seems consistent with the movement to thinking about risk factors and not asset allocations. 

The overall satisfaction with smart beta is high with over 50% of survey responders saying they are very satisfied or satisfied. While there are still a strong percentage of users who want to see more performance information, the smart beta revolution has done a good job of delivering on their investment promises at a reasonable price. 

As comfort levels further increase, we expect there will be more desire to buy long/short risk premia products to gain the full advantage of risk premia investing and not just tilts to long-only exposures. The desire for long/short exposures will require the use of different investment choices like swaps to gain efficient exposures.  

Saturday, June 15, 2019

Why the trade war will continue - It is a not a trade war, it a battle of economic models


The purpose of war according to Clausewitz is simple, "...compel our opponent to fulfill our will" and "war is the continuation of politics by other means."  It may be a last resort, but it is an extension of diplomacy even financial and trade diplomacy. 

These quotes are very applicable to the current trade war between the US and China and represents a part of the diplomatic strategies of each country. Nevertheless, there needs to be a focus on the deeper strategies being played by each country and the implications for investing. The simple view is that the tariffs were increased to change the balance of trade, but this fight is now being played at a much deeper level and is the reason why this conflict may be more protracted. This has become a contest of competing systems; consequently, it is less likely to be easily resolved.

The simple view is that tariffs are a fundamentally new policy response and that the pre-Trump period was absent of import restricting policies. That view is simply not true. Policies such as anti-dumping and countervailing duties have been on the rise since the entry of China into the WTO. The current policies, albeit ratcheted to a much higher level, are an extension of ongoing trade skirmishes, albeit not in the headlines. The amount of tariffs levied has been small but not absent. (See the PIIE working paper from Chad Brown for a good overview 19-7 "The 2018 US-China Trade Conflict After 40 Years of Special Protection")



This is a battle between western economic liberalism and a corporate state mercantilist system; however, liberalism is in the perverse position of imposing tariffs as sanctions on the anti-competitive behavior of state enterprises and state growth policies. These tariffs are not to gain revenue or just make US businesses seem more competitive and bring manufacturing back to the US. The tariffs are attempting to place a wedge in market structures and change state behavior for doing business in China which includes patent and copyright work as well as the transfer of technology that move beyond sharing between business partners. 

The mechanisms of the WTO may not address or have the enforcement powers to change overall business structure in China. The tariff club is ham-handed, but a choice within the tools of financial diplomacy. It may not be the right choice, but frustration with state behavior has made this a tool. Corporations by themselves do not have the market power to ignore or change China, so the state apparatus is necessary. China's will is to maintain the political status quo and continue to achieve high growth through global trade policy.  

Unfortunately, there is no international organization that has the power to change a large dominant player for the benefit of the global community. The end of economic liberalism is tied to the lose of faith in using international organizations and law to mediate these disputes. Currently, no one trade player or group that can impose their will on another, so there is an escalation of policy and rhetoric that will not go away

There are some key themes that should be applied to any portfolio construction:
  • Global growth was driven by the growth in China and the US. This trade war will continue to weigh on growth. As China diversifies its exports, the rest of the world will face margin pressure.
  • Revenue growth from selling across borders will decrease. The absolute level of trade will decrease even if tariffs are dropped. The threat of future sanction is real. We are see a significant drop in trade that is beyond a growth slowdown and that will not reverse in the short-run.
  • Margins for companies with China supply chains will compress. Even with an agreement, companies will diversify suppliers which will increase costs.
  • Cross-border investments between China and US will decrease. The environment is too uncertain. This will apply to real estate as well as companies.
  • For China, dedollarization will be a long-term policy goal which will only cause further constraints on economic liberalism and cooperation.
The net global loss from trade and finance frictions will be based on each country being driven by their self-interest based on what they believe is good for their citizens. Global liberalism and cooperation is a hard sell when viewed through bilateral policy views in both the US and China. 

Friday, June 14, 2019

Equity hedge funds versus equity risk premia

When you invest with an equity hedge fund, you are actually getting two investments. One, a portfolio of equity risk premia, and two, the skill of the manager to blend these risk premia and find assets better than the returns from the premia. Hedge funds provide risk premia style exposure with their skill with the style. For example, a value manager is providing exposure to the value premium and his ability to find extra return. While we are not conducting a factor analysis of the different hedge funds, placing the returns from bank equity risk premia swap styles next the HFR hedge indices provides some insight on the return generation process. 

The positive returns in risk premia this year are focused on four areas, low volatility and beta strategies, multi-style, size, and volatility. We will note that the volatilities for the HFR bank risk premia are in some cases more than double the volatility of the average hedge fund performance. A good portion of the low volatility risk premia came in May when equity markets declined. Equity hedge funds lost money last month, but generated gains in value and growth strategies for the year from the earlier strong movement in equities. There is a greater focus, as expected, on stock picking with hedge funds and not with strategies like low beta that are defensive in nature.

Equity risk premia can be bundled to provide successful alternatives to equity hedge funds, yet their focus on style exposures means there is still room for holding equity hedge funds with stock picking skills that may create more concentrated portfolios of specific opportunities.

Hedge funds - Mixed performance for month and year

Diversification and return, this is what investors want from their hedge funds, but it is the rare case when you can get both. 2019 is shaping up to be no different than the past for the average fund. 

Most hedge funds will have volatilities between bonds and stock indices. Hence, if you want more return, there has to be an improvement in the return to risk versus traditional assets to gain versus the benchmark alternatives. This improvement in return to risk requires skill. There can be gains from diversification of investing styles and risk premia but finding value and exploiting inefficiencies are the keys to any return gains. Year to date, hedge funds, on average, have not been able to generate strong absolute returns. At best, the average fund is generating just over 2 percent. Equity managers have done slightly better given the market gains earlier in the year. 

Investors expect diversification from their hedge fund investments. Yet, it is exceptional to find managers who have low correlated with traditional assets and still generate strong absolute returns. In most cases, hedge funds will have dampened returns versus traditional assets as the case in May for most strategies.

This does not mean hedge funds have failed investors. Rather, there is a mismatch between expectations and reality. Investors have to taper their expectations and understand what is exceptionalism within the hedge fund space. Diversification benefit with return is exceptional.

Thursday, June 13, 2019

Building liquidity is a safe choice in a flat yield curve environment


The focus on inverted yield curves has been on the signal it provides about future recessions, but it is more important to look at how investors will change their behavior given the inversion. It is the behavior that will impact market prices and capital flows and right now it pays to raise cash levels.

  • Current short rates (3-month Treasury bills) are greater than the dividend yield on S & P 500; (2.24% vs 2%)
  • Current short rates (3-month Treasury bills) are greater than 10-year Treasury bonds; (2.34% vs 2.15%) 
  • Holding cash better than stand alone equity risk assuming zero capital appreciation.
  • Holding cash better than taking on duration risk assuming current yield and no movement in rates. 

If there is an expected slowdown in economy which will led to lower rates, then worth taking duration risk but not equity risk. If there is no slowdown, investors may prefer equity risk over fixed income duration risk. If investors are uncertain and risk averse, then their preferences may be with increasing cash at the current low opportunity cost. At the least, increasing cash levels will lower risk but will actually increase current yield. Simply put, every percent decrease in a risky 60/40 stock/bond (SPY/IEF) portfolio will lower portfolio risk but actually increase stand-alone return. This is not a difficult trade if you don't have a strong positive view on stocks or bonds.

If each investor increases the cash portion of their portfolio, in aggregate, there will be a significant decline in demand for risky assets. Prices will have to fall to clear the market. The earlier asset price fears are realized. Of course, cash rates will also fall or the Fed will engineer a decline that will eventual take us back to an upward sloping curve, but that will occur sometime in the future.  

Wednesday, June 12, 2019

Are momentum models better than moving average models? Some useful tips


There are two major strains of models for generating momentum and trends signals. One, analyze simple past price levels (returns) for some look-back period. This is the classic momentum approach (MOM) extensively analyzed in academic research. For example, if the return for an asset over a nine-month look-back is positive (price today above price nine months ago), buy the asset. Two, use the classic trend approach (MA) and buy an asset if the price is above some moving average, linear average, or exponential weighting. The signal is based on some weighting scheme of past prices. 


Recent research has tried to answer whether one approach is better than the other and it concludes that the classic approach of moving averages is a better approach. (See Trend Following with Momentum Versus Moving Average: A Tale of Differences by Zakamulin and Giner.)


The researchers present details on model comparisons that many trend-followers have intuitively know but may have not formally tested. Their work compares MOM and MA models against different autocorrelation schemes to determine which approach has better forecasting skill as indicated by their ability to properly determine market direction. The authors compare models with different look-back periods and show their predictive skills and correlations. This numerical testing allows the researchers to measure the robustness of different models. Their conclusions make intuitive sense and provide a good guide on where modeling should be focused.

The correlations between MOM and MA models are high and gets higher if there is a strong trend, but the MA approach will have more robust forecast accuracy. It is more forgiving in accuracy for changes in look-back periods. This result suggests that MA models will do better when there is trend uncertainty. In some sense, one moving average is not much different than another. On the other hand, using a simple MOM approach can lead to more error.

Put differently, the correlation between two MA models with different look-back periods will be high and stable. You obtain only limited diversification benefit from using more than one MA sign. You will receive more diversification benefit or differences in correlation between MOM and MA models, but the MOM model will have lower forecast accuracy. There is limited value with choosing a model of MA or MOM models.

The choice of model will also depend on the autoregressive behavior of prices. If there is stable and equal autocorrelation through time, then a MOM model may be better, but if there is declining autocorrelation there will be more value with a MA model like an exponential weighted approach which place more weight on recent data. Researchers need to know the autocorrelation features of price data to pick the right MOM and MA model.

The reasons for the failure of back-tests are because the predicted power of any model will change with change in the autocorrelation of the underlying data. Unstable data structure will mean high variation in what is the best model form. Their numerical tests show that on average, in a changing uncertain world, the MA models will do better than the MOM structure. Still, picking the optimal weights for a MA last period and applying to data next period is a risky business; ask any trend-follower. However, this paper can provide some guide dealing with the problem. 

The practical rules from this paper are simple:

  • Prefer MA to MOM models.
  • If you diversify signals match different look-backs with MA or a MA and MOM combination.
  • Accept that diversification across models may be limited 
  • Accept that autocorrelations in prices are uncertain but MA models are more robust (forgiving). 
  • Optimizing over a back-test period is a fool's game.

Monday, June 10, 2019

What is a risk-free safe asset? Safety ambiguity


What is a risk-free asset? Similarly, what is the risk-free rate? It could be US Treasury bills for US investors or for foreign investors who believe that the dollar is a currency of safety. It could be a local short-term rate foreign rate. However, depending on how you frame the question, there can be many risk-free assets or there can be no risk-asset and this is a problem. This issue is not new, but it should be discussed since we are again seeing lower rates around the world. 

Short-term sovereign rates in many countries are negative and there are over $11 trillion in bonds with negative rates. It is hard to say that these are safe assets. If the defining characteristic is protection of principal over time, the current rate environment in many countries says that you should settle for a loss. 

Real rates also are negative for many assets, so investors should settle for an erosion of purchasing power over time. The only way that investor should be willing to hold these assets if they believe that any risky combinations of assets will produce even lower returns. The oddity of negative rates is that it is not a choice of keeping your money versus a chance of gain or loss, but a certainty of losing money versus a chance of losing or gaining some different pay-off. An investor will lose. It is just a matter of how much.



The investment world is a set of risk choices and not safe choices. If your idea of safety is to ensure a certain cash flow for retirement, create a specific nest egg, or generate returns that will meet specific yields or cash flows needs, risk-free assets could be very risky. If you need to meet specific liabilities the risk-free rate could ensure failure. There may not be any risk-free assets. 

The fact that there are no safe assets does not change the fact that investors still have to make relative choices. Some are risky than others. Each have a different set of risks. Difficult choices will have to be made. 

Sunday, June 9, 2019

The credit story - Not a household or bank problem but a corporate problem

As part of the Financial Crisis recovery program, the Fed wanted corporations to borrow for new investments. Low interest rates would drive a credit expansion. Well, now we know what happened. There were excesses but not everywhere. Households have retrenched except for student loans. Bank leverage has been constrained by macroprudential policies. Corporate growth expanded greatly and firms borrowed even more when they thought rates were headed higher. This corporate lending was not just for long-term investing but leveraged loans for companies that are trading at high debt multiples. 


All firms have increased leverage and have taken the markets to leverage levels not seen before. While some can argue that interest expense ratios are lower, principal will still need to be paid.
All of this leveraging makes the economy more vulnerable to a shock, but the composition of lenders is what is truly different. More bonds are held by mutual funds and ETFs which will create liquidity problems. In the past, corporate bonds were held by longer-term buyers who could wait out a cycle. The current liquidity mismatch between buyer and seller may create feedback effects that will make any credit shock more disruptive.

Friday, June 7, 2019

Stresses in farmland - An example of the problem of leverage



A recent Financial Times article "US farmers' borrowing boom is built n shaky land value" highlights the issue of leverage and the overvalue of assets in the farm industry. Farm prices have been somewhat depressed and only worsened withe the decline in exports from the tariff wars. This issue has only be exacerbated for some farmers with the wet planting season in the Midwest. Prices may have moved higher, but if you don't have a crop there is no income. 




Debt is at the same levels as the peaks in the early 1980's, yet now farmland prices are falling. Leverage is increasing for farmers, so they are vulnerable to any shock in the price system. The result will be a disruption in the farm industry structure. Weak hands will have to pass assets to others which may be institutional. Improvements will be delayed and productivity will be shocked. 

This disruption will not jeopardize the crop food chain, but just like the farm debt crisis of the 1980's there will be a human toll and an impact on industrial organization that will affect margins and future pricing. This can be viewed as a fall-out from cheap money for too long. High debt and leverage, cheap money, and market uncertainty will result in unexpected changes. View this farm industry disruption as a warning.

The development of alternative risk premia - Isolating factors


There has been a natural progression of investment developments associated with risk premia. First, there has been the identification of risk premia. Second, there has been the development of long-only focused funds or smart beta, and finally, the pure isolation of risk premia through long/short hedge funds. These developments have not always been sequential, but they should be thought of as a progression from market beta to focused premia. This progression changes the choice set for investors.


Investors have a widening set of premia choices. They can buy beta in a pure form. They can buy bundled risk premia with funds that have a premia tilt either managed passively or actively. For example, their choice could be a value fund or a small cap fund that is benchmarked against a portfolio with this premia. They can buy specific risk premia in a passive long-only form through smart beta which is a more direct approach to accessing a risk premium. For those who want the "purest" form of risk premia, investing can be done through a long/short portfolio. These premia can be accessed through hedge funds, although hedge funds may be a bundle of a few ARPs, or the investment can be done directly through a total return swap which is has a rules-based index for the risk premia.

One of the largest changes in money management over the last decades is the widening of investor choices with a broad map of methods for accessing risk premia. Identifying and isolating risk premia is a significant advancement. Investors can build and tilt portfolios that express specific factor weights in ways not possible just ten years ago.

Thursday, June 6, 2019

Alternative risk premia performance mixed for May


Returns for alternative risk premia for multi-style swaps which include a bundle of different risk premia categories like carry, momentum, and value have performed well this year, but these swap portfolios showed mixed performance across asset classes in May. Equities styles, as measured by the HFR indices, were down slightly with value and carry declining but low volatility and low beta strategies doing well in the declining market beta environment. Rates did well based on the strong bond rallies around the world. Currencies styles were mixed. Momentum strategies did well, but currency carry was a drag. Currency carry has shown to be correlated with equity market beta. Credit was hurt as spreads moved with the decline in equity beta. There is more dispersion with credit risk premia in these indices because there are less bank swap products. Commodity multi-styles were positive; however, many strategies underperformed based on the wide return variation in different commodity sectors. Overall, the multi-styles strategies were negative for the month.

Alternative risk premia have low correlation with market beta, yet that does not mean that there is no correlation with the market. There is good diversification but when there is a large market decline, ARP returns for a number of strategies will be pulled lower. The composition of the portfolio makes a difference when there is a large market move. As expected, more defensive strategies like momentum/trend and low beta did better in these environments. Our overall impression is that ARP portfolio returns were consistent with expectations.

Monday, June 3, 2019

Strong bond rally but we have seen larger in last decade - Largest since Fed tightening


The current bond rally is strong. Investors are discounting a global slowdown and further trade wars that will trade. There is no question bond investors have turned pessimistic and there is a growing flight to quality, but this move should to be placed in historic perspective. We have seen larger one month and three month moves in terms of basis point declines and we have seen greater percentage declines in yields. Two-year yields changes are less volatile than during the transition between quantitative easings. The 10-year yields have exploded to the downside earlier in this cycle only to reverse direction. This is the largest bond rally since the Fed switched to tightening.

The declines in PMI during 2012-2013 were more dramatic than the current decline, but we do not know whether this economic decline will continue. We could be in the middle of a further PMI fall, so we can easily see further yield falls. 

The market pressure on longer yields places more pressure on the Fed to act given the potential for further inversion. Two cuts are being priced in this year. Whether holding cash in an inversion or playing for a further bond rally, there is a strong case for further switching from risky to safer assets. Even if you are uncertain about economic direction, cash is attractive and safe. 

Sunday, June 2, 2019

Academic (public) and hedge fund (private) alternative risk premia


There are many ways to classify alternative risk premia that are developed by hedge funds and bank swap desks. The simplest categories are style and asset class. Styles can include value, carry, or momentum, and asset classes include equity, rates, commodities, carry, and credit. However, another classification method is through where the risk premia idea originated. There are two major sources, academic research and trader idea generation or implied risk premia. These could be classified as public and private alternative risk premia.


The academic path is simple. Research on factors or risk premia from academic working papers is weaponized into an investment or trading strategy that can be implement through a variety of markets. A hedge fund or swap group will read the research, breakdown the work into components that can be replicated, and convert this work into a repeatable set of rules. The investment idea is not proprietary but the conversion process requires quant and trading skill. The implementation or practical knowledge may be considered proprietary. 

Unfortunately, some of the latest research states that after working papers are published or the research enters the public domain there is a significant and economically meaningful decline in the expected returns. Once the idea is out in the market, excess returns are arbitraged away. Crowds reduce the excess returns found in the research.

The second path for alternative risk premia comes through research done by hedge funds or banks and is not in the public domain. This is often in the form of firm-specific hedge fund strategies. This is a tradable and repeatable idea that a manager can believe is unique and requires special execution skill. There may be an economic foundation for the idea, but it may not have been explicitly tested in academic research. These ideas have often focused on volatility trading and replication of fund strategies like trend-following. If developed and marketed through a swaps desk, the investor is more directly dependent on the back-testing of the bank. 

The academic work is more public and subject to crowding from investors following the strategy as the idea is disseminated. The trader idea generation is private to the firm originating the idea but subject to the more unique risks associated with specialized construction. There is a trade-off of receiving a generalized risk premia versus one that is unique to the firm who generates and constructs the risk premia. The private (non-academic) risk premia requires more investor analysis and more trust in the bank swap desk construction and execution team. Our view is that the academic risk premia should be preferred albeit the crowding issues must be addressed. A trader risk premium requires added return to compensate for their structural uniqueness  

May market performance - Rotation from stocks to bonds based on trade war worries



Risk-taking seems like it is ready to be on summer hiatus. Nevertheless, a simple look at the data suggests that the stock to bond rotation seems a little overdone. The difference between stocks and bonds (SPY vs TLT) was over twelve percent, yet the economic data does not suggest a slowdown shock. Investors are reacting to two major themes permeating the global economy. The response to these themes is uncertainty since both issues are still unresolved. 

Trade wars are not going away anytime soon. In fact, positions are solidifying and there does not seem to be any sense of compromise in the air. Tariffs are increasing and widening over more goods. Alternative policies are also being discussed as further war responses, and tariffs are now being used as a tool for foreign policy in the case of Mexico. Costs will increase, margins will tighten, and consumers will retrench. While, in the case of the US, import are still a small part of the economy, these tariff wars extract a toll on consumers, impact capital expenditure plans, and hurt forward earnings for many firms.

The global economy is looking like it will be slower than expected. There may not be an immediate recession, but the concerns from the fourth quarter of 2018 have returned. While housing may be softer, durable good weaker, and retail sales slightly lower, the overall tone in the real economy does not look bad. Conference Board and the University of Michigan surveys both show strong positive views from consumers. The labor market is still very strong, and leading indicators and PMI numbers still suggest positive growth. Signals are more mixed than priced by markets.

This uncertainty is making global macro investing so difficult. There is not much different from 2016 when industrial production was negative but there was a continued strong labor market. Prices reversed after data became more consistent. Bond markets are pricing in two rate cuts in Fed fund futures and the inversion suggests that bonds are more negative than policy-makers. Growth and trade wars will have to get worse for these forecasts to be realized. 

Thursday, May 30, 2019

Pierre Wack and deeper thinking about scenario analysis


“Scenarios deal with two worlds; the world of facts and the world of perceptions. They explore for facts but they aim at perceptions inside the heads of decision-makers. Their purpose is to gather and transform information of strategic significance into fresh perceptions. This transformation process is not trivial—more often than not it does not happen. When it works, it is a creative experience that generates a heartfelt ‘Aha' … and leads to strategic insights beyond the mind's reach.”
- Pierre Wack 

Building scenarios is a key creative process for investment management. You can get a quant to run an optimizer, and you can get a good analyst to tell a strong narrative with supporting documentation, but building alternatives for future market performance is much more difficult. Many simplify this process by just providing three scenarios, an optimistic, pessimistic, and a base or status quo. That is a form of scenario analysis, but it is not effective scenario building. It may not provide the deep thinking of how changes in the economy, adaptive expectations, and capital flows interact to create new return worlds.


The classic scenario is usually just built around expected return or price estimates. A portfolio manager will run a likely case based on his best guess of what may happen across a set of asset classes. There may be a narrative attached based on a set of assumptions with how markets respond to news. From this base case, there will be a positive (good news) scenario that will have higher returns for riskier assets and a negative (bad news) scenario where risky assets fall in value. Each scenario is given a probability and the portfolio upside, downside, and likely scenario are assessed to determine risks. This is not a bad way of looking at alternatives and is consistent with the method taught in most business schools. but it is not an effective way for conducting deep portfolio planning.

Pierre Wack was the leading scenario planner for Royal Dutch Shell and revolutionized thinking about scenario thinking in the 70's. Unfortunately, he has not been studied extensively in more recent history and never gained any traction in the world of finance. The processes of running scenarios for a large corporation are different than for an investment portfolio. Corporate risks are greater because capital investment decisions need to be made with long lead times. The costs of being wrong are also higher given there is less diversification with focused industrial company.  Nevertheless, the deeper operational thinking and examination done by our best corporation should be applied to investment portfolio construction. 

Wack did not come out of the quantitative world so his thinking did not fit with normal optimization and scenario analysis. A focus on perceptions has never been a normal part of investment thinking. Hence, he is an obscure figure for money managers. Nonetheless, he can teach us how to make better decisions by embracing an uncertain world.  

The premise of good scenario analysis is that managers have to be engaged with the relationship between facts and alternative perceptions. It is not using the same thinking with a good or bad state of the world, but developing thoughts on alternative models of thinking.

For example, the normal view is that larger debt supply should lead to higher rates, yet the facts suggest that larger deficits have been consistent with lower rates. The perception of many for how the world works does not fit the facts, so we have to think through alternative perceptions of reality, or alternative model of how markets operate. 

Another instance of changing reality is thinking about modern monetary theory (MMT) and the cost of financing deficits with money. Few would have thought just two years ago that MMT would be given much deep thinking, yet politicians, policy-makers, and investors are all now discussing it as an alternative for running fiscal and monetary policy. 

A similar story could be told about trade wars. The role of China in the world economy and how trading partners work with China have changed radically in the last year. Scenarios for how countries will engage with trade will truly impact return profiles with both winners and losers that cannot be described in good and bad scenarios.

Perceptions change and those alternative realities have to be considered. Once we form alternative perceptions, we can discuss what will happen with new disruptions of shocks to markets and the implications across assets. Investors can then think through a set of alternative investment choices. 

The market disruptions in 2008 were a failure to think through how shocks may promulgate through markets. It was a failure of broadening our perception on risk, liquidity, and market reactions. In the post crisis period, no one would have perceived that there would be $11 trillion of negative yielding bonds. 

Deep scenario thinking asks those engaged in the process to walk through the implications of whether their assumptions of market behavior are wrong or at least how they should be weighted relative to the thinking of others. There is no optimization model for a good scenario process and it cannot be structured as set of rules. Scenarios require thinking about new investment worlds.

Tuesday, May 28, 2019

How alternative risk premia are built - The devil is in the details



What generates a return difference between similar alternative risk premia - the construction details. Alternative risk premia have to be defined and constructed to isolate a specific risk factor. Institutions can define a risk premium differently because there is no standard definition for most. Alternative risk premia can be described in generalities but the actual construction is based on a set of specific criteria and definitions. These criteria can be used as a short-hand for what you need to know to understand the performance differences between risks premia. 

For example, in the case of a commodity backwardation risk premium strategy, the criteria for making the strategy index can be useful construction checklist. 

  • First, what is the universe of testing. How many commodities are included in the analysis? There can be a limited set of very liquid markets or a broad list of all commodity futures markets. Some backwardation strategies use less than 20 markets and make specific exclusions. Others may consist of a broader basket.
  • Second, the definition of the factor also critically affects return. For example, the backwardation could be measured by the difference between the first and second nearby contract, or it could be the maximum backwardation over a longer time to maturity. It could also include some exclusion for seasonality. 
  • Third, the scoring method serves as the basis for measuring the high and low for backwardation. 
  • Fourth, the selection classification may be that the top and bottom 20 percent of the scored universe.  It could also be a set number like the top and bottom three markets.
  • Fifth, the portfolio construction selection criteria will determine how the commodities will be weighted in the portfolio. For example, the three highest backwardated commodities may have equal risk contribution or an equal dollar weight.  
  • Sixth, the long/short method determines what will be the net exposure in the portfolio. This method could be dollar neutral or beta neutral. The net exposure may still have beta exposure that is not desired. 
  • Finally, there is the leverage associated with the total portfolio. This factor can be affected by the earlier choices of risk exposure. 

We can go though the same exercise for a currency carry alternative risk premia. If these are delivered through a bank swap, all of the rules for constructing an index will have to be defined so the swap can be priced on a daily basis  


While we have provided simple framework and example, the construction and analysis will generate a deeper analysis. The key point is that two alternative risk premia may be called the same but may have differences in performance based on the method of construction.

Better define asset categories and cut alpha - New Morningstar core and core plus bonds


Morningstar changed the definition of core bonds last month by breaking the category into two, core and core plus. The core definition is an intermediate bond fund that includes government, corporates, securitized debt, and less than 5 percent in other categories. The core plus category includes high yield, bank loans, emerging markets, and non-US bonds. Clearly, the old definition allowed for a significant amount of gaming through taking on more risk is assets not usually included in investment grade bond benchmarks. 

Alpha was created by loading up on the things that were not in the benchmark and including more assets that are not usually expected in core bond investment. Hence, there may have been significant hidden risks in these funds. The new categories change the Morningstar rating for many well-rated funds since they are now in a new peer group. A graph of the difference between core and core plus over different horizons shows that the average excess return for core plus is positive. This would have given these funds a ranking advantage in the old broader category. 

These more detailed or restrictive definitions are good for investors, regardless of what you think of Morningstar ratings, but it again focuses attention on what alpha means. Is alpha skill the ability to choose assets not in a benchmark that may have higher risk? This portfolio composition is a skill, but most think of alpha as the ability to choose weights based on timing of excess return and not by overweighting non-benchmark assets.  Better definition leads to an incredible shrinking alpha.

Monday, May 27, 2019

Corporate credit risk not just a US thing - It is a global issue

The Bank of England in their Bank Underground blog, commented on the growing risks with corporate bonds. Their risk concerns are the same as has been voiced in the US. First, the percent of BBB-rated sterling bonds are on the rise.  Second, the market structure makes for more risk through a mismatch between assets and liquidity needs of investors. In the case of sterling bonds, there are  increased risks from BREXIT.

It is interesting that central banks are sounding an alarm about the growth of riskier credit around the globe when this was exactly what they wanted with lower interest rates. High quality credits can always borrow and in many cases do not need the money. Lower quality firms are more sensitive to lower interest rates and will respond to cheap financing. Lower rates will also create the demand for riskier bonds as investors chase yield. Should we be surprised?

Since equities have softened this month, it is notable that BBB-rates spreads have increased by about 10 percent. This may not be enough to scare investors, but it is a sign that investor desire for risk is sensitive to this asset class.