Wednesday, January 30, 2019

The stock-bond mix and equity premia over time - Never oversell equity exposure


Many investors don't appreciate that 2018 was highly abnormal for asset allocation. First, the annual excess return from holding equities is generally positive with the exception during recessions. 2018 was not a recession year. Yes, there was a slowdown in the fourth quarter, and growth expectations have slowed but the numbers do not suggest a recession at this point. Second, the likelihood that both stocks and bonds will be negative in a given year is very unusual. There has only been a 4.44% chance of this occurring over the last 90 years using the SPX and 10-year Treasury returns. It is highly unlikely that we will see a similar year in 2019. There have only been seven periods when the equity premium was negative for two or more years in a row.



Additionally, the equity return premium over bonds is usually large. The arithmetic average is about 6.25 percent with a standard error of 2.25 percent.
Any bias should be to still hold strong equity risk exposure although a bias away from a 60/40 base case is warranted given the slower economic growth, uncertainty about liquidity, and higher volatility. The historical numbers always justifies holding equities unless there is an exceptionally poor macro environment. 

Tuesday, January 29, 2019

Global stocks - All about avoiding global slowdowns and recessions


Is it that simple? Global equity investing is all about missing the big macro risks - recessions. There are headline risks every year, but it is always about economic growth when you step-back and look at annual performance. If global growth appreciably slows, global stocks are hurt. A simple long-only asset allocation strategy is to stick with long-term trends with the ability to walk-away when a recession or slowdown occurs. 

We don't believe that calling growth slowdowns is easy. Forecasters have done a poor job over the last few decades, but the key investment point is that there should be clarity on where there needs to be focus. There is a significant amount of news, but the growth story is all that matters. Global slowdowns do not occur often. There were nine negative years out of our sample of 30. There will be local recessions and negative country events; nevertheless, it is the global growth cycle that matters.  



Monday, January 28, 2019

Liquid or Illiquid: Are you getting paid enough for less liquidity?




Liquidity is a coward. - Mark Yusko


A key issue with any hedge fund investment is liquidity. How much should you be paid for illiquidity with assets? How much should you be paid for illiquidity with a fund structure? How much liquidity do you need? What are the liquidity terms that are acceptable for a fund?


We have noticed a desire by a growing number of hedge funds to change their liquidity terms or to at least hold the line on making funds more liquid. This may not be a trend, but investor should watch liquidity terms closely and not give away this valuable piece of fund structure. A structure that reduces liquidity or has gate provisions increases the friction and cost of investment decisions. Investors should be compensated for this structural illiquidity.

Alternatively, a fund that has easy liquidity terms may still be harmful to investors if the underlying assets do not match the liquidity terms of the fund. A fund that has daily liquidity but holds assets that cannot be easily sold may be subject to runs. The investor who buys the daily fund but does not use the liquidity when others are exiting will be subject to significant risk from the behavior of the more active fund participants. Liquid assets will be sold first and investors left in the fund will have lower future liquidity. 

At a high level, the liquidity of a fund should match the liquidity of the underlying assets that it holds. A fund that trades futures should have better liquidity terms than a fund that invests in private debt. However, terms that allow for gates as firms get larger sends a signal that the firm is not able to generate enough liquidity despite the expected liquidity of the underling assets. 

A simple question is whether investors are getting paid enough for funds that are less liquid and are they getting paid enough for the threat of a run. Put differently, investors should be paid a premium for illiquid assets and they should be paid a premia for the illiquidity of the fund vehicle. 

This liquidity premium is not alpha and is not based on the skill of the manager. A fund with illiquid assets, all else equal, should generate higher returns and those returns should be passed to the investors and not just be added to incentive fees. There is a price for both structural and asset illiquidity.

Sunday, January 27, 2019

Global Financial Cycle - Look for the risk regime


A recurring theme for our forecasting model is predicting the future but just identifying the current regime.  It is more important to first know where you are before you determine where you might be going. If you have ever been lost, the best solution is to first figure out your current location.

There has been growing research work on the Global Financial Cycle or the fact that global growth is driven by a limited number of factors. These factors focus on long-term monetary or credit expansion and volatility. Specifically, the monetary expansion of the dollar as the reserve currency is a key to global growth and volatility determines where and how much this global dollar liquidity is used. Dollar liquidity supports global funding. Volatility changes the risk profile for this liquidity.  

There are two major regimes in the global financial cycle: risk-on booms and risk-off busts. A global financial cycle boom occurs when there is monetary expansion in the dollar and low volatility. Under this regime, it makes sense to invest in emerging markets and higher levered economies. Follow the money flows that drive asset prices higher and enhance global leverage. A risk-off bust environment will see dollar monetary contraction and higher volatility. In this environment, there should be emphasis on holding lower risk safe assets. Lower liquidity will push risky asset prices lower and reduce funding for new projects. The retrenchment will be exacerbated by higher volatility.

So where are we know in the global financial cycle? First, there has been a stalling of dollar monetary expansion and an increase in volatility over the last 18 months. We have moved away from a risk-on environment. This has corresponded to the selling of risky global assets. We have been transitioning to a more dangerous risk-off regime as the Fed has raised rates. However, the reversal of volatility since the fourth quarter and comments from the Fed on a pause, suggest that the risk-off trend is being muted. With less liquidity pressure and less volatility risk global assets have become more attractive 

Saturday, January 26, 2019

Dollar smile - We are moving to the smile bottom

A good simple approach for framing the longer-term movements in the dollar is through using the narrative of a dollar smile. We have written about this years ago, but think it is relevant today. The dollar smile, first popularized by Stephen Jen, says that currency behavior is driven by two competing regimes. 

Regime 1 is determined by macro factors such as growth, inflation, and liquidity. The dollar will move higher when better relative economic performance of the US economy causes dollar inflows to capture higher capital returns. This was the main driver up until the last quarter.  

Regime 2 is determined not by macro factor but by the dollar being a reserve currency that is driven by the flight to quality. The dollar will see increased demand in a crisis as investors look for protection. This will happen when US relative growth is slow or negative.

The space in the middle is when the dollar muddle about. There is more focus on local currency risk and not broad trends. The dollar will spend a fair amount of time in the middle region. The flight to safety periods will be abrupt and strong as money flows into the US for protection. The high growth region will have to compete against a general risk-on environment so US returns and growth have to be higher on a risk-adjusted basis. 

Right now, we now we are moving from flight to capital or high growth to the middle region. Investors need to focus on local country risks under a dollar range environment.

Friday, January 25, 2019

Concentration, inequality and the status quo - Size matters but not always for the better

A capitalist system is not always competitive environment, but competitive environment is a capitalist system. One key macro issue that is not often discussed is the increasing concentration of businesses in the US and other capitalist countries. While not monopolies, an increasing amount of market share is in the hands of fewer companies and form oligopolies. 

The top firms in most industries have gotten increasingly larger and this hurts long-run competition, the balance of power between labor and firm, pricing, innovation, investment, and productivity. Industrial organization matters for the economic environment. It should worry consumers, wage earners, investors and those that are interested in balance of power for democracy that this march toward concentration continues. 

From the Jackson Hole conference in August 2018, there was discussion on this topic, but it needs to be addressed more broadly and subject to further discussion for policy. See Increasing Differences between firms: Market Power and the Macro-Economy John Van Reenen.




There is a rich set of research on issues of market concentration. Most conclude that gaining market share and increased concentration will be good for the firms that achieve this stature but for the economy as a whole there can be negative effects. Large firms behave differently when the competition is reduced. Investors, of course, look for companies that have "moats" that are often able to provide higher returns but what is good for the investor may not be good for the economy. 

The desire by firms to strive for a monopoly generates competition, but allowing firms to successfully dominate their industry may not be in the public's interest. Governments have to ensure that even if there are large firms, an industry is contestable or can be challenged for dominance. 

Focusing on industry competition and looking to stop concentration may generate a knee-jerk response that it is anti-competitive but an environment of competitive fragmentation may create more innovation, more competition for workers, and greater investment to generate productivity.  Size matters, and the big may have economy-wide negatives. It is worth stepping back and thinking through the good and bad effects of competition.  

Wednesday, January 23, 2019

Momentum is still a viable strategy - Look at the numbers


There has been a lot of discussion on the lack of success with momentum and trend-following strategies. There is little doubt that there has been greater dispersion in returns across managers. There have been winners and losers with disappointment focused on some larger high profile firms. 

Small differences in model have lead to large changes in return. This is what happens when momentum is not smooth. Smoothness is defined as the trend to volatility ratio, or the switching of return patterns for classic momentum filters. Nevertheless, the strategy is sound. Just look at a simple momentum strategy over a relatively difficult year. 

This SP/Dow Jones momentum index, using the large cap 500 equity set, is compared with the SPX index. The overall return impact has been positive over the last year. Clearly there are some expected patterns between the two indices. One, when the market trends in one direction, momentum will exaggerate the market direction for the better and worst. Two, momentum reversals lead to givebacks versus the market weighted index. Three, a long-only momentum index will exploit the long-term positive equity direction. Four, there is a cost with momentum, higher volatility and a return penalty during transitions. 

Momentum strategies work, but part of the risk premia for holding the strategy is the cost of transitions. Investors who are late entrants to a momentum strategy will face the highest risks. Momentum should be a core part of asset allocation or entry for this risk premia exposure should be during periods of poor performance. Timing on superior past performance is risky. 

Tuesday, January 22, 2019

The Balancing of Global Risks - What Do You Need To Do?

The World Economic Forum has produced their Global Risks Report 2019 (14th edition) this week. The report provides an exhaustive listing of the greatest potential threats to the global economy and discusses the potential linkages between these risks. The WEF describes five categories of risk: economic, environmental, geopolitical, societal, and technological. It is worth spending time getting their assessment although be warned that risks are everywhere and not going away. There is no good news with these potential threats.

The report effectively shows how all of these risks are interconnected. There is no escaping from many of these global risks. 

It is also clear that many of the current risks that are at the top of survey work are political and institutional. There is greater concern that the established order of government and international cooperation are under stress. In the short-run, there are also significant concerns with technology through cyber attacks.
After reading all of these threats and being better educated on risks, investors still have a to ask a simple question, "What should I do for protection?" We offer some simple advice.

These threats are long-term and not short-term opportunities. The top threats for the year  may not see an actual risk event, so the focus should be on long-term portfolio construction.

1. Diversification - Diversification should be on two dimensions, geographic and asset class. To account for longer-term risks, this diversification should be independent of short-term trends but should account for long-term valuation.

2.  Avoid country and firm leverage - Any country or firm that is highly levered will face greater costs with any risk event. Hence, leverage should be avoided.

3. Hold long/short risk premia - Don't think in terms of long-only diversification. Allow for investments in hedge funds and alternative risk premia that profit from downside events.

4. Hold commodity exposure - For environmental and weather-related risks, commodities are a good hedge. Climate shocks will lead to higher prices. Geopolitical shocks will disrupt energy and commodity logistics. 

5. Hold a diversified pool of cash - Investment in cash (currency) alternatives that allow for protection of purchasing power.

6. Be comfortable with flight to quality investments - Treasury bonds and short-term fixed income unrelated to financial institutions.

7. Allow for dynamic asset allocations - Long-term asset allocation is important but asset allocation should not be static. Markets change and allocation will need to change as risks arise.

The world is dangerous so protection of principal is critical. 

Monday, January 21, 2019

Divergent and Convergent Hedge Funds - Alternative Investing And The Market Environment


With the increase in '40 Act alternative investment fund offerings, there is greater interest in how to effectively use these funds to help diversify portfolio risks. There are a number of classification schemes that often overlap with some traditional mutual fund categories. Hence, there is an issue of how to best classify the set of both traditional and alternative offerings. 


For example, there are long/short equity and credit funds. Should these long/short managers be classified within equity and fixed income categories or should they be given their own classifications? The key difference may be the flexibility to go short within the asset class. The flexibility allows for greater fluctuation in beta and an increase in alpha potential. Is the difference just the net beta exposure, or is there true alpha production? Is a long-only credit bond that has a wide mandate and can show large fluctuations in duration more like a long/short credit fund?


How are managed futures funds different from global tactical asset allocation or multi-strategy funds? Both strategies will invest across asset classes and in some cases both will use trends to make investment decisions. Again, the key differences are the ability to go short with a broad set of investment alternatives, a focus on momentum, and a focus on liquid derivatives. The focus on these three factors suggests that managed futures will have a better opportunity to gain during periods of dislocation than a tactical asset allocation fund.


You can classify by instrument characteristics or you can classify by strategy or behavior, but ultimately there should be classification by what strategies do or should do based on the economic and market environment faced. Picking strategies for the environment is more important than picking style categories. Correlation across strategies is driven by a link to economic events, so style is related to environment, but a sense of the environment is more critical. 


We have often classified hedge fund behavior as convergent and divergent. The convergent trader has a world view based on mean reversion or movement back to some equilibrium. The focus or driver for returns is stability or normalcy. Divergent trader makes money when there are large market dislocations that will often be consistent with large trend moves. Divergent strategies will do well when markets are in transition. 


These provide a way of thinking about fund choices based on the market environment. How will managers do in different environments? Past performance or correlation is not as important as walking through future scenarios that will suggest when managers will do well or when they will underperform.





Sunday, January 20, 2019

In credit do you trust? - This trust may be misplaced



The origin of the word credit, credere, is Latin for believe or trust. So there is a simple question for any credit investor, do you believe that current outstanding credits can be trusted to payback all interest and principal over the next few years? It is a simple question and many who trusted payments a year ago do not have the same trust today.

Default rates expectations are higher from BAML survey. Although not as high as 2016 levels, the default expectations are trending higher.


This is important because the size of risky debt is higher than ten years ago, and the growth has been especially high for BBB-rated firms.

Spreads have widened both for high yield and investment grade although there has been reversal with the gains in equities this month. Certainly, volatility for spreads is at the highest levels in years.




Our view is very simple. Credit spreads are a risk premia attached to a Treasury bond. There is growing downside with being long this risk premia; consequently, it makes sense to diversify into other risk premia that have less downside. 



Harold Demsetz - A powerful thinker on the intersection between law and economics


Harold Demsetz, one of more brilliant minds of the last 100 years in economics, died earlier this month. Most MBA, asset managers, or investor have never heard of Demsetz, but his work is foundational for understanding microeconomics and price theory. He was one of the key thinkers working on the intersection between law and economics. His most important work focuses on the theory of property rights and the theory of the firm. He tried to answer some very simple but complex questions. Why do property right exist? Why do firms exist? 

Property rights issues are all around us and are constantly under assessment and assault, so a theory for how they will come into existence and when they are useful is critical for trying solve many real life legal problems. The theory of the firm may be even more important in the current "gig" economy with contract workers. The firm attempts to cut costs through effective coordination and monitoring. It does what a market cannot do.

Property rights are fundamental to what investors buy and sell in markets. The foundations for what is a firm are critical for understanding the value associated with share ownership. Read the work of Demsetz and expand your thinking on some critical issues.  

Saturday, January 19, 2019

Stupidity - Not acting on what is right in front of you




I defined stupidity as overlooking or dismissing conspicuously crucial information. - Adam Robinson


That definition seems obvious, but there has been deeper research studying how to define stupidity. Of course, this research was published in an academic journal called, Intelligence. 

Nonetheless, it seems that one of the key ways to generate success in investment management is to just not do stupid things. Cut the stupidity and you will be more likely be a success. Unfortunately that is easier said than done. Stupidity is all around us. We are not just talking about behavior biases but rather the issue associated with a lack of good sense or judgment. Of course, behavioral biases and stupidity do intersect. The attempt to employ mental shortcuts will lead to stupidity. 

Three behaviors linked with stupidity from survey research work include:
  • Confidence ignorance - taking high risks without the skills to be successful;
  • Absent mindedness - the lack of practicality. Not being able to properly execute simple tasks;
  • Lack of control - allowing compulsive behavior to interfere or override important tasks.
Stupidity is not a problem for individuals. There is a spillover effect to others. The economist Carlo M. Cipolla defined some laws of stupidity:
  • Law 1: Always and inevitably everyone underestimates the number of stupid individuals in circulation. We may underestimate the number of stupid investors in financial markets.
  • Law 2: The probability that a certain person be stupid is independent of any other characteristic of that person. Any one group has not cornered the markets for stupidity 
  • Law 3. A stupid person is a person who causes losses to another person or to a group of persons while himself deriving no gain and even possibly incurring losses. There is no intent to be stupid. It happens and hurts others.
  • Law 4: Non-stupid people always underestimate the damaging power of stupid individuals. In particular non-stupid people constantly forget that at all times and places and under any circumstances to deal and/or associate with stupid people always turns out to be a costly mistake.
  • Law 5: A stupid person is the most dangerous type of person. A corollary: a stupid person is more dangerous than a bandit. You cannot form laws against stupidity.
The importance of rules with asset management is very simple. Systematic action helps enforce good behavior on your actions. The use of discipline will help ensure President Obama's rule, "Don't do stupid stuff".






The Efficient Frontier - Not a Line but A Cloudy Dream


This is a very interesting chart of the efficient frontier from Fidelity for a number of reasons. On one level the return to risk locations for different asset classes are relatively stable, but there has been a mean reversion of returns during the fourth quarter that is pulling return to risk ratios back to long-term averages. Excess returns by definition cannot last forever. The fourth quarter was a correction to the long run and by the evidence in January perhaps an over-reaction.

As important as mean reversion is the fact that the efficient frontiers cannot be thought of as fixed lines. They are dynamic and changing through time with the sample of data used. Think of the efficient frontier not as a line but as a cloud. The efficient frontier for any three-year period is just a sample of the true return to risk. Another period will give a different sample. Each sample of returns will have errors and these error are what cause headaches for investors forming asset allocations. 

Consequently, there is no single most efficient point on the frontier. The sample time period used, and the asset classes included affect the frontier. These are some of the important points made by Richard Michaud years ago that need to reinforced on a regular basis. The efficient frontier is constantly changing based on the simple idea that it is only generated from a sample of data on return, volatility and covariance. The actual or expected returns will not match the sample. Hence, there can be multiple solutions to what is the most efficient portfolio for given level of risk. 

Given the actual performance for asset classes will differ from the expected sample values, there can be wide variation in the results generated from an optimizer. This does not mean that there is a failure with optimization but that sampling matters. The optimal allocation will change with samples.



Investors need to think over multiple time periods. Investors should not overreact to short-run return information. Similarly, investors should understand medium returns like the last three years do not represent the long run. Perhaps this is one reason why looking at momentum and trends are important. Trends provides context for where we are and where we have been with price. Finally, the issue of sampling error reinforces the idea that diversification can offset the mistake of investment exuberance.

Thursday, January 17, 2019

Dollar down - A big trade for 2019?



What was keeping the dollar moving higher? A simple difference in monetary policy has been a key driver. With the Fed tightening through raising rates and engaging in QT, the reserve currency provider was out of step with the rest of the world. However, recent comments by Fed Chairman Powell and other Fed bank presidents have changed policy expectations. If there is a pause, patience, and caution, it is less likely that rates in the US will move higher. Expectations in forward rates have already declined significantly. A key underpinning for the dollar has been taken away. If the interest rate gap between the US and the rest of the world does not widen, other determinants will drive currency moves. 

One of the next currency drivers is valuation. In this case, the dollar, as measured by a number of models, is overvalued and the divergence is not trivial. The Big Mac index is just one example. US growth that is more consistent with the rest of the world will support a move to fair value. Now history has shown that the half-life for closing valuation differences can be measured in years, but with monetary policy not as supportive of a strong dollar other factors will serve as drivers. Investors may look to selected equity and fixed income markets to take advantage of these opportunities.


Monday, January 14, 2019

What will be the cause of the next recession?


There has been increased market talk about the next recession. Many are predicting it will occur this year albeit the dispersion of views is wide. To do a proper assessment for the cause of the next recession investors should go back to the causes of past recessions. This one will be different, but we should assume there will be common features with the past. 

Brad DeLong provides an historical view in a recent Project-Syndicate commentary. While his work is not definitive, it focuses on a key point that the last three recessions were all related to a financial crisis or dislocation. There may be a multitude of causes for these financial crises, but there still is the commonality that financial excesses have been the driver.

Working from this premise, it is likely that the next recession will also be crisis driven. Consequently, we need to focus on what will be the financial crisis catalyst that will potentially drive the US economy into recession. It is likely that any crisis will be linked to an inadequate policy response caused by the uncertainty associated with the crisis events and the cautious nature of policy-makers. Policy missteps will exacerbate any crisis, and the potential for mistakes is higher under current policy management.

Given the first cause will still be a financial dislocation, our sleuthing will have to focus on where this financial crisis will occur. The global financial system is highly levered based on the extended period of low interest rates. Many governments continue to run high deficits with little room for counter-cyclical policy. Corporates are highly levered with a high degree of risk in the triple BBB corporate bond market. Consumers leverage is a mixed bag, but student loans have exploded in the last decade. Both European and US banks have been negatively affected by the recent market downturn and there is heightened stress in Chinese financial markets. An especially sensitive area is the dollar denominated debt with emerging markets. 

While many credit sectors are at heightened risk exposure, there is no one single market sector that is extremely stretched. There is no tech bubble. There is no mortgage bubble even with housing prices at highs in some markets. There is not special stress in key financial sectors. The heightened risk from high leverage will make any economic shock more meaningful. The potential for a financial crisis is everywhere and nowhere and that overall leverage risk may be the potential flash point but it may not be immediate. 

Sunday, January 13, 2019

That marginal piece of information - What do you need to change you views?


“What would I need to see to change my view?”  
- Adam Robinson

Most data are confirming. New economic data are always occurring, but these announcements just reinforce what we already know. First, a lot of economic data moves together, so there is limited added or marginal information. Second, there is a bias with investors that they look for or see confirming information to their existing view. 

If data are not confirming, it is often viewed as just noise or discarded because of our biases.  Non-confirming data does not often cause us to change our view. In a few special cases, there is new data that will cause change. This exceptional data is what we need to focus on and look for, yet we are unlikely to be prepared for it. Some information is special because it is inherently timely and important, or it is of such size that investors have to take note.  

If you ask investors what announcements do they need to see this week that will change their minds about the construction of their current portfolio, most will not have any idea what you are asking. They will understand the question, but will not think about focusing on any one piece or set of information, yet in reality, it is a limited set of information that often causes portfolio changes. A good investor should know what marginal piece of information is necessary to change his portfolio and focus on that information.

Think about events earlier this month, the market perception was that the US was headed to recession. Then the 300,000 jobs print occurred and the world changed. The same could be said about monetary policy. The investment world was up in arms about a Fed that would be too restriction, but then Chairman Powell said everything was on the table and the world changed. The investment world is not that cut and dry, but let's also be realistic about how new facts may be the catalysts to a new narrative or a change in the narrative. The two events could not have been forecasted, but n investor should know that jobs report or a Powell comment can change market expectations.

To be more specific and systematic, an investor should rank or prioritize information announcements. Some information is useful but not meaningful. Other data are critical for making a decision. An investor should know what is critical and make sure the focus of his time are on those data and events most important. 

Saturday, January 12, 2019

Recession probabilities - There is no consensus

What is the chance of a recession this year? Many have tried to build systematic models to give a probability number. This has been a good advancement in thinking about macro forecasting, but the variability of forecast is unusually wide. Different inputs will give different probabilities and there is no consensus on what should be the right inputs.  

Currently, there are systematic models that estimate the probability as being less than 1 percent as well as models that say the likelihood is 90 percent. There is also survey work that measures the median view of a recession. There is no doubt the chance of a recession is higher today than a year ago but a median of all the forecasts is around 25 percent. This is not high enough to cause a fully defensive cash rich portfolio to be implemented. However, the upward trend in expectations is signal enough for investors to reduce risk. 

Continued increases in probability should, in general, lead to further reduction in risk exposure, but the high dispersion means there is a greater opportunity for higher returns based on swings in market judgment. 

Wednesday, January 9, 2019

Risk Parity - A tough year for this diversification strategy


Risk parity was thought of as a portfolio strategy that would protect investors buffeted with uncertainty. Don't think about dollar allocations, but risk allocations; it is a better way to manage a portfolio. Unfortunately, theory does not always work in practice. Using a simple benchmark of the average return for mutual funds with 50-70% equity allocation would have had slightly better returns than the 10% risk parity index and would have done much better than the higher vol indices in 2018.

When no asset class does well and volatility is targeted at higher levels, risk parity cannot save an investor from loses. A combination of two volatility shocks, February and the fourth quarter, was enough to cause under performance. Levered into a volatility spike and then delevered on the reversal after the spike will create a whipsaw effect. There is no safe harbor with risk parity. Does this mean investors are done with the strategy? It will still have advocates, but there will be a search for new portfolio solutions. 

Set it and leave it alone portfolio management has significant costs when there are regime changes. While active discretionary management may not be a solution, systematic rules that address regime change will help with allowing for some flexibility when there is a market change. 

Tuesday, January 8, 2019

Where are institutional investors going to put their money? Not where you may think

It was a tough year for money managers. All asset classes underperformed cash and most were negative for the year. Equities were a return disaster for December. Hedge funds did not do well for the year. So what will investors do? 

The BlackRock Institutional survey for 2019 has come out and provides some interesting choices by managers. The survey represents over $7 trillion in assets under management and and 230 institutional managers. The actually timing of the survey is not clear so I cannot say whether all of the return information for 2018 was available when the survey was conducted.

The  number show a decrease in equity and increase in fixed income for 2019 with hedge funds and cash allocations staying about the same. However, private equity, real estate, and real assets all show an increase in allocations. Does it seem at all odd that after a poor performance quarter, greater talk of recession, higher volatility, and the likelihood that we are late in the financial and credit cycle, investors want to increase their exposure to less liquid investments?

There was the stretch for yield when rates were low but now it seems like there is a stretch for investments that don't have to face the ugly effects of volatile pricing. How can anything go wrong with holding less liquid assets when if there is an economic slowdown, there will be increased redemptions on the part of end investors?

What are shadow interest rates telling us?


We cannot forget that the zero bound on interest rates caused distortions in market price signals. Now in the US rates are above the zero bound so it seems like the concept of a shadow rate is not important; however, it is still relevant for many other central banks and it provides a good measure of where we have come over the last few years. Using the shadow rate as a historic measure of relative tightening, we can say that the Fed has actually been on a tightening policy since the end of quantitative easing. The size of this tightening is not much different than what we have seen in other Fed tightening cycles. While we cannot measure the true bite of rising rates, we can say that the Fed has been at tightening for much longer than most investors think.

The concept of the shadow interest rate was developed to determine what should be the short-term interest rate when constrained by the zero bound. The shadow rate can be an important tool to look at monetary policy even when rates go above the zero bound because it can give investors insight on where we have been versus where we are with rates. 

We use the Central Bank of New Zealand website as a place to check on the shadow short rates around the  world. 

For example, you cannot think about US rates rising from zero as the amount of tightening seen by the market. Rather investor should think about the rate rise from the minimum of the shadow rate. In this case, the Fed has been tightening for longer and the amount of tightening is significantly more than 200 plus bps. Similarly, there has been a significant rise in the shadow rate associated with the ECB. 

Looking at some of the research by the original author on shadow rates, Jing Wu from the University of Chicago, "A Shadow Rate New Keynesian Model", it is clear that tightening really began when QE ended. The connection with rates is a link that has been missing with many market watchers.

There is a fair amount of estimation error with these shadow rates. It is not  precise tool, but we can go back to the Taylor Rule and see that it does a good job of predicting the fed funds rate as well as the shadow rate. The shadow rate is similar to the Taylor Rule implied rate. Track the shadow rate and follow the Taylor Rule and you have a pretty good combination of indicators of what central banks may be up to without relying on reading central bank tea leaves through policy speak.

Sunday, January 6, 2019

Hedge fund performance - Not great for those looking for absolute returns




The only hedge fund sectors that made significant returns in December were global macro and systematic CTAs.  These are the divergence strategies that are supposed to generate returns when there are market dislocations. Macro and systematic managers, through casting a wide net across asset classes and going both long and short, should find opportunities when there are significant dislocations. The remaining hedge fund strategies lost money, but significantly less than the exposure to market beta. It was not a successful month for most hedge funds, but it was not as bad as exposure to equity beta. However, long duration Treasuries proved to be a better hedge.

For the year, many hedge fund strategies actually underperformed equity and fixed income beta benchmarks. The only areas that performed well on a relative basis were fixed income relative value and CTA (global macro and systematic) strategies. Of course, these are index averages, but it provides some insight on hedge fund behavior during a difficult year.