Thursday, February 28, 2019

That's crisis not correction alpha, you fool! Trend-following value is in its simplicity




I discovered from reading an informative piece on managed futures and CTA's from HedgeNordic magazine that trend-followers will produce "crisis alpha" but not "correction alpha". A crisis is defined as a significant and extended downturn while a correction is short-term drawdown. Unfortunately, one man's correction is another man's crisis. All crises start and end as corrections. 

Let's stop with the attempt to make trend-following something special during a crisis or that what trend-followers do is alpha. Trend-followers do not need the help. The value proposition for trend-following stands on its own.

We can make this simple. Managed futures trend-following, because it can take positions both long and short across a diversified set of markets, should do well in both up and down market trends. By construction, it will have low beta. This is an investment advantage. 

This beta will not move to one in a crisis because it is not long-only and trades many markets. It will provide diversification in a crisis by the nature of the strategy especially against long-only equity benchmarks. This is an advantage. 

If a market downturn is longer and more extreme, short trend positions will make money and profit relative to any long-only strategy. This is an advantage.  

There is no prediction by trend-followers of when a crisis will occur. There is no need for a prediction. The success of trend-following is embedded in the basics of the strategy. There is no special alpha, crisis or otherwise. A trend-follower looks for price signals and is indifferent about the economic environment. This is an advantage. 

The success of a trend-follower is consistent with the length and amplitude of a trend and the signal generation length. Long-term trend-followers need or exploit long-term trends. Short-term trend-followers need or exploit shorter-term trends. Crisis alpha is not function of manager skill but related to the time and intensity of the trend. 

There is skill with finding the right model and right rules for risk management but that is independent of a crisis and more important for protecting principal when there are no trends. Making money during a crisis, large down equity moves, is a skill but the more relevant skill is being able to protection the profits generated between large market moves. A skill often overlooked is just following the model.

Stop with the crisis alpha and go back to basics for why this strategy will do well when long-only managers will suffer. The value of trend-following is its simplicity not complexity. It is an effective investment process based on following prices regardless of what you may call the environment. It may not be "alpha", but it is works by utilizing systematic skill.  

The limits to investment stories - Better to have a sample of data


I have an anecdote, but not an antidote, for whatever ails you; that is the problem. Stories or tales of past economic events do not solve investment problems. Investment tales may persuade as a device for action. They may provide useful background information, but they do not provide the basis for an effective solution. 

A tale can be a description of a specific event, or it can be a generalization associated with an event. For example, an investment story can be about the Fed Chairman. "I made a lot of money by fading comments by Chairman Powell; he does not have a lot creditability. Look at his last speech." Good story. Maybe true. But, a story is dangerous if it is not backed with data. Extrapolation from a sample of one is not effective decision-making.

Story can be useful but mainly in a case where there is no data set to help with the decision. Narrative is applicable for the unique situation, but only because there are no countable alternatives. Count similar events and focus on the odds not the narrative from one example.  

Wednesday, February 27, 2019

Are you prepared for a tail event? - Investing for extremes



However certain our expectation, the moment foreseen may be unexpected when it arrives. -- T.S. Eliot



Everyone is expecting a big negative credit event. Leverage is high. Overall debt is high. Growth is still low. Loose monetary policy continues at extremes through quantitative easing that has supported the extension of the global credit cycle. Nevertheless, the knowledge of a large downside tail event does not mean that investors are prepared with an action plan for when the downturn arrives. Investors can still be unprepared for what they will do with their portfolio when the time comes.



We suggest investor play a "war game" to walk through the steps that should be taken under downside scenarios. The game can be played through a few simple steps.


Step 1: Isolate an event - Assume a specific downside event. For example, what happens if there is an escalation of a trade war with China?
Step 2: Walk through the implications of the event. What markets will be affected? What will happen to the correlations across these markets? Are the market effects expected consistent with cross-market relationships? What will be the reaction of other investors?
Step 3: Portfolio review - Can the current portfolio take advantage or mitigate the event? What are the risks from this event?
Step 4: Analyze the restructuring alternatives that will be effective for hedging against this downside event. Be specific on what you will buy and sell? 
Step 5: Analyze whether your hedging will meet your return expectations.
Step 6: Walk through other possible solutions.

The process of preparing for portfolio alternatives will allow for an effect plan to minimize risks when they actually come to pass. 

Saturday, February 23, 2019

Follow police procedure when investment modeling - Use independent models as witnesses


"To derive the most useful information from multiple sources of information, you should always try to make these sources independent of each other. This rule is part of good police procedures. When there are multiple witnesses to an event, they are not allowed to discuss it before giving testimony. The goal is not only to present collusion by hostile witnesses, it is also to prevent unbiased witnesses from influencing each other."  - Daniel Kahneman  - from Farsighted Steve Johnson


This sounds very simple, but it is very important to eliminate groupthink for any investment decision. A poor situation is to have an investment committee meeting and have everyone around the table start to give their views without taking a position, and making sure the chairman or lead manager gives his strong opinions first. Take a guess on what will happen? By some miracle, the committee is likely to have a similar view to the chairman. 

If there is an effort to gain consensus before a vote, there will not be much independent thinking. Groupthink reduces independent sources of information and opinion. Conflict with investment decisions is good. Good decision-making does not allow for pre-meetings. 

Perhaps the best approach for eliminating group think is to have every committee member write down their views and potential action before anyone talks. Unfortunately, this is unlikely to happen in real live. As social beings, there is a desire for consensus. 

However, there is an alternative through developing independent quantitative models. There is no socialization. There is no waffling or influence from other groups. Separate models can be done through having different models focus on different sources of information. A simple case would be to have a price-based trend model and a fundamental model that uses macro data. Two different and independent views. Another model could focus on cross-asset data. Still another model can take a very short-term view versus others that focuses on long-term information. These models can be compared and rated to derive an overall forecast. 

These ensemble model approaches allow for independence and a strong basis for comparison. The decision framework is straightforward. If there is no consensus across models, then any action should be tempered. Strong consensus will lead to greater action. The investment procedure of creating independence can be preserved. 

Follow Howard Marks - Know where you are in the business cycle


Investors can gainfully spend their time researching three areas:
1. Knowing the knowable, the fundamentals of an investment.
2. Understanding value and being disciplined on the price they pay.
3. Studying the investment environment we are in and appropriately positioning portfolios for it.
-Robert Farago - From book review of Mastering the Markets 


Farago provides a useful framework for describing the great short book Mastering the Markets by Howard Marks. The Marks approach is simple but often not given enough attention. Know where you are in the business and credit cycle and you will make better decisions and miss blow-ups.

Most investors and analysts spend their time trying to research the fundamentals. If you know the investment details, you will surely do well. You can always talk with others about any investment in greater detail so many will view you as an expert. Unfortunately, everyone is doing this work, so it is hard to get an edge. Knowing the details is not the same as knowing how to make a good decision. 

The second area for potential investment success is to spend your time focusing on valuation. Make sure you buy cheap. If you can focus on value, you will never make the big mistake. Unfortunately, understanding value is much harder than you think. It is not an issue of value today but what will be value in the future. Cheap securities are cheap for a reason and can become cheaper.

The third area of research is the core of global macro investing and is the most important when thinking about building a portfolio. Know where you are in the business cycle. The business cycle drives value. The business cycle will tell you a lot about the success of any company. Good companies in the wrong industry can still suffer in a market downturn. Knowing where you are in the cycle is the critical piece of knowledge for building a portfolio, finding value, and measuring the fundamentals.

You don't need to know where you are going. You first need to know where you are. Know where you are in the cycle and most of your investment problems will be solved. Cycles have similarity. You cannot predict with certainty but you can place a likelihood on what could be next and that is an edge.

Tuesday, February 19, 2019

Global Risk Premia - Long-term support across strategies and asset classes especially for trend and carry


What should you believe about global risk premia? There has been so much research on the topic across so many different sample periods and specifications that it is hard to draw strong conclusion if you are an investors. Now we have a new paper that can be classified as one of the definitive studies on the topic.  See "Global Factor Premiums"  by G Baltussen, L Swinkels, and P Van Vliet.  

Examining 24 global factor premiums across the major asset classes with a data set that spans 200 years the authors are able to provide a unified testing environment to provide some deep knowledge on the topic. Global risk premia are statistically significant and stand the test of time. 

However, their research also finds that these risk premia are not driven by market, downside, or macroeconomic risk which is not expected based current asset pricing theories. A premia is paid for risk taken, but what is the risk that investors are being paid to take if we cannot relate back to "bad times", the market, or some downside? This is an issue for much further discussion.

The authors look at trend (time series), momentum cross-sectional), value, carry, return seasonality, and betting against beta. These are analyzed against equity indices, bonds, commodities, and currencies for  total of 24 premia. They address the p-hacking problem but still find that there are a significant number of global risk premia that are clearly significant. The two risk premia that show the strongest significance and the most universal value are trend-following and carry followed by momentum. The significance of trend and carry risk premia applies to centuries of data.






The historical Sharpe ratios are highest for trend and carry when applied across the broad set of asset classes. Over the long-run, seasonality also serves as a strong risk premia. There is value with following global macro carry and trend strategies. 
This exhaustive and careful work supports the universal appeal for global risk premia albeit there is no guarantee that significant Sharpe ratios will be present during all periods. Further research is needed understand the why these strategies receive risk compensation. Nevertheless, a core strategy of trend and carry is fundamental to a strong performing diversified portfolio. 

Gell-Mann Amnesia - Be an investment skeptic and do your own research


“Briefly stated, the Gell-Mann Amnesia effect is as follows. You open the newspaper to an article on some subject you know well. In Murray's case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward—reversing cause and effect. I call these the "wet streets cause rain" stories. Paper's full of them.
In any case, you read with exasperation or amusement the multiple errors in a story, and then turn the page to national or international affairs, and read as if the rest of the newspaper was somehow more accurate about Palestine than the baloney you just read. You turn the page, and forget what you know.”

― Michael Crichton


The Gell-Mann amnesia effect may seem to be an interesting behavioral novelty for cocktail conversation, yet it provides an important lesson for doing research in any financial markets. 

It is a good story, but you will not find it in any behavioral finance discussion. There is no actual research on this effect. Crichton wrote about it years ago in a posting "Why Speculate?". He actually stated in the article, "I refer to it by this name because I once discussed it with Murray Gell-Mann, and by dropping a famous name I imply greater importance to myself, and to the effect, than it would otherwise have." 

If you believe there is an amnesia effect, you should be always be a news skeptic. Market efficiency has the view that all public information is properly discounted in markets and cannot be exploited. Public information is discounted but that does not mean it is done correctly. Reality is likely more nuanced. 

Public information can come in two forms: public announcements of data and public announcement that is opinion or observation. Facts are better than opinion, but if you don't have direct knowledge of facts you are still at risk of getting the meaning wrong.

For a public data announcement, the majority of market participants will read the headline and react. Few will read the details in the data. Headlines may not reflect reality. The headline may say unemployment is lower; however the details within the announcement may provide deeper more useful information that is not present with what you see in the headline. This is one reason why we sometimes have reversals after announcements. Upon deeper reflection, investors change direction. 

For opinions of events, reality does not match your direct knowledge because opinions are often condensed reality. Opinions are just one person's interpretation of events and subject to biases. They are likely to disagree with the direct knowledge you may possess. 

Any "Gell-Mann amnesia" can be eliminated by not trusting anything you read that you don't have direct knowledge. This should limit the investment decisions you make. Stay passive and diversified except for where you have direct knowledge. This tongue-in-check amnesia is just a better way of saying you should be a skeptic. If skepticism is a requirement for investment success, then an investor has to increase his direct knowledge, that is, do his own research. Accept that others will not do their homework because the costs are high. Direct research is the cost of entry for investment success.

Thursday, February 14, 2019

Thinking about skew - Alternative skew measures


I was having a discussion about the merits of managed futures relative to other hedge fund styles. Managed futures funds will often have positive skew versus other hedge fund styles. The measurement of skew is tricky and is not present with all managers but for trend-followers who allow profits to accrue, it is more likely. The argument for positive skew is embedded in the behavior of the managers. 

A trend-following CTA will structure their trades to create positive skew by holding onto winners and sell losers. More precisely, a manager who uses stop losses to reduce downside exposure and will follow trends for upside returns creates pay-offs which generate more upside potential. The profile shows many small loses with the opportunity for a few very strong gains.

The return pay-off will be like a synthetic option. If these synthetic options are created for both up and down markets, the result will be a profile like option straddles which are effectively employed to describe CTA performance. 

Still, skew is not intuitive when described through the standard moment formula. Skew is referred to as the third moment of the distribution which is defined as the cubed scaled deviations from the mean or more precisely [(x - mean)/stdev]^3. Notice that it is easy to calculate and Excel will provide a normalized measure of skew. The skew can be tested for significance, but there are some simple rules of thumb. A skew above 1 is positive or below -1 negative. The range between plus and minus .5 is considered normal and the ranges between .5 and 1 or -.5 and -1 is considered mildly skewed. 

If you say that a managers has positive skew of x, it does not tell the investor much about what excess returns they will actually be receiving other than the right tail of the distribution is pulled positive relative to a normal distribution. Volatility or fat tails may dominate any skew. A positively skewed distribution will actually be left leaning versus a normal distribution. The distribution is contorted away from symmetry around the mean. A positive (negative) skew will have a mean greater (less) than the median or mode.

There are different methods of looking at skew that may be more intuitive and provide a more useful means of thinking about skew. There are two Pearson measure of skew and the Bowley's (Galton) quartile skewness measure. The Pearson measure is the difference between the mean and mode divided by the standard deviation. The Pearson second measure of skew measures three times the difference between the mean and median divided by the standard deviation. If the mean is higher than the median there is positive skew. This has a nice intuitive feel because it says that the average return is higher than the middle value of a return series. The Bowley measure looks at the difference in quartiles (q3+q1-2q2)/(q3-q1) which again has a simple intuitive appeal. If the third quartile is much further away from the median than the first quartile, the distribution has positive skew.

The skew will change through time based on sampling. Enclosed is a simple example of 36 month rolling average skew for the CS managed futures index. Notice that skew changes and the skew measures generate slightly different results. The moment skew which cubes deviations will have big changes when there are outliers. The Bowley skew based on quartile will not be as affected by outliers. The Pearson second skew coefficient will be sensitive to the difference between mean and median. 


These differences are partially due to sampling and the mixture of samples. The skew will differ based on market conditions. The managed futures skew moved to strongly positive during the out-sized 2014 return period. Looking at the different measures of skew, the classic moment measure used in excel can generate big jumps when there is a large outlier. This is less likely to happen with the Pearson and Bowley measures.

Wednesday, February 13, 2019

Managed futures trend-following performance - It is not volatility but the stress that matters


"Crisis alpha" is used as a quick description of managed futures trend-following, but there has been very little work to explain what the term means. A generic definition is that a crisis is when equity markets have a significant decline, but that definition tell us nothing about what will be the conditions for a crisis or when a crisis will occur. 

It is a frustration for investors when this term is used. We only know by this definition that, ex post, if equities go down a lot, trend-followers are supposed to do well. That is not a basis for explaining when or why trend-following will do well. Wait until you lose 20% of your equity principal and then you will be happy with your managed futures exposure. While it is true, it is hardly an effective sales pitch. 

We want to examine the idea of crisis alpha a little more closely. This is a topic for ongoing research. A crisis should be defined by some set of economic factors that represent stress in the macroeconomy. The stress or crisis will impact the pricing of financial assets and lead to price divergences. These divergences offer opportunities for trend-followers who profit long and short from price trend dislocations. By following variables that represent stress, we should expect above average trend-following returns. 

Trends is stress tell us something about trends in prices. Periods of financial stress are associated with price dislocations and these are the times that are likely to be profitable as markets reprice across the broad set of asset classes. Stress represents "bad times" and this is when prices fall to provide a premia for holding risk assets. Increases in stress are associated with declines in demand for risky assets.


While there is a connection between equity returns and spikes in volatility, the link between volatility and managed futures is less clear. However, overall financial stress may be a better measure of when returns will be above normal. Financial stress includes volatility but is a broader concept that looks at a wider range of indicators. 

Financial stress will change the risk preference of investors and force adjustment of portfolio exposures. The simplest investment response would be an adjustment from risk-on to risk-off behavior which will manifest in equity, fixed income, rates, currencies, and commodities. The broad repricing of risk increases the set of trend opportunities and returns in a manner that would not occur if there is a localized price disruption to a single market. Significant repricing allows for significant trend trading returns.



The times of maximum opportunity for trend-followers may be during times of increased market stress. Some may call this alpha but more likely it is just related to the lower beta or dynamic adjustment of beta. Remember the market risk premia is compensation for risk during "bad times" There is no risk premia if an asset actually does well during bad times because it exploits price dislocations by adjusting risk exposures or selling short. The low beta means trend-following does not receive a risk premia during normal times but positive returns during times of abnormal stress. 

Look for periods of stress and investors will find better trend-following returns. No stress, like the post Great Financial Crisis period, and there will be limited return opportunities. Increased stress in the 2018's fourth quarter generated returns for many trend-followers in December. The reversal of stress showed a reversal in trends and loses in January. 

Tuesday, February 12, 2019

FX intervention - Analysis says central bank activity works


Many have held the view that central bank FX intervention is ineffective. It can be disruptive and have some temporary impact, but central banks cannot make currency markets do what they don't want to do. Research using public data, a limited sample and mainly focused on floating exchange rate regimes, shows, at best, mixed value for intervention. Nevertheless, intervention does create market frictions and an investor can take advantage of those central bank actions. 

The latest economic research based on extensive private central bank intervention data tells a different story and suggests that central bank intervention is effective at meeting bank goals. See "When Is Foreign Exchange Intervention Effective? Evidence from 33 Countries" American Economic Journal: Macroeconomics 2019 by M Fratzscher, O. Gloede, L Menkhoff, L Sarno, and T Stohr. 

When looking at the private information from central banks with a data set never before assembled, the evidence shows that central banks are very good at getting the policy goals they want. The authors find that central banks have a success rate of over 80 percent when using specific goal criteria. Intervention is effective at both smoothing exchange rates, and stabilizing exchange rates that are controlled by a band. The success of intervention in floating exchange rates, however, is lower and needs larger trading volume, public disclosure of the intervention, and supported by communication of goals. There is less success if central bank attempt to move rates against fundamentals or try to change the direction of exchange rates is response to an event.


For traders, there are some straightforward take-aways:

1. Read intervention based on the context of the currency regime, policy objectives, and communication.
2. Listen to what central banks tell you - They signal their actions. 
3. Don't fight with central banks especially in currencies that have bands.  
4. Central banks are good at controlling currency levels especially in EM and less liquid currencies in the short-run. 
5. Central banks are not as good at using intervention to stop fundamentals.
6. Central banks will smooth prices, create frictions, and can be exploited given the currency regime (flexible versus bands). 

Central banks have a stronger impact on currency rates than has generally been seen in research. Central bank actions against macro fundamentals will not be effective, but the path to central bank currency control failure can be long and bumpy. In the meantime, use intervention as a means to exploit trends and short-term mean reversion. 

Monday, February 11, 2019

Alternative risk premia overreaction in 2018 - Don't fall for recency bias


What happened to alternative risk premia returns in 2018? This was a major discussion topic at a UBS risk premia conference last week. It was a difficult year. In fact, it was a the worst performance year since 2008, and the decline for many strategies was a multiple standard deviation event.

Yet, there is a good opportunity for investors who focus on the longer-run. Since the performance for many risk premia seemed unrelated to macro factors, there is strong potential for mean reversion to longer-term strong positive performance. To extrapolate recent performance as representative of history would be to fall into a recency bias. 

The talk of alternative risk premia extremes started well before year-end. See "Alternative Risk Premia: Crisis or Opportunity?" by Michael Aked, CFA, Brandon Kunz, and Amie Ko, CFA of Research Affiliates.  Using their categorization for hedge funds, we find that their analysis and conclusions through November does not change when analyzing the full year. It is notable that January was a major reversal of the earlier negative extremes.


Research Affiliates breaks alternative risk premia into four major categories: equity market neutral, volatility, trend, and macro. Investor should consider ensuring diversification across these categories other classification schemes. 
  • The equity neutral category focuses on long/short strategies that have low correlation with market beta. 
  • The volatility category is sensitive to increases in volatility because of embedded optionality. 
  • The trend category is viewed as a defensive strategy that will do well during market disruptions. 
  • The macro category focuses on strategies across asset class such as carry, momentum, or value that will have low correlation with equity returns. 

Each of these categories underperformed in 2018, but for different reason. The equity neutral category showed increased correlation with market beta and was dragged lower by dislocations in the value style sector. The volatility category was hurt by spikes in volatility during February and the fourth quarter. Trend was harmed by volatility spikes and limited or choppy trends until December. Macro strategies that have an equity bias like carry were hurt during the year and shocks to both global and emerging markets negatively affected overall performance. 


Any shock to risk premia performance is a wake-up call and should not be dismissed as just an aberration. 2018 proved that alternative risk premia are not immune to market disruptions, but an over-reaction may also be viewed as an opportunity to reset or reengage with these styles and strategies. Clearly, January proved to be a significant offset to fourth quarter loses. 

Saturday, February 9, 2019

An investor's desire for negative skew - Behavioral biases

Investors have been warned about the ill-effects of negative skew, but they still choose assets that have it. Negative skew is like catnip to investors. They cannot help themselves. If an investor is sensitive to recency bias, an overweight to current information over historical data, and loss aversion, there will be a natural gravitation to negative skewed assets. 

Negative skew looks so attractive in the short-run. Only in the long-run does the impact of negative skew show itself. The longer an investor holds a negatively skewed asset, the more likely he will suffer the ill effects. On the other hand, there are strong long-term benefits with positive skew.

There is important investment advise when you dig into the details of skew. See: The Impact of Skew on Performance and Bias How Skew Distorts Short Term Performance, Triggers Bias, and Changes Drawdowns by Dugan and Greyserman. The authors have done an exhaustive job analyzing skew and have drawn some clear conclusions. 

First, it is important to look at what happens to the probability distribution when it becomes skewed. A negative skewed distribution loses the righthand tail but the probability mass is not lost. It is repositioned in a way that makes for a deviation between the mean and median. This repositioning of the mass is what makes it attractive.

Second, the frequency of outperformance changes radically over time. The negatively skewed distribution will do better in the short-run, but this advantage declines as the days extend to one year. Nevertheless, all else equal equal, a loss averse investor will usually like the negative skew.
Third, the value of negative skew is present even when compared with a return distribution that has higher returns. An investors needs time to even find out that a higher returning asset is better when skew is present.
Fourth, the average maximum drawdown will be higher for a distribution that has negative skew given a fixed time period. The short-term gain of holding negative skew will be rewarded with a larger drawdown over time.

Fifth, the researchers show the value of skew for different volatilities. The value of positive skew at reducing drawdowns is significant. If you are worried about drawdown find the positively skewed asset.


Forget the short-run and show patience in the face of skew. If you must have an asset that has negative skew, find some assets with positive skew as an offset. A judgment on asset skew is needed otherwise you will be skewed.