Tuesday, July 30, 2019

What are multi-alternative funds? You cannot tell much from their names


Multi-alternative hedge funds are growing in popularity even though there is an issue of defining exactly what they are and how they should behave. Obviously, if there is more diversification or alternative sources of return within a fund, the return pattern will be different than traditional assets, but it is not clear what will be the beta or correlation with traditional assets. Two funds with similar names could have very different correlations with equities.

The naming convention across the multi-alternative fund choice set is quite wide. Key words within the names include:

  • Multi-strategy, 
  • Alternative strategy, alternative beta, fundamental alternative
  • Global Macro, Macro Opportunity
  • Systematic 
  • Tactical
  • Opportunities 
  • Diversified
  • Multi-style 
  • Alpha, Dynamic alpha 
  • Global Absolute
  • Absolute return 
If a fund can be called the Diversified, Multi-strategy, Multi-style, Alternative, Systematic, Dynamic, Global Macro, Tactical, Alpha, Absolute Return Opportunities Fund, it will have covered all of the key word descriptors. Yet, we would have no idea what it does. 

The difference in returns within the multi-alternative category from Morningstar is significant. The year to date returns have a spread of 27 percent 
between the highest and lowest returning fund and the one year return spread is 24 percent over more than 350 firms.


The name will tell investors nothing about what the fund will do or how it will produce returns. The only easy way to determine what these funds are or can be is through some form of beta decomposition with different indices. Is it fixed income focused or equity focused? What are the conditional correlations or beta? How stable are these relationship? Can these strategies be grouped into style buckets? Of course, this analysis will be subject to the problem of a backward-looking analysis but there is no real alternative beyond using the description of the fund. 


"What’s in a name? That which we call a multi-alternative fund,
By any other name could return something different".

 In the case of multi-alternatives, a name does not provide much information. 

Sunday, July 28, 2019

Gold Agreement will lapse - Perhaps this noble metal is a good asset



The Gold Agreement that has limited the sale of bullion by central banks will lapse after placing restrictions on sales for 20 years. Central banks have generally stopped selling gold since the Great Financial Crisis, and in fact have become buyers of gold. Allowing the agreement to lapse is a statement that many central banks do not view gold as a "Barbarous Relic". 

If there is a concern that all currencies can be debased and yields on many assets are negative, holding gold at a zero rate does not seem so bad. In a negative rate world, a noble metal may seem like a good store of value.

Saturday, July 27, 2019

Governments are all “economic populists” and that is a problem


Let the deficits be damned, we need growth. Let money supply constraints be damned, we need growth. Let's use not-market policies to achieve redistribution and growth. The appeal to voters is that benefits can be given without costs or economic consequences. What current politician running for higher office in the US thinks otherwise? This economic populism is causing increased uncertainty for any longer-term investments. When will there be a payback on capital invested today? 

Not believing in constraints may work for a time, but there will be an eventual cost and a price will have to be paid. The price will be imposed not immediately on the majority but first on business owners, but as the costs further increase it will be borne by all.

Economists always need to define terms. Two leading economists, Edwards and Dornbusch, actually have a good definition of economic populism, a government that does not belief budget deficits are or should be a constraint on growth. (See Populism and the economic laws of not following budget constraints for more details.) A governments without constraints can provide resources to the many without worry. 

Why worry about this now? Budget deficits are growing even with economic growth. Monetary policy is viewed an unlimited pump for new credit. Government intervention through regulation is an active means to change the flow of capital and labor. We are seeing this with global monetary policy, credit expansion, and trade policy, yet the marginal effect on growth seems diminished. We are not being doomsayers, but accept that economic populism is not sustainable in the long-run. This is why investors have to worry about left-tail risk now.

Friday, July 26, 2019

Pick your spots based on relative market efficiency


Some markets are more efficient than others. That is a simple fact. Efficiency is still related to competition and market structure. In a perfectly competitive market, excess profits are driven to zero. If you want to invest in those markets you will get paid for risk-taken but do not expect to do better than that, and don't expect to do better than your peers. More competition and the speed of adjust to new information will be faster. If there are more market frictions, there will be less efficiency.

This basic framework can guide any investor as to whether some markets will be more likely to be profitable through information gathering or through the use of trend-following.  Investors will be paid fore their information analysis in a less efficient market. There is less competition of market assessment. Similarly, there will likely be more trends either because there is less capital to push markets to equilibrium or the cost of responding to any piece of information is higher.

Above is a simple table of characteristics of markets that may be less efficient. This does not mean that all markets with these characteristics will more profitable than others. We have not seen any work that has directly tested this hypothesis. There is some evidence from general studies and conjecture. Most investors still focus on large liquid markets for the simple reason that they are easier to trade and can handle more size. 

However, we can say that global macro markets are more likely to be inefficient because they are harder to value. This is often been referred to as Samuelson Dictum on markets "micro efficient but macro inefficient". Unfortunately, fewer traders and less liquidity also place these markets at higher risk of larger downside moves. You may be able to exploit inefficiencies, but there are special risks. 

Structural Risk Premia - They are all around you but may not last


There are number of risk premia styles, but styles tell how risk premia are exploited not why they exist. The reason for existence is key to whether a risk premium can be exploited over the long-run or is likely to disappear. The risk premia could be classified in three categories: fundamental, behavioral or structural. 
  • Fundamental risk premia are associated with compensation for risk due to the inherent characteristics of the securities such as quality, size, carry, or volatility.
  • Behavioral risk premia are associated with returns generated from the under or over-reaction to information caused by behavioral. For example, momentum is associated with behavioral biases that create trends.
  • Structural risk premia are associated with return from inefficiencies created by market structure, rules, and regulation. Rules and structure impact liquidity, flows, and the ability of markets to eliminate arbitrage. For example, insurance and bank regulation impact liquidity through investment restrictions. 
The fundamental and behavior risk premia are most often identified and discussed by investors. The fundamental risk premia are driven by an economic and theoretical rational for risk compensation. The behavioral risk premia fit within or current thinking of market behavior. Both fundamental and behavior risk premia should be persistent through time. These premia may be time varying but should offer investors long-term positive returns.

Structural risk premia are different in that are related to man-made rules and regulations. A change in market structure can eliminate the premia. They are not immediately obvious and may not have a theoretical or economic rational outside of the structural frictions. While behavioral biases may affect these risk premia, investors can be very rational and still have these structural opportunities. However, these risk premia may be arbitraged away if there is enough capital to offset the structural inefficiencies. Hence, structural risk premia are not persistent, yet they may be everywhere if you look closely at market microstructure. 

A list of some structural risk premia:
  • Commodities - Liquidity congestion premia associated with contract rolls.
  • Rates - Money fund maturity restrictions.
  • Credit - Restrictions on ratings against high yield. 
  • Currencies - Trading in non-deliverable forwards.
  • Equities - Index composition liquidity effects.
For some investors that focus on the micro details of markets, these are tradable opportunities. Perhaps not like finding dollar bills on the sidewalk, but these premia that can be profitable albeit fleeting with a change in the rules.

Wednesday, July 24, 2019

In an uncertain world, don't just sit there, do something - Unfortunately, it is a flight to safety


The Fed talk has been forecasting a 25 bps cut with some market extremes discussing a 50 bps change for a short period last week. Forget forward guidance based on the data, central banks are reacting to uncertainty. 

We don't know what will happen to the trade war. We don't know what will be fiscal policy, what laws will be enforced, who should be in charge, who to trust, or even who to listen to. There is real news and fake news and many cannot tell the difference. Every political speech has to be followed by spin to tell us what we just heard. Last Friday, we had to have a clarification from the NY Fed that what the president of the NY Fed clearly told us was not what he actually said, or the market's interpretation of his words were not what message he wanted to send.

The economic policy uncertainty index has been rising and this does have a spillover to financial markets. If you don't know what to expect, capital investments are hard to discount. Forget about the discount factor if you don't know what cash flows will look like. Valuations will suffer when there is more uncertainty. Risky stocks will be discounted. Leveraged stocks will be discounted. Trade contracts will be on hold. Hiring will be done on a temporary basis.



Risky stocks will be discounted and safe assets (low volatility) will bid higher. The contrarian who believes that uncertainty will be resolved will be rewarded for holding risky assets, but this change in uncertainty is hard to predict. Certainly, political (policy) uncertainty in key markets is unlikely to fall. The US political cycle is just getting started. Still, a change in the uncertainty headwind will create the opportunity for growth and higher stocks. 

Tuesday, July 23, 2019

The Great Global Yield Curve Inversion - It is a world problem


The inverted yield curve is not just a US issue. It is global issue with most countries having some form of inversion. There are two common signals from this inversion. One, there will be a global recession. Whether the US, Europe, Asia, every curve is saying that future nominal rates will decline and there will be an economic slowdown. Past research on international yield curve shows the same relationship between inversion and growth as found in the US. The international data is consistent with the expectations of many economists. Two, an inverted curve tells us about global monetary conditions. In spite of all the quantitative easing, the inverted curves suggest that monetary conditions are tightening. This view is in contradiction with adjusted monetary growth. Granted the Fed has reduced its balance sheet and the ECB ended their QE program last December, but the amount of high-powered money has not declined. 

The greatest inversions are with lower-rated countries that are trying to stabilize currencies through tightening monetary conditions. This is not the case with most of the countries studied.

This global inversion is also suggestive of tight dollar conditions and these conditions are affecting global banking. The dollar has not fallen since the talk of rate declines and US short rates are at the high-end of any rank ordering. The Fed actions may not be for the US which in isolation may not need a rate cut. Rather, the rate cut is to relieve global dollar pressure. Central bank thinking in a rational expectations world is that if inversion suggests a slowdown then our job is to reverse inversion to stop the future slowdown from being realized. 
Central bankers to avert the expected impact from an inversion will manipulate short-rates lower.

Monday, July 22, 2019

Wimpy and private equity - Investors can avoid the worst issues through replication alternatives


Wimpy's motto is, "I will gladly pay you Tuesday for a hamburger today". The concept of long lock-ups in private equity investments without full disclosure of the investments or effective valuation follows the Wimpy motto. Pay us today with cash which will be invested over time with a management fee every year and a 20% carry that is paid when you are given your cash back. There is clear investment uncertainty and illiquidity that requires extra compensation than what would be expected from any public investment. 

Many studies have shown the strong returns from private equity that make it an attractive investment. Still, private equity requires an inherent optimism with a strong commitment of time. There is also evidence that private equity returns can be replicated in more liquid public markets. Private equity may not be as unique as marketed.


Private equity replication requires three components, equities that match the underlying PE investments, leverage, and long-term accounting. See "Replicating Private Equity and Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting" by Erik Stafford of the Harvard Business School for a good study of the differences. See L’Her, Jean-François, Rossita Stoyanova, Kathryn Shaw, William Scott, and Charissa Lai. 2016. “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market” Financial Analysts Journal 2016, vol. 72, no. 4 (July/August): 36-48 for another comparison between public and private funds. In both of these cases, looking at some simple criteria such as small cap and value provides the basis for liquid replication of private funds.

Private equity investments focus not on large cap firms but smaller firms with low EBITDA and some leverage. The problem with replication is that the valuation process will show a markedly more volatile investment than what is received with a private equity fund. While valuations will be similar to a public fund, there will be greater smoothing and possible upward bias in private equity valuations. The accounting differences matter. 

Nevertheless, investors can have greater control over their investments and still reach the same return potential at lower costs through replication strategies. However, to realize these gains requires the investor to commit to a long-term investment and accept variation in valuations that will suggest greater risk than a private equity alternative. 

Sunday, July 21, 2019

Stocks Don't Do So Hot - Most equities don't beat one-month Treasury bills

Stocks are risky investments. Let's be very clear, stocks are risky with positive skew. Of course, everyone knows that but some data published about two years really drove that home. (See my earlier post "Most stocks are losers - Median and skew tell an important story" about the paper "Do stocks Outperform Treasury Bills" by Hendrik Bessembinder)That path-breaking work has now been updated for more time and across international stocks, see Do Global Stocks Outperform US Treasury Bills?

This meaningful research again comes from Henrik Bessembinder who found in his original paper that over half the stocks in the US never make more than the risk-free return. Most of the wealth from equities comes from a very small percentage of firms. This research has now been updated and includes 62,000 domestic and international stocks. The results are about the same, but even worse for international stocks.



The long-run performance is highly skewed positive and shows that most of the global wealth from equities comes from a limited set of names. Investors are not compensated for the risk that they take with buy and hold investing with individual equities. Most stocks around the world cannot beat the risk-free rate. An investor can still make money by holding an index which will contain the few winners, but long-run stock-picking by this simple measure is a losers game 

Thursday, July 18, 2019

Hedged Corporate Bonds - Not a good deal over the last year


A corporate bond has two components, an underlying Treasury exposure with risk premium or spread associated with the default risk of the issuing company. Your return will be associated with the performance of each of those pieces. If rates do not change but spreads tighten, the investor will receive a total return gain. The added return will be the spread yield plus the spread tightening times the duration of the bond. 

Investors can buy a corporate and high yield bond index (LQD and HYG). They can also buy LQDH and HYGH which is the hedged version of the same index. The hedge reduces the underlying duration or Treasury interest risk in the portfolio. An investor is only holding the corporate risk exposure. That change in risk can have a significant impact on performance.

In the last year, grabbing for yield has been good for corporate and high yield investors, but the gain has come from the interest rate duration exposure and not from the added yield of holding corporate risk. Over the last year, investors only got 20% of their return from corporate bond spreads and less than 50% from high yield spreads. Buying yield is a two-part decision. Sometimes you want to buy the premia and other times you want to have the duration.

Using alternative yield curves tells the same story of inversion - Recession coming


The yield curve is inverted. Who has not heard about? Who does not expect a coming slowdown given this information? Is there any more information that  needs to be said?  A Fed paper suggests that looking at the short-end of the curve may be slightly more informative than a 2-10 year Treasury spreads or some other Treasury combination like 10-year / 3-month spreads. (See "The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted View" by Engstrom and Sharpe.) Now the yield curve inversion is somewhat of a blunt forecasting instrument. There can be variable lead times before a recession and it has predicted recession that did not occur; however, having alternative looks at the yield curve may provide additional information.

Engstrom and Sharpe find that the focus should be on the 12-18 month part of the forward curve. Their argument is that when the market prices in a monetary easing they are also pricing in an expected recession. The Fed is responding to the threat of a recession. 

Using their work with a simple variation, there is a lot to learn by focusing on shorter-term forwards as opposed to longer-term spreads. Here is the Eurodollar futures curve as forward yields out beyond five years. Notice the inversion that suggests a recession and is also consistent with easing monetary policy expectations. The real economy and monetary economy are closely linked. 

There is less noise from longer rates using the Eurodollar futures data. The long rate by definition is an average of expected short-rates so focusing on the 12-18 month curve is a more direct measure of changes in relative prices. While we still look at the consensus inversion numbers, we agree with the Fed researchers that short rates may provide better information.


Tuesday, July 16, 2019

What are sovereign asset funds thinking? The Invesco survey


A constant job of any market analyst is trying to determine themes and flows from big money managers. While the behavior of big guys matter, this does not mean investor should always follow the lead of large managers. Large manager allocation changes and expectations create headwinds and tailwinds against which smaller managers have to navigate. 

Invesco recently published their Global Sovereign Asset Management Study 2019. The report focuses on sovereign wealth funds and central banks totally about $20 trillion in AUM and adds to our knowledge of what large managers are thinking. The base portfolios are actually consistent with many other large managers, like endowments, who do not have to worry about short-term liquidity.

A common theme is the build-up of illiquid alternatives which includes real estate, private equity, and infrastructure. This growth in the illiquid is occurring in spite of the almost 90 percent believing that the economic cycle will end in 2 years or less. There seems to be a strong desire to buy assets that will generate yield/return beyond the economic cycle. The demand for private equity and illiquid assets is alive and well with these big asset managers. Of course, given their size the choices for investing are more limited. While fixed income and cash are both growing this year, manager behavior does not seem defensive. 

Interestingly, central bank portfolios show a marked increase in diversification and liquidity. In general, central bank portfolio maintain a higher degree of liquidity than traditional sovereign wealth funds, but this shift in behavior provides a contrast worth further discussion.

The big themes for sovereign funds mirror the views of all investors; however, the focus seems to be greater on geopolitical stress than any single investment theme. The leading themes are all ones that will impact long-term global investing as opposed to near-term declines.

In the survey, Invesco reviews a number of themes beyond the shifts in an aging market cycle such as the movement to China investments, ESG investments and the continued increase in technology investing. A quick read will provide useful information on how another group of investors look at the investment choice set. 

A Century of Factor Premia Timing Evidence - What you need to know - Part II



The value of investing in risk premia is well-know. They have positive expected return over long time periods and have low correlation between styles and asset class as well as with the market portfolio. There is significant potential value from forming portfolios of different risk premia styles and asset classes. The measurement of risk premia returns and correlation were reviewed in our recent post, A Century of Factor Premia and Timing Evidence - What you need to know - Part I.

Recent research has also focused on whether these time varying risk premia can be forecast. The results on forecasting risk premia are mixed. The extensive research conducted by AQR Capital on risk premia in their long paper suggests that timing will be difficult and that a simple diversified risk premia portfolio may provide an easier way to obtain an effective return to risk combination. (See "Factor Premia and Factor Timing: A Century of Evidence") 

The "century of evidence" paper details and studies a significant number of forecast choices. For example, a simple specification, derived from the data, is to look at the value spread as a timing model. This model can be applied to all styles and asset classes. What is clear from their testing is that the value spread as a timing model has spotty performance. While it works for some asset classes and styles, there is no pattern strong enough to state that this type of timing model will lead to significant success. Nonetheless, a value spread model applied to multi-factors for all asset classes shows some value-added.  

The researchers also look at a wide combination of models to test timing. There is some marginal value or alpha production from timing but no one approach dominates the timing choices.  
A time series of returns using these timing strategies illustrates the point better. Some timing models fail completely while others show mixed performance between positive gains and failure like the value spread and inverse volatility. When a full model of timing variables is applied there is positive returns, but it will come at a cost and generates limited alpha. 

The table below shows the increased Sharpe ratio for different timing models versus a static portfolio of no timing. The table also shows how much weight should be given to a timing model. Looking out of sample, it is not clear that the timing models can significantly boost performance as measured by improved Sharpe ratio.


The results from this timing work may be disappointing but should not be surprising. Timing market betas is not easy. Markets are generally efficient. The relationships with macro variables are also likely to be time varying. Hence, any conclusions on market timing especially when testing out of sample are likely to show, at best, mixed results. 

The same efficiency prior should apply to trying to time risk premia. Risk premia portfolio construction should focus on broad diversification and any timing decision beyond adjustments for volatility and correlation should be done with care.

Monday, July 15, 2019

A Century of Factor Premia and Timing Evidence - What you need to know - Part I


Risk premia across assets have been extensively tested but over different time periods and using different testing methodologies. Risk premia have existed for as long as we have data across a wide set of asset classes and for a number of different styles including value, momentum, carry and defensive. The value of risk premia is well documented by the research folks from AQR Capital in their opus "Factor Premia and Factor Timing: A Century of Evidence" that was updated last month. This research piece provides a wealth of information and thoroughness which should make this paper required reading for those who want to get a full analysis of the historical numbers associated with risk premia.  I will break up a summary of their work into two parts, the performance measurement of risk premia, and the potential timing of the risk premia.

The broad risk premia tested have real economic value that has stretched back for long time periods. This research extends the measure of risk premia to almost a century of data confirming what other researchers have found, but in a number of novel ways. Unfortunately, in our next post we will summarize their work on timing which suggests that after testing a wide battery of alternative models, profits from conditional forecasts is unlikely. 

Foremost with this work, the returns from risk premia are real. They are significant for core styles like value, momentum, carry, and defensive. They are present for equities, rates, commodities, and currencies as well as US and international stocks. The value-added is all the more significant when bundled across asset classes or styles.
However, a careful look at the data suggest that excitement about the value-added for risk premia investing should be tempered through comparing the data before and after the original sample used for finding these premia. Generally, the original data sets show stronger results. Thus, it is fair to conclude that risk premia are meaningful but not as significant as found in initial research. The value of risk premia is sample and test dependent. At a minimum, there is clear time variation with risk premia. At worst, some of the results present are from data-mining.


One of the key benefits of these core risk premia is that they have low correlation. They are generally unique, yet the correlations between them are highly variable. The correlation calculated today cannot be expected to remain the same. A portfolio of risk premia will have highly variable performance and risk characteristics. Nevertheless, the data show that some pairing of risk premia like value and momentum will consistently show negative correlation.

The rationale for the time variation of risk premia is not clear. An extensive set of factor for contemporaneous and predictive economic news shows mixed explanatory results. There are only a few macro factors that have meaningful impact on returns. More work on these relationships should be conducted. While this is disappointing, it not overly surprising given the generally poor link between macro variables and market returns. 

It is also found that the correlations between the market portfolio and risk premia are also time varying and fit within a wide range. Still, the data show some relationships, such as the negative correlation between value and momentum are quite strong regardless of the market environment. These relationships help to form the basis for any portfolio construction of risk premia. 

The extensive research on risk premia draws some simple conclusions:

  • Risk premia are significant across a wide set of styles and asset classes.
  • However, identified risk premia are subject data-mining of the original testing period and the long history suggests are more tempered view on return.
  • Correlations across styles, asset class are time varying. The correlations with the market portfolio are also variable.
  • There are some significant economic factors related to risk premia, but there is no strong consistent pattern across style and asset classes. 
  • There are some consistent patterns of correlation among risk premia for different market environments.