Beware of the Sharpe ratio - Use the Sharpe ratio

 

The new paper "How to use Sharpe Ratio" is an important reading for any analyst attempting to compare two managers or strategies based on the Sharpe ratio. Many of the implications associated with the Sharpe ratio have been discussed in previous papers; however, this one presents all the limitations and possible solutions in a single reading. The authors present several adjustments to the Sharpe ratio to account for issues such as non-normality, but they also list and comment on all past research that has been associated with the Sharpe ratio. The overall conclusion is that using quick calculations should be done with peril. Oftentimes, minor adjustments will help on the margin. This is important because often Sharpe ratios for many strategies are close to each other, so rankings will flip once you account for some of these adjustments

The uncertainty of monetary policy - from internal to external

 

There is considerable discussion about the uncertainty surrounding Fed monetary policy; however, it is essential to break down that uncertainty into two key components: internal and external. Internal uncertainty is associated with policymakers not having a consensus on the direction of policy. External uncertainty is related to the lack of agreement among market participants or how investors perceive the direction of monetary policy. 

Generally, the market focuses on external uncertainty. Internal uncertainty is minimized by the Fed, usually voting in agreement at the Fed meeting. We may learn about disagreement with a long lag. However, we can use the SEP forecasts as a proxy for internal conflict. If the path of the SEP forecasts shows little dispute, then there is little uncertainty. If the SEP forecasts are diverse, then there is little agreement on inflation or growth. You cannot have agreement on policy action if the forecasts for interest rate directions are all over the dot plot. 

Currently, we are seeing significant divergences between these forecasts. You cannot have an agreement with the policy if you have some Fed SEP showing wide differences. This is clearly the case for 2025 and the following years. Investors cannot be expected to make firm investment plans if they cannot see agreement among the central bankers.

Central banks like gold more than Treasuries

 

This is one of the most interesting charts this month. Central banks have kept more gold than Treasuries for an extended period until about 1997, when there was a switch to holding more Treasuries. This was the period of Bretton Woods II, when central banks increased their reserves as a measure to help defend their currencies in a crisis. Now, these central banks prefer gold over the safe asset of Treasury securities. There is a fundamental change in the perception or common knowledge concerning Treasuries as a safe asset.

Economics and the need for history

"Forty years of investment in mathematizing economics has made it less acceptable among economists to admit ignorance of mathematics than to admit ignorance of history" - Deirdre McCloskey

You cannot be an economist today without knowing your math. To complete any PhD program, you will need to possess a strong understanding of mathematics, statistics, and econometrics. You will also likely have strong programming skills. Finance is being dominated by quants. 

You will not need to know history in this environment; yet, as I get older, understanding history becomes a critical skill. All policy analysis needs context for what has worked in the past. You need history to describe "experiments" in the past. The past determines the path for the current and future. 

In finance at the local level, you need to know the history of companies; their evolution is relevant. At the macro level, we need to know the specifics to appreciate our generalizations. It seems that one semester of economic history is not too much to ask for our experts.

This has been a common theme on how we think.

Finance needs more history to help with the future

Financial amnesia and the need for financial history

Don't just follow history, act on it

The value of history for economics from Charles Kindleberger

History in five crashes - Finance in the last century

Counterfactuals, history, and market analysis

History, linear thinking, and addressing market noise

Financial crises are inherent within our system

 

Gary Gorton provides a good history of financial crises in the US financial system from the free banking period to the Great Financial Crisis. These crises are not one-off events but are inherent in our financial system. There will be credit booms and busts,  and our history is filled with them. What is unusual is that we had a long period from the Great Depression to the 1980s when there were no crises. Innovations that change the financial landscape, moral hazard issues, too-big-to-fail, and shortages of bank capital all contribute to liquidity crises and contraction of credit. Through following economic history, we can see how the seeds of crises are sown. Gorton does a good job in this short book of providing the history and theory for why we should always be concerned about the possibility of a financial crisis.

The Richard Stone Diagram of models, policies and plans

 

I came across the Model, Policies, and Plans diagram from the 1984 Nobel Prize winner Richard Stone. It attempts to explain the production process for economic knowledge. It is a helpful picture of how economists first blend facts and theory to form a model. A model is mixed with objectives to form policy. Controls on the policy will create a plan, and events will impact the plan, leading to our set of experiences. We then go back to the beginning and repeat. This is an iterative process. As we get new facts, we will adjust theories and models. In the case of monetary policy, we should ask how the Stone diagram works inside the Fed.

Managers outperform mid and small cap benchmarks

The SPIVA report from S&P provides a good measure of the quality of alpha generation from long-only equity managers. The numbers are usually not very good. Managers usually underperform the large cap benchmark. Managers typically do better than mid- and small-cap benchmarks, although they still generally fail to beat the corresponding benchmarks. For 2025, equity managers are performing much better than the benchmarks by a much wider margin. 

Why are managers doing better? The simple answer is that it is a better stock-picking environment, yet that does not tell what the characteristics are that are causing this better environment. We argue that the dispersion in the stock market is higher and the cross-correlation is lower in the associated indexes. If there is more equity dispersion, the choices that are made by managers will lead to added performance. The choices improve when there is less correlation between stocks

 

The cause and effect link is not always obvious

This comic addresses many economic problems. There is no reason to think about unintended consequences or second-order effects, but you don't get the cause and effect right. 

Currently, there is an increased focus on cause-and-effect thinking within finance, as a result of the proliferation of factors used to explain returns. Some have stated that there are hundreds of factors that may drive returns, yet they often do not work outside of the training period, or they seem to periodically move in and out of favor. The problem is that there is insufficient consideration of the relationship between cause and effect. Factors are found and stories are developed to explain why a factor may be relevant, but that is not the same as positing a theory and then testing it. Correlation with a story is not causal.

Liquid Alternative Beta (LAB) performance for August

 

The Liquid Alternative Beta (LAB) indexes, available from HedgeIndex, formerly Credit Suisse, offer a comprehensive view of the performance of various hedge fund strategies in August. All the hedge fund strategies were positive for the month. Returns were consistent with the overall market, SPX, which gained 2.03% for the month. The LAB indexes beat the S&P500 growth and momentum factor-based indexes. The global strategy and managed futures indexes were able to take advantage of the tail winds from positive international equities and bond returns. This places most strategies with positive returns for the year, except for the managed futures and liquid indexes. The managed futures strategy has started to find trends after a difficult first half of the year. 

The LAB indexes have lower volatility than the long-only benchmark strategies. 

Prediction is not optimization

Many researchers and practitioners have questioned how the input parameters of MVO should be estimated. To this, Markowitz is said to have responded with wit and grace, “That’s your job, not mine.”

- Stephen C Sexauer and Laurence B Siegel. 2024. Harry Markowitz and the philosopher’s stone. Financial Analysts Journal

With the quant revolution, there have been significant advancements in the methods and types of optimization that can be used for portfolio management. However, the key to successful optimization remains the accurate predictions of expected return, volatility, and correlation. Optimization on the wrong inputs is a fool's errand. 

The machine learning explosion has to focus on system predictions across a large set of assets, which can then be used as inputs into a traditional optimizer. Before using an optimizer, focus on the input variables. 

European versus American trend-followers

 

A recent paper, "The Science and Practice of Trend-following System", makes the interesting observation that there is a difference between European and American CTAs or trend-followers. The paper tries to provide a unified system for trend-following, a noble cause. However, what piqued my interest was the authors' comment that there were three major trend-following classifications: European, American, and time series momentum. 

I have always believed and commented that there is a difference between the major European and American trend-followers. I have stated that Americans are ideologues who adhere to a system developed in the 70's and 80's, while Europeans are pragmatists who focus on any technique that seems to generate profits. Sepp and Lucic hold the view that European CTA focuses on continually adjusting positions based on current risk, coupled with exponential moving average systems. American trend-followers emerge from the technical system world, focusing on breakout systems that involve full positions based on the signal. The third system focuses on time series momentum systems, which are correlated with moving average crossover systems. 

You might think that these approaches are all the same, but you would be wrong.  The American system has the highest Sharpe ratio, but the other methods are not far behind. In a given year, there will be differences, but it is hard to say that one approach is superior to another. You are left with the issue of finding a strategy that works for your risk tolerance, and in this case, risk tolerance is based on your comfort with the return generation process. 

The hedge fund industry - Changed with Bernie Madoff

In our last post, we focused on the upheaval to the hedge fund industry from the GFC. The downside risk caused surviving hedge funds to innovate through forming management structures that attempt to gain scale and scope. Size and diversification as a form of hedging downside risk.

In this post, we focus on the second major upheaval to the hedge fund industry - the Bernie Madoff scandal. While hedge funds realized that they needed to gain scale and scope to save their businesses. Investors demanded more professional management and a broader scope of functions, as seen in other industries, in response to the uncertainty within the hedge funds in which they invested. Call it the rise of super due diligence. Of course, the government increased regulation, but investor due diligence also rose in response to fraud. The costs, especially for running a small hedge fund, increased because investors were not going to pare back due diligence because the manager was smaller. In fact, the risk of failure or fraud was likely higher for smaller funds. 

The Madoff change led to stronger internal controls, legal, and compliance departments. There was also a greater demand for transparency and contact with the manager, which increased the need for investor relations and marketing. The demand for risk management and exposure reporting led to the creation of separate departments from the investment business. 

Once the demand for transparency and more formal due diligence took hold, hedge funds had to provide many of the same investor services as long-only managers. The market shifted assets to larger firms, which in turn led hedge funds to focus on scale and scope, adopting more formal organizational structures.

The hedge fund industry - Changes from the GFC

The hedge fund industry - Changes from the GFC

 

The hedge fund industry has undergone significant changes since the Great Financial Crisis (GFC), which have not received sufficient attention. The focus is usually on performance, yet it is essential to consider hedge funds as a financial industry, one that evolves and adapts to the market environment. 

Hedge funds have not really developed new ways of generating alpha. They have adopted a greater use of quantitative tools, which represents a significant innovation in enhancing existing methods for generating alpha. However, the real innovation has been the movement toward vertical integration, a widening of scope through product development, and the formalization of management structure. 

The hedge fund industry was not immune to the significant declines in returns from the financial crisis. Many firms went out of business, and many experienced severe declines in cash flows. Assets under management declined, and the expected incentive fees were reduced or eliminated. The industry had to change because the surviving focused star manager could not survive another downturn like the GFC. 

The choices were clear, no different from those in other industries that underwent upheaval. First, the innovation of the hedge fund industry was to diversify the firm's offerings. This could be the same fund but with a broader market focus. It could also be different products within the same asset class or across asset classes, or it could be some customized product with features set for a large client. Second, there was a need to gain scale and better control costs through better professional management. This could take the form of formal marketing. It could also be a separate legal and compliance department, as well as separate risk management and trading departments. 

The desire for scale and cost control meant that the small shop, with its focused manager or personality, needed to become a departmentalized, professionally managed organization. There was an end to personality and a shift to departments that focused on specific tasks, overseen by the manager/owner.

This process was observed in many other industries in the US prior to the turn of the twentieth century. This is the story of American business and its pursuit of scale and scope. The hedge fund industry is not special. It follows the pattern of other industries.

Jerome Brunner - Logic and narrative go together

 

Jerome Brunner, one of the towering figures in psychology and cognitive learning, developed a simple cognitive theory through framing experience into two models, propositional and narrative. Propositional thinking focuses on logic and formality, while narrative is based on storytelling. Narrative is emotional and needs to be personally convincing. It is the narrative that holds the propositional logic together as a useful tool. Simply put, we cannot develop theory and logic in a vacuum; instead, we use narrative as a tool to support our thinking or convey it through stories. The narrative provides an emotional connection.

We can use that framework to think about how stories are conveyed on Wall Street. Nothing is done through a review of model results. No talking head refers to a model. The models are condensed into a concise story or narrative. The narrative can provide a connection that is not present in a model. 

Perhaps an extreme, but Fed independence is not presented as a formal problem in time inconsistency, but as a fight for control over a policy lever. The acquisition of a firm is not described in terms of numbers, although a price is associated with the purchase. There is a discussion of strategic advantage and how the whole will be greater than the sum of the parts. 

See also:

Narrative and investing - Follow the facts

Financial globalization is determined by state actors

 

State and the Reemergence of Global Finance: From Bretton Woods to the 1990s by Eric Helleiner is a fascinating book on the politics of international plumbing. As a macro person, I focus on models and price relationships, rather than regulation or international relationships across countries. This book highlights the significant impact of global policy choices by states on markets. This should be viewed as obvious, but we often focus on innovation and market forces as the drivers of change; however, it is frequently the will of the state that is the major contributing factor. Financial globalization was not an organic change to the international order but was orchestrated through the policies and dictates of state players. This was a different perspective that I did not fully appreciate. 

Clearly, the world is being reset with respect to trade through tariff policies; however, we cannot forget that the world can also change through policies that impact capital markets and flows. Capital markets may have a greater impact on inter-country dynamics. While we have not seen capital flow policies change directly, the talk for a weaker dollar is clearly having an impact on flows. The sanctions placed on countries also have a flow constraint. We have not changed policies on capital controls, but the weakening of international organizations has spillover effects on capital flows. Financial globalization or deglobalization is in the hands of policymakers, and should be given more attention by all in finance.

Return stacking - an easy approach for return enhancements

 

Return stacking is not hedging. Return stacking is not a solution to higher returns. Return stacking is a means of efficiently using capital through mixing core assets with the benefits from futures margin structures. It is a variation on portable alpha strategies, or portable beta by another name. An investor gets capital efficiency through gaining exposure in futures for a core asset. The unlocked capital can then be used to buy another asset. See "Return Stacking &Portable Alpha: An Investor's Guide".

The core approach can allow capital to be used to create a better return-to-risk trade-off efficiently. Of course, the choice of the stack will determine the return-to-risk. The foundation of this work is based on choosing assets in the stack that are uncorrelated.

Private equity payoffs - Set of options

 

The return profile for private equity is one of the critical investment issues for many institutional investors. This will also become a crucial issue for retail investors if many of the large PE firms have it their way. We need to go back to basics and look at the pay-off structure for private equity, and the graph below provides valuable insight. This chart is from the new paper "Analytic Valuation of Private Equity Investments". 

Notice that four distinct pay-offs form a real option. If you cannot pay the borrowing costs, the investor makes nothing. Once the costs are covered, the investors make money until the invested capital is returned, and the GP then receives his fees. Afterward, the investor receives the excess. You have to clear hurdles to receive the next set of cash flows. There are failures which impact this pay-off, and the investments are illiquid and take, on average, 5-7 years to return capital. This is a long-term option on the quality of management to provide a return above the cost of capital. 

Toynbee on history - can relate to finance

 

From Toynbee on Toynbee: A conversation between Arnold J Toynbee and GR Urban. 

...in both physical science and in the study of human affairs, the test of the difference between what is chance and what is law - regularity - is one's conception of the structure of non-human nature and the structure of human nature. 

FInance is the search for regularity

...history being the victor's propaganda.  - Urban 

A fact in history is not really something concrete like a brick or a stone, that you can pick up and handle; a fact is manmade in a sense  - it is the result of a selection from the raw material... Homo sum humanum nihil a me alienum puto - the spectator is also an actor.

In finance, we select our facts. 

...Italian philosopher Croce as saying that all history is contemporary history... every human being is situated in a point-moment of time, and he can only observe the universe from this shifting point-moment. 

Our view of finance changes with time.

History is what historians write, not what actually happened, because it is only through the cognitive process of the historian that we can read meaning into an otherwise random accumulation of facts.  - Urban 

In finance, we search for meaning through our point of view.

What if Treasury bonds are not a safe haven?

The convenience yield associated with Treasuries has declined. The safe haven effect for Treasuries has also declined when measuring the reaction during the COVID pandemic. The most pressing question is why Treasuries are less of a safe haven. Researchers have focused on the supply of Treasuries as the leading reason. There is a premium paid for the safe asset if there is a threat of a shortage. If the supply of Treasury increases, the threat will be reduced, and more importantly, there is a risk that the safe asset will lose its value. There will be a desire to find alternative safe assets. 

Since the Great Financial Crisis, there has been a doubling of the debt to GDP in the US. Additionally, there has been a more than fourfold increase in the total public debt from $8 to $36 trillion. That is a lot of safe assets. If there is less need for the safe asset and if investors believe the safe assets are less safe, then the convenience yield will go down and the relative cost of financing will increase. 

If the safe haven effect falls, there will be a search for substitutes, and the cost of Treasury funding will increase.

The convenience yield for Treasuries

The safety associated with Treasuries means that it has a lower yield than comparable bonds. A simple way to measure this convenience yield is through the spread against AAA-rated bonds. The convenience yield or premium you are willing to pay during a crisis will rise, but what seems to be a trend is the decline in convenience yield over the last ten years. We are at the lowest convenience yield since the mid-1990s. The interesting point that has been noted by several researchers is that the convenience yield during the pandemic was much lower than the GFC or the tech bubble. 

The question on the mind of many is whether Treasuries have lost their safe-haven status. Many are now saying that the significant increase in Treasury debt is softening the safe haven effect. It is unlikely that it is gone, but it seems to be muted. What is its substitute? It could be gold, but there is not enough of the real asset to make up for the Treasury demand. It is not likely to be Europe, so what is the new safe haven?

 

BlackRock suggesting higher allocation to hedge funds

The BlackRock Investment Institute announces that investors should increase their allocation to hedge funds. It is not clear what the rationale is for this increase. Equity markets are overvalued and bond yields are not expected to move lower. Private equity is facing liquidity issues. Hence, hedge funds are a safe haven by default. As a diversifier, hedge funds may do the job, but the story should be more nuanced. Stock-picking has improved with market dispersion, but many hedge funds have relatively high betas. If the market moves lower, hedged funds will likely also see lower returns, albeit muted. 

The choice of hedge funds and the allocation are related to a market view. If there is a view that equity and bonds will not perform because of the macro environment, investment strategies should be focused on managed futures and global macro. For equity exposure, market neutral should be preferred. 

However, there is a bigger issue associated with fund flows. If there is limited alpha, what will happen to returns if there is a major increase in fund flows into hedge funds? There has not been enough work on the flow effects on alpha returns. More money chasing the same number of opportunities will lead to lower returns. Part of good investing is being in strategies before the "big money" enters the trades. 

The current problem with government statistics

In contrast to physics, there is no estimate of statistical error within economics in spite of Oskar Morgenstern’s book, On the Accuracy of Economic Observation. The problem of error in economic observations is still a widely neglected problem. The various sources of error that come into play in the social sciences suggest that the error in economic observations is substantial. As the error might be substantial, this paper argues that the usefulness of econometrics becomes questionable. - Philipp Bagus Rey Juan Carlos University

The multiple news stories about the change in leadership and the BLS miss the key point that we are facing with macroeconomic analysis. We are only as good as the data that we use. If there are significant errors with the underlying data used to make macro decisions, there will be greater market inefficiency. Major revisions will reduce he trust in the numbers. Minor modifications will help investors refocus their attention on this data. The market reaction to any announcement will decline. It is not that the market will make wrong judgments based on the data, but that no judgment will be made at all. There will be less market reaction on any announcement date, yet there is likely to be greater misallocation of resources. 

Gold and the problem of fiat money

 

The US government has consistently tried to marginalize gold, and has all of the focus on the dollar, but that only works if we behave ourselves. If we add a lot of debt on top of a fiat currency, it doesn't work.” - Chris Walen

I have not been a gold bug, nor will I change, but there is a problem with fiat money. Money is a store of vlaue because people believe it is a store of value. It is a matter of trust. The safe asset is a safe asset becasue it is belived to be a place where value is maintained.

The literature on safe assets does note that the safety is a relative concept. If there is too much of the safe asset, there will be a decline in that asset's safety value. When that happens, investors will look for other safe assets. If those other safe assets have a problem of excess supply, there will be a demand for real assets that offer safety and limited supply. 

The increase in gold demand is a response to the excess supply of Treasuries based on the large US budget deficits. The safety of Treasuries is being eroded, so there is a search for alternatives.  

Apple in China - a very important read

 

If you want to learn about the complexities of trade and geopolitical relationships, read Apple in China. This is a long book with a lot of inside details about Apple, but only through a long history of the development of manufacturing to meet the strong need for Apple products can you appreciate how we got to the current place in trade wars with China. With a desire just to meet demand, Apple invested heavily in Chinese suppliers. Other firms could not deliver what Apple needed. 

It was a one-way street with Apple demanding extraordinary goals from its suppliers. In exchange for these demands, they provided significant knowledge and support, but eventually, Apple became too dependent on their suppliers and the handout from local governments. Tied with strong demand for Apple products, the China-Apple relationship flipped with China through suppliers, customers, and the government wagging the dog. With all of the knowledge transfer, suppliers were able to support local companies that now compete against Apple. 

The ties with China were expedient but now have an edge where Apple may not be in charge of its destiny. There are no easy solutions for relocating manufacturing from China without significant financial costs. While the author does not write about the future, Apple has some very hard choices to make and it may not be able to weather this trade storm

The quantity theory of money still exists

 

Tim Congdon authored a new book, The Quantity Theory of Money: A New Restatement, last year. It is a historical retrospective of the classic quantity theory of money with some new twists. It is not a easy book for those who are not familiar with the long history of money. It takes a number of twists and turns on why some explanation do not work, but in the end, Congdon again emphasizes that money is at the heart of any discussion of inflation. 

The key insight is that money will impact not just the bond market which is the traditional view in the classic IS-LM modei but will also affect othe asset markets and goods markets. Money seeps into everything we do. We have to also focus on broad money, and how it affects asset purchases and goods purchase decisions. The link between money and credit is a better description of how it impacts transactions nd prices than the simple Friedman money multiplier.  

The inflation post-COVID should not have been a surprise for anyone who follows the money trail.

A very important book even for finance people - Autocracy, Inc.

 

I don't often comment on non-finance issues, but I was moved after reading Autocracy, Inc. by Anne Applebaum. This was not an emotional feeling, but anger that the autocrats of the world are forming connections to maintain their power in their respective countries. These autocratic connections are thwarting democratic movements around the globe. Applebaum provides good descriptions with substantial evidence on how dictators want to work together for their common benefit. 

The solutions to this problem are not obvious; however, there needs to be some form of international order and coordination between Western democracies to ensure that the global behavior of dictators does not rule over others. A coalition of democracies needs to actively engage in efforts to stop autocratic coordination. Obviously, this is being done, but the efforts have not been strong enough. 

The next credit crisis - student loans again?

Corporate spreads are at all-time lows and household finances seem to be in good shape, but there is one area of concern - student loans. There was an extended moratorium on student loan payments during the Biden Administration due to the COVID pandemic, but that is in the past. Borrowers now have to pay up, and the bailouts are not there. The result has been an increase in delinquencies. This is especially the case for older borrowers who are nearing retirement. We are not at a crisis, but this is an area of concern that impacts spending and the ability of these consumers to take on any other debt. 

HedgeIndex July performance - generally on track

 

We look closely at the HedgeIndex Liquidity Alternative Beta indexes that are replications of the HedgeIndex Composite Index returns. As a liquid alternative, investors can get a quick look at performance before many hedge funds report their monthly returns. 

Returns were positive except the managed futures index, which continues to have a difficult time finding trends in the major futures markets. If there are no trends, the trend index will not make money. The other strategies continue to show positive gains. Nevertheless, the Liquid and Global Strategies are a weighted average of the other strategies and have been pulled lower in 2025 by the managed futures performance. 

While the SPX generated a return of more than 2% for the month, these liquid alternatives have a lower volatility than the market beta. The LAB indexes performed better than the low volatility index, which returned a negative 29 bps this month. These indexes are not supposed to beat the major risk factors but should add diversification to any portfolio. The equity LAB indexes performed better than the fixed income composite.

A Simple rulle of thumb on trading - the 3M's

 

"Markets always trading the 3Ms… Macro, Momentum, and Misfit trades" - Michael Hartnett BofA.

I like this short description of trading because it covers almost all you need to know. Trade the macro or at least have the macro determine the asset allocation. Trade the momentum or the trends because this is a risk factor that usually works. Trade the misfits or the outlier anomalies that are away from fair value. This is it. This is all you need to know as the base case. From there, the real work begins on how to make this work with actual trades. 

The big divergence in confidence

 

What is surprising is the large difference between the confidence of institutional investors versus individual investors, according to the International Center of Finance at Yale University survey. There is some lag with the data. The most recent data comes from May, yet it shows that institutions are very bullish while individuals are moving in the opposite direction, albeit recent data has demonstrated improvement. While this data shows unusual behavior in the last year, the gap is surprising. Nevertheless, this survey data with information on valuation suggests that the market can go higher - expectations are not discounting higher valuations

The power of combining value and momentum factors

 

One of the more interesting combinations of factor exposures is value and momentum. Value and momentum have both delivered strong excess returns, and blending them together also has strong benefits, even though the value and momentum strategies are negatively correlated. 

An interesting new paper looks at the combination by trying to explain the excess returns through a pricing kernel that uses nine latent variables from the combined value and momentum cross-section, see "Value and Momentum Leftovers". The combination has proven to be much better than investing in each factor by itself. However, there is an issue of what the pricing kernel should be to help combine these two factors because there is a significant alpha after trying to price the combination. Additionally, the idea that you can just blend the value and momentum as a 50/50 combination may not be effective. 

We will not go into the details of this "leftover" argument other than to say that the use of latent variables can help price these two key factors and can lead to better factor combination outcomes. The blend of value and momentum can be improved through well-defined pricing techniques.