Fama-French factors and economic drivers - Watch macro

 

The Fama-French factors have been used extensively to describe any set of returns; however, further work is needed to explain the economic drivers behind these factors. The paper "Understanding Asset Pricing Factors" takes a novel approach to analyzing the connection between economic events and factor moves. The authors analyze days with significant factor returns and then classify them by linking them to new articles the following day. Macroeconomic news, monetary policy, and corporate earnings reports are the main drivers of returns for factors, as should be expected. 

The Fama-French factors include four major factors beyond market risk: SMB (small minus big size effect), HML (high minus low value effect), RMW (robust minus weak profitability effect), and CMA (conservative minus aggressive investment effect). It is found that HML value premium is related to the macro factor. CMA is related to the commodity factor. SMB is correlated with the exchange rate factor and the unknown factor. RMW is related to shocks in individual companies. The authors use AI and human coders to classify news events that were tied to the FF risk factors.  

The categorization shows that humans and AI do a similar job and there is a clear distinction between the events that drive factor returns. Unsurprisingly, macro is the dominant driver of large moves. This resurrects the issue that even equity investors who may focus on factors RV should follow what is happening in the macroeconomy.

Trend-following returns during S&P 500 drawdowns are not all the same

We are learning more about the qualities of trend-following as a hedge or safe asset. A hedge asset is one with low correlation to a risky asset. A safe asset has low correlation overall, but will have a negative correlation during a drawdown for a traditional risky asset. Trend-following will have the characteristics of a safe asset, but only if an extended drawdown exists. If there is a short-term drawdown, it is less likely that trend-following will generate the desired return pattern. This is a key risk of holding a trend-following manager.

There may be some diversification gains, but a safety effect may not exist. We have seen Treasury yields during the current crisis, so it is hard to say whether there is a true safe asset. Therefore, it may make sense to return to first principles. A safe strategy is one that can hold either long or short positions and adjust those positions based on the direction of trends. It is not a structural safe asset but a behavioral safe asset based on the dynamic actions of market participants. 

 

Trend-follower dispersion in return performance

SG Prime Serves has provided their assessment of trend-following managers over the past 25 years since the inception of their index. There is dispersion in performance, which should be expected since there are many variations in trend-following. The trend indicator, a simple trend model for comparison, shows that the correlation between managers and a generic fund will deviate when there is a strong macro event.

The data suggests that holding just one manager may not be optimal and that a portfolio will reduce the potential for regret. Now, is there a correct number of managers to hold? That is a more difficult question. One is too low, yet 6 may be too many if the trend allocation for an overall portfolio is 2%. That said, a large pension may want to include a trend index and then add some satellite managers who have specialized skills. 

 

Get your financial stylized facts right - The Bayesian foundation for empricial finance

Economists and financial professionals often use the term "stylized facts" as an alternative to a set of descriptive statistics or just data. Formally,  a stylized fact can be a simplified representation or an empirical regularity that serves as the foundation for building theory. It may not be a simple piece of information, but a formal empirical regularity. In a recent paper, "International Financial Markets Through 150 Years: Evaluating Stylized Facts", the authors test a set of well-known stylized facts across a broad set of markets and a long time. This is the most exhaustive analysis of well-known stylized facts ever undertaken. We will not present all of the findings, but will show the summary table of what was tested.

Why is this so important? The stylized facts should be thought of as the Bayesian prior for any future analysis. Start with the stylized facts of what should appear in the data. You should not find something different, but you should argue that this is the basis for any future work. Before you pass judgment on a theory or set of data, look for the stylzied facts that already exist.