Market focus has been on stress and uncertainty not fundamentals - This will change in May

Macro fundamentals are important but changes in many these economic data over the short run will unlikely explain a large portion of the variation in asset prices over the last sixty days. Changes in risk and uncertainty have had greater impact on markets. The reversal in these risk and uncertainty measures may have been the key performance driver last month, but that will change as the focus moves to the lockdown reversal logistics. 

Take a look at some of the variables that drive risk perception (risk-on/risk-off thinking) versus the real economy. These variables seem to have had a greater impact on return for April. The real economic continued to slide lower in April.

The VIX spike peaked in March and is on a steady decay. Volatility is still high by any measure versus most of the post-GFC periods but there is a move to normalization. The Fed financial stress is still above the average score, but is also normalizing. The Chicago Fed financial conditions index is following the same pattern as the stress index. Equity and policy news indices are still high but have peaked or are stable. 

There were overshoots with many of these variables. These overshoots have been reversed by the large infusion of new money from Fed, but now the focus will be on earnings and cash generation. 

Manager alpha and manager selection alpha - Two different investment skills

Is there such a thing as selection skill? If there is manager skill at identifying opportunities, there is also investor skill at identifying good managers. Both can represent alpha, but the skills are different. Managers produce alpha. Investors identify alpha.

Some investors are better at choosing managers than others. Other investors may be poorer alpha selectors but better portfolio builders. Manager choice may be more involved than just measuring alpha. Is there a good way to describe that skill beyond simple attribution?  

All the focus is on measuring alpha for a manager, but investors have to find and allocate to these managers based on how they may fit within a portfolio. Manager selection is a different skill than picking stocks. It is macro portfolio focused not security focused. 

The due diligence analysis for a manager is similar but not the same as picking a good portfolio of stocks. This difference can be formed as a question. Could an analyst that can identify alpha investment opportunities easily transfer those skills to picking managers and could a good manager picker make a good investment analyst? It seems like that these skills are transferable, but this similarity should not be viewed as a given.

Attribution and performance analysis of pension funds and investors can measure skill at building a portfolio. You are a good investor because your choices generated alpha versus a benchmark, but investor skill is more than the sum of manager alpha choices. Investor skill is also about asset allocation and manager fit - the bundling of managers to create a portfolio. 

Investors have the added issue of choosing between active and passive (benchmark) investments. Their skill may include not playing the game of manager selection. Additionally, investors have the added burden of having to build a portfolio across all asset classes. Lower alpha in the right asset class may be more valuable than more alpha in the wrong asset class. 

Picking managers and building an investor portfolio has a different skill set than manager skill. It is important to recognize the difference in investment skills before there is an attempt to pass judgment how portfolio performance. 

Trend-following managers - Paid to be with the crowd?

A quick look at CTAs for the first quarter show wide dispersion across managers. Nothing like a little volatility to separate the performance of managers, yet there is an interesting research piece from last year that generated some counter-intuitive results for CTAs. Following the momentum factor crowd actually generates better performance than trying to be different within the CTA space. (See "When it pays to follow the crowd: Strategy conformity and CTA performance") 

The general view, backed by empirical tests, is that hedge fund uniqueness translates into higher returns. Managers who do not move with the crowd show better returns as measured by low R-squared with benchmarks, low correlation with peers, or high SDI (strategy distinctiveness index). The SDI is equal to 1 - correlation(ret(i),ret(cluster)). Those hedge funds who make more or greater idiosyncratic bets show higher skill and returns. 

The authors of "strategy conformity and CTA performance" test whether this hypothesis also applies to CTAs. It should be expected that they will follow the same pattern as other hedge funds. Since CTAs are usually trend-followers, it would be natural to analyze distinctiveness versus a momentum factor benchmark. This paper's empirical analysis shows a different conclusion than normal. Those managers that have more uniqueness underperform in general. CTAs that have low (high) SDI also have high (low) time series momentum beta. 

Note the high average return, Sharpe ratio, and alpha for low SDI firms. These returns persist over time, so the cumulative effect is large. Those firms that have low SDI have a high time series momentum beta while the more unique managers do not have any beta with momentum.

CTAs in the low SDI quintile have high positive returns when momentum is up and negative returns when momentum is down. There is a minimal momentum effect in the high SDI group.

The CTAs that do not follow the crowd or follow the time series momentum factor are not rewarded for their uniqueness. Momentum seems more prevalent in active futures markets, so trying to exploit other factors is for many managers a loser's game. This has proved to be the case during the strong market dislocations in the first quarter of 2020.  

Equities signal recovery is underway - Where is the recovery?

Equities are forward-looking and discount future earnings. They will peak and reverse before the real economic numbers. The large April return reversal, up 12.8 percent for the month, is sending a message of optimism that seems premature. There is no national agreement on reversing the Great Lockdown. A state by state opening will ensure that any reversal will not be a single step process but a gradual stair step process. Confidence is down. Investment is down. Consumer spending is down. Unemployment is expected to hit 16 percent with the next report. All of these economic declines have generally been greater than anticipated by the market forecasts.

What is driving equities are the non-real measures that drive markets. Volatility is declining. Financial stress as measured by the Fed bank stress indices is falling. Economic policy and equity market uncertainty as measured by news indices have stabilized or are falling. The Chicago Fed financial conditions index has improved from highs in March. These numbers indicate room for optimism.

While earnings have been reported for the first quarter, they show only a partial impact from COVID-19, so it is hard to tell what the rest of 2020 will look like. The full impact of the lockdown will not show in the numbers until July. We have to rely on investor optimism over current real data pessimism if this rally is to continue.