Barclays hedge fund survey and COVID19

How did hedge fund do during the COVID19 scare?  A simple way to analyze their performance is through a quick comparison for the first quarter of 2020. The numbers from Barclays Investment Bank suggest that their performance was consistent with past events like the Eurozone Crisis, the 2015-16 correction, and the 2018:4 periods. Hedge funds are not immune to market declines but will have a muted response. In this case, the MSCI world index declined 21.1% but the HFRX declined 8.2% or 39% of the equity decline. A similar comparison can be done for bear markets. Hedge funds offer lower volatility and market exposure. The numbers do not tell a story of absolute return but muted returns.

A quick survey look reported in May shows that investors have a desire for more long only equity, less fixed income and more balanced expected exposure in hedge funds and illiquid alternatives relative to last year. 

These survey numbers are consistent with the market moves we have seen over the last two months. Hedging and diversification are out, and market exposure is in. 

Turning points kill trend-following performance

Markets trend higher and trend-followers should make money. Markets trend lower and trend-followers should make money. The transitions or turning points are the problem. There will be periods of giveback and execution delay while the new trend signals are found. If there are more turning points or reversals, returns will suffer. This enemy of trend-followers is all well-know, but a new paper documents the cost of turning points. See "Breaking Bad Trends" by the researchers at Research Affiliates and Campbell Harvey of Duke University. The elegance of this paper is with its simplicity. 

The return impact of turning points is devastating for exploiting trends. Using a simple approach of comparing 12-month to 1-month return direction as an indicator of a turning points, the researchers find that as the number of turning points per asset increase the performance from a trend strategy declines. When the number of turning points for an asset reaches six within a year, the median Sharpe ratio falls below zero. This is intuitive but can be used as a good starting point to explain why trend-followers may lose money.  

The second graph shows the portfolio performance versus a weighted average number of asset turning points per year. There is a negative linear relationship between portfolio returns and turning points by year. The more recent periods have shown more turning points, on average, for markets. This performance pattern is similar to what has been found with trend-following managers. Asset turning points have become more frequent in spite of the fact that many markets have become less volatile in the post-GFC period. 

Their final graph is surprising. The static trend strategy seems to be independent of volatility. If you believe this graph, the work was done carefully and well-documented, the idea that trend following is a long volatility strategy is called into question. It does not matter what is the volatility environment. The turning points matter more.

The switching between long and short momentum trends has increased in recent times and has an appreciable impact on static trend-following. The paper offers further analysis on how to adapt to turning points through a dynamic approach to adjusting to changing trends. This is a fruitful area for further research. The challenge for trend followers is to find ways to adapt to these turning points. In fact, investors should spend less time on how trends or found but how managers adapt to the turning points.

Understanding the financial cycle - Look for where risks will materialize

The researchers at the Bank of International Settlements (BIS) have spent a lot of time developing the concept of the domestic and global financial cycle. This work has advanced our understanding of capital flows around the world.(See, for example, "Global and domestic financial cycles: variations on a theme", "A tale of two financial cycles: domestic and global", "How important is the Global Financial Cycle? Evidence from capital flows") 

I want to focus on what is a key concept of this work, the idea that risk across the financial cycle is not high or low but is rising and then materializing. The materializing of risk leads to changes in behavior which will cause the turning points in the financial cycle. While this distinction may be viewed as subtle, it is critical for investors who want to be prepared for swings in the financial cycle.

Whether a domestic or global financial cycle, changes in the financial environment are manifested through the flow of capital to risk-taking ventures. Excessive capital flows can occur when there is greater credit availability for risk taking above what is necessary to support economic growth. Credit allows for higher leverage and generates increases in collateral prices as asset valuations increase. Risks will build given the availability of cheap money, higher leverage, and increased valuations. 

Investors need to focus attention on those places where risks will materialize. This is not a function of looking at macro variables but studying specific markets which will be affected by capital flows and overvaluations. Macro risks are the summation of increases in the risks of individual market sectors. Investors who want to make money need to analyze the micro flows and how they will be affected if there is a macro catalyst. This could be at the country level, a domestic financial cycle, or at the global level, when capital is cheap across all countries.

The amplitude of the financial cycles has gotten higher because the Fed and other central banks have fueled credit expansions. When risks have materialized, which would have created market retrenchment and risk avoidance, central banks have furthered the credit expansion to stop the adjustment process. Macro-prudential and regulatory policies have been used as an offset to plug leverage problems while maintaining credit expansion. The post GFC period saw an increase in banking regulation to cut leverage excesses only to now have them appear in other market sectors, CLOs, cov-lite lending, and other forms of shadow banking. Cheap credit from the Fed fueled the global financial cycle and the great EM leverage increase. 

Volatility has fallen, yet this is not a measure for an investor's focus. Eyes should be on the risk builds and where they will materialize. Investor focus has to be on the largest beneficiaries of the great post GFC credit expansion and look how an adjustment will play-out given the current round of central bank stimulus. 

What is normal volatility for bond markets when the only major player is the Fed?

We use the CBOE MOVE index for 10-year Treasuries as a good measure for volatility expectations, similar to the VIX for equities. It is an option-based measure of market volatility expectations. The MOVE index in March reached levels last seen during the bond temper tantrum; however, these index numbers never reached the levels seen during the Great Financial Crisis. The spike was also lower than the bond jump in 2003. 

The MOVE volatility index is now lower than late 2018 and mid 2019 levels and currently does not suggest an abnormal market environment. The MOVE will increase on the latest unemployment numbers; however, can we really say the world is now normal given trillions of Fed purchases of Treasury debt and similar increases in Treasury issuance. 

As fast as the Treasury issues, the Fed buys and the private market participants are not the marginal buyers or sellers. What we can say is that a flood of central bank liquidity and large Fed purchases will dampen any change in expectations from private investors. There are only price information signals on central bank behavior, nothing more.