Crypto correlation - no clear relationship with hedge funds and equities

 

Cryptocurrencies and crypto hedge funds have a return performance life independent of other asset classes and strategies. This is one of their clear benefits but also the reason for why many investors have a problem with crypto. It is not clear what are the drivers for return. Certainly, crypto has moved higher with the stock market and has gained from the excess liquidity across global markets; however, finding independent drivers for price has not been easy.  Some simple analysis from FactorResearch tells the story. 

The correlation between crypto hedge funds, the S&P 500 and the top 50 hedge fund index shows both negative and positive correlation over the last six years. The correlation has ranged between -.6 and .8 with more recent numbers again closing in on zero. 

However, the returns for crypto hedge funds seem to be driven by Bitcoin beta. These hedge funds have the feel of long-only investments with limited downside protection. 

Applying known investment strategies to crypto asset makes sense, but it cannot be expected to have the same return patterns.

The continued search for yield - You cannot have everything

 

I’ve never heard such a chorus of repeated phrases such as “fixed income replacement” and the “new 40.”  - John Bowman CAIA comments at Miami hedge fund conferences

The drumbeat continues for changes in the 40% of the classic 60/40 stock/bond mix. Dump the fixed income and get some alternative investments. This alternative theme has been around for years but has increased in intensity - don't think of hedge funds as high-performance strategies but as substitutes for the low performance bond portion of an asset allocation. 

Some have taken this anti-bond view to an extreme, see "Endowments and equity factor - Just too much exposure?", yet there is still an inertia with many concerning fixed income. It has been a good hedge and many think it will continue to be a good hedge. The facts suggest otherwise as the stock/bond correlation has turned positive.

The problem is that investors cannot have everything with their fixed income. Real rates are negative and there is little near-term improvement. Inflation may revert from current highs, but without a significant increase in nominal yields, real yields especially for short maturities will be unattractive. 

A combination of low yields, negative returns, and a positive correlation to stocks make alternatives much more attractive, but there still needs to be a focus on the switching of risks. 

Hedge funds need to show positive real returns if they are to be an effective alternative. Right now, there is a five percent inflation hurdle for alternatives. This seems like an easy threshold to beat; however, alternatives still must deliver. If there needs to be a real return as compensation for risk, the nominal returns should be well north of the 5% level. 

Fixed income Treasuries are usually a liquid investment. That assumption has been tested in March 2020, but generally it still holds. Moving to alternative investments will have a liquidity cost that needs compensation.

By most definitions, moving out of Treasuries or liquid bonds will require taken on more volatility and increase investor risk. Anything other than Treasuries will require taking credit risk. 

There is a continued search for yield, but investors should not just look for close substitutes. The search for yield must include appropriate compensation for risk and liquidity.

Equity duration and the current sell-off - all about timing and discounting cash flows

 

There has been some compelling research work that focuses on the timing of equity cash flows, or equity duration, to explain some of the recent movement in cross-sectional stock behavior. The basic investment idea is that the concept of bond duration can be applied to equity cash flow timing. If cash flows are backloaded, an equity will have a longer duration from stocks that have cash flows more certain and clearly defined in the near-term. The implications are clear from the classic formula for duration which accounts for the timing of cash flows. 

The equity that has longer duration will be more sensitive to changes in the discount rate and changes in the distant cash flows. Hence, if there are rising rates, these equities will see a greater negative impact. Of course, these stocks have benefitted more from low rates in the post GFC period and during the most recent decline in rates.  (See "Equity Duration" for a recent example. The equity duration idea has been kicking arounds for more than two decades but has recently been given new focus.) Nevertheless, there is compelling evidence that low duration stocks should do better than long duration stocks.

Determining the timing of cash flows for equities is not an easy problem. Equity duration can be measured through several unique but justifiable models: cash flows, growth forecasts, and bond-beta approaches. It certainly is more difficult than any calculation of a bond's duration where the cash flows are well-defined. The idea of an equity duration can be contrasted with other risk factors, but the true value comes from the primal nature of focusing on cash flows. 

Equity duration can account for the wild swings in price of growth stocks that will be affected by expectations of long-term cash flows. Long duration will be more sensitive to cash flows volatility and changes in the business cycle and will be more susceptible to stock mispricing.

The low duration stocks have the same characteristics as value, high profitability, low investment, and low risk stocks; however, the link between duration and value is not one for one. Both have value for measuring differences in stock risk.

Equity duration is intuitive and can provide another way to look at factor risks that are helpful with explaining some of the differences cross-sectional stock behavior.

Factor performance in bull and bear markets - Diversification in bear market is valuable

 

Consumption-based models predict that risk factors should be less profitable in bear markets than in bull markets; however, recent research shows that value (HML), profitability (RMW), investment (CMA), and momentum (UMD) factors are more profitable in bear markets than in bull markets. The size (SMB) and market (MKTRF) factors show the expected performance in bear markets. (See "Where is the risk in risk factors?".)

A risk factor may proxy for a consumption state and generate lower returns in a bad state. A lower return in a bad state requires a premium to be held. This research shows better returns in a bad state and low returns in a good state.

This strong behavior in bear markets has important implication for portfolio construction and asset allocation to factors. The poorer performance during the market recovery after the GFC is also given some better context. The long recovery was not good for factor risk versus market exposure.

The authors find that equity cash flow duration can explain this bear market behavior for the value, profitability, and investment factors and to a lesser extent momentum. Financial constraints can explain the profitability factor in bear markets. Constraints and duration are more important for those risk factors that seem to be more cash flow dependent.

Factor diversification can add value especially when the market turns bearish.