A difference between theory and practice

The historian will tell you what happened. The novelist will tell you what it felt like. 

- E. L. Doctorow

Academics will tell you what happened to generate returns in finance, but the manager will have tell you the feel for how it is done.

There is difference between theory and practice. The academic research study that identifies an obvious new risk premium may be difficult or impossible to implement in practice. The good firm is able to separate theory and practice and avoid implementing bad ideas. They will have a feel for whether it can be done in practice.

An important part of any hedge fund due diligence is understanding the process of moving from theory and research to implementation. Some firms are good at it while others are not. Asking good questions is important to finding who is good at research implementation. Implementation processes should add realism to measure the success of new ideas. 

For example:

• How is research conducted to add realism?
• How is new research actually included in a portfolio? 
• How are changes in existing models addressed? 
• How are new research ideas sized relative to existing strategies? 
• How are new ideas traded in different market situations? 
• How is liquidity for a new strategy addressed? 
• How does a manager address crises or extreme events with a new strategy? 
• How are the experiences and unique situations faced by the manger employed within strategies? 

A good trader or portfolio manager may not be the best at measuring statistical relationships, but they should be good at addressing the intangible issues of market dynamics in order to implement research and size risks.

Networks and plumbing - The mechanics of systemic risk

Behind the backdrop of the vast changes in monetary policy over the post Financial Crisis period has been the movement to improve the regulatory environment for financial markets in order to reduce systemic risk. Significant work has been done to improve monitoring and rules to eliminate excessive speculative behavior, but as more regulations are proposed and more changes to the financial system are made, there is demising marginal benefit and a greater likelihood for unintended consequences. A rule that makes sense for one group may lead to a shift in risk capital and changes in behavior toward unregulated areas.  Simply put, risky behavior will shift to the places where the cost of speculative behavior is least. 

Money and credit will always seek the lowest cost environment. The micro dynamics of markets where there are different players seeking to reach various objectives is all the more critical when thinking about crises, liquidity, regulation, and pricing. The microstructure of markets matters and the behavior of players toward changes in the "rules of the game" is important. In an older school of thought, this would be called market structure or industrial organization. In the current environment, we can relate this market networks.

Given a focus on the financial behavior of agents, there has been more research on the interaction or connectedness of players within the financial environment.  The economics of networks is an important advancement on our thinking of markets work and how market agents or players interact to changes in the environment. 

If you believe that markets are efficient, then the behavior of players in a network may not matter. If you believe information comes from disparate sources both exogenous (from economic policy announcements and data releases) and endogenous (based on the players in the market, hedgers or speculators), then the network and connectedness of player matter. More importantly, if the costs for trading change for agents in the network, the connectedness of players will change. The efficiency of the market is based on the interaction of dealers, traders, and hedgers.

The network approach will suggest that regulations that change the cost of trading or place restrictions on traders will impact the efficiency of markets. If the cost of trading is higher, arbitrage may be more expensive and there will be more market frictions. Price relationships will change with the relative expenses of trading. 

A network view of market behavior will focus on structural changes that will affect the flows of information and capital through the network. Systemic risks will change with the blending of the network. The systematic risks of yesterday will be different today when you change the costs to players in the network.  Follow the transaction, regulatory, and capital costs to determine the changes of risks within the network. Then follow the money through the network. The simple answer is that the systematic risks today will be different than from 2008 because the network of trading has changed.

Global Macro in one page - Forget the noise and watch the numbers

As a more quantitative focused analyst, I keep focus one thing - the numbers. Stories are good, but numbers are better. At best stories, provide context for numbers, but stories of politics will not lead to market trends. Capital flows on trends in profits, growth, liquidity, and risk. Do not suffer from "shiny object" syndrome. The news of today may not impact the important fundamental trends.

The stories and themes for this month are similar to the last few. An investor has to address three questions. What is happening to global growth and is there a rotation in capital? What is the impact of potential liquidity changes from central banks? Will there be actual fiscal stimulus that can ignite growth and profits? Focus on these three to determine any changes in portfolio construction.

Sector behavior consistent with economic story but wider dispersion

While large cap and international stocks continued to move higher, the markets are starting to see more dispersion with small cap, growth, and value indices all posting negative returns for the month. The Russell value index has fallen to negative returns for the year. A growing dispersion is also evident in sector and country returns. Bonds have been a safe asset with positive gains for the year across all sectors. The returns are consistent with slow but positive growth around the world with controlled inflation.

With oil prices moving lower, the energy sector had a strong May decline and is negative on the year. The finance sector also declined in May while technology has moved to well above 15% for the year. Investors are being rewarded for making sector bets. 

Country equity indices mostly reported strong gains for the month and generally have done much better than the US, albeit over 5 percent of the move may be associated with currency moves. Commodity-driven countries showed poorer performance this year.

While the gains have not be strong for the month or the year, bond sectors are all positive for the year. The only negative sector for the month was TIPS given the decline in inflation and forward expectations. Our trend and breakout indicators are all showing that bonds are a buy for any portfolio.