Factor returns - Expected patterns in an unexpected world?

For all of the craziness of the last month, it may be good to step back and think about whether markets on a relative basis have been behaving as expected. Did risky investments lose more to a common shock? Did safer investments perform better relative to a benchmark? We cannot make complete judgments, but we should expect sanity even when there is a significant surprise.

A review of the factor returns shows factor returns that follow expected patterns. Quality firms performed better. Pure value and high beta showed significantly worse performance. The only real surprise may be a high dividend portfolio; however, if investors expect a cash crunch will require dividend cuts and government money may be conditional on an end to dividends and buybacks, this makes sense. 

Absolute returns may be surprised by a shock, but relative performance may still follow rational patterns.

How much diversification should you have expected from hedge funds?

What returns should have been expected from hedge funds during March? There was a wide range of performance across styles. Systematic CTAs generated positive returns and beat all alternatives while emerging markets and fundamental growth indices did worse than the benchmark equity index (SPY). Most hedge fund indices underperformed relative to the Bloomberg/Barclays Agg bond index (AGG). 

Given that most hedge funds have equity betas that are between .3 and .7, the average performance numbers from the HFR liquid indices are somewhat consistent with a quantitative estimate, albeit not what investors may have expected. 

Feynman Learning Technique - This can be applied to investing

Richard Feynman, the great physicist, was known for using a simple learning technique which can be usefully applied to any investment issue, or in the present time, learning how to be an amateur epidemiologist. (Hat tip to Farnam Street Brain Food #361 for reminding me of the Feynman technique.) It is a simple four step rule: 

1. Pick the topic you want to learn.

2. Figure out how to explain this to someone in the sixth grade. (Ok, we can switch this to a 14-year old if it involves more math.)

3. Identify gaps in your explanation and go back to the source material to learn more.

4. Review and simplify, use clearly understood words and eliminate jargon. Repeat steps 2 and 3 if necessary.

There is no better way to learn something than to teach it to someone else. I might add that you should have to explain both the pros and cons of an idea if is supposed to be knowledge that is being put to use and have some risk. 

This simple learning technique can be applied to any finance concept. Can you explain the idea to someone in the sixth grade? Full stop. If they cannot understand it, there is something wrong. You can always get more complex and go into further detail but start with the simple standard.

All the troubles with investment strategies start with the fact that many investors do not know what they have bought. Would we have problems with risk parity if you had to explain it to a sixth grader? Look at any tech firm. Can you explain its reason for being to a sixth grader? Can you explain Fed policy to a sixth grader? Some of these explanations can be a challenge but isn't that the point of this learning technique.

Feynman also discussed the difference between knowing the name of something and knowing something. Everyone can learn to spout facts. Not everyone can claim understanding of those facts. Unfortunately, learning takes work and time. You cannot be an expert at everything even though you may know the name for almost everything.

Behavior from common factor shock following expected pattern

"These markets are crazy!" How many times have you heard that phrase over the last month? I have tried to ban it from any discussion. Markets  have not been crazy in the sense of behaving as expected when faced with a large common factor risk shock. Markets are constantly moving up and down but most of that movement is associated with idiosyncratic risks that can be diversified. There are long-run factors like the business cycle which will drive market returns through time, but there are few sharp common factor shocks that will impact all markets. The COVID19 pandemic is one of those common factor shocks. 

When there is a strong negative common factor shock, we should expect three things: 

1. An increase in volatility that is related to commonality, intensity, and level of surprise. If the shock has more uncertainty on how it will affect the economy and firms, volatility will see a non-linear increase.

2. Correlations will increase to one. Diversification benefits will collapse.

3. Market dispersion will increase. This is not counter intuitive versus correlation increasing. All stocks may go down, but lower quality firms may be hurt more. 

Small comfort, but this is what we have seen in March. The return pattern is consistent with other negative common factor shocks. You can be surprised by the intensity, but you should not be surprised by these second order statistics as evidenced with stocks in the major equity indices.

What should we expect next?  Usually common factor shocks will see a slow decay in volatility which will last longer than the initial spike. The same decay effect will be seen with correlation and dispersion. These patterns may be more consistent than returns.