Wednesday, August 15, 2018

Rivals take more risks - Is this a good thing for money management?

You might think some research is obvious after the fact, but in reality, good research can allow us to deepen our understanding on a topic and may provide subtle insights that were unexpected. One topic of interest is competition and rivalry.

Recent work finds that when there is competition between rivals there will be more risk-taking. See "Research: We Take More Risks When We Compete Against Rivals" in the Harvard Business Review. The idea that you can pit employees within a firm against a rival to get better work will actually lead to greater risk-taking. The same can be said for those who form rivalries with other firms. It may motivate people to work harder, but there will be the unintended result of greater risk-taking.

The researchers from the article study this problem in a number of novel ways. For example, they look at risky play calling in football between rivals. They track the incidence of two-point conversions after a touchdown or not punting on fourth down. Both are more likely when playing a rival team. They also created experiments in card playing where other players wore rival sportswear to see if risk-taking increased when playing against perceived rivals. It did. 

There is less prevention focus, avoidance of negative outcomes,  and more promotion focus, reaching for ideal outcomes when playing against rivals. We all know that the hedge fund and only management business is competitive and there are rivalries between firms and individuals. Any time spent in New York will tell you money manager not only want to win but beat their perceived rivals. (Perhaps this is why managing assets outside of New York is a good thing.) Most managers cannot help themselves, but if rivalries are not controlled there can be excessive risk-taking solely related to this competition. In competitive bidding like private equity, rivalries will cause excesses and the "winner's curse". Again, emotions can be the enemy of a money manager.

Risk management, the quantitative measure of risk-taking, is necessary to stop the excesses of rivalry. If risk can be measured, the emotional bias and baggage can be limited. Discipline will trump emotions.

  • Tuesday, August 14, 2018

    Carry alternative risk premiums tied to macro market relationships

    The returns of alternative risk premium strategies and products developed by banks and investment managers will have close links with the underlying macro relationships that are modeled. In the case of credit carry risk premiums, investors will gain from the difference between high yield and investment grade spreads. In the case of rate carry risk premiums, returns will be tied to the term premium in the yield curve. 

    The credit carry HFR alternative risk index shows the strong returns generated since the end of the Financial Crisis. The rate carry risk premium shows positive gains albeit lower than credit carry.

    There has been a general decline in the spread between high yield and investment grade corporates since the Financial Crisis. There has been significant gains from carry positions in credit risk premium products since the high reach at the height of the crisis. There have also been gains in holding term premium in Treasuries since the Financial Crisis, but these gains have been more limited because the spread and change in the term premium has been less. 

    There has been a close relationship between the change in spreads and returns with the HFR carry risk premium indices. This exists for both credit and rates.

    There has been a view that investors should build diversified portfolio of risk premiums because you don't know where returns will be generated. Investors should hold carry, value, momentum, and volatility across all asset classes because this will give you the best risk-adjusted returns. This is a sound strategy, but we actually know a lot about the behavior of some risk premiums and this will help with building any portfolio.

    For example, credit carry will not be as attractive for the simple reason that as the spread between high yield and investment grade debt close, there will be less carry opportunity. The same can be said for rate or term premium carry trades. These carry spreads will change with the business cycle, so that as we move from recession to recovery and onto expansion there will be a change in the return opportunity set. The returns will be time varying but will be tied to business cycle performance. Hence, the strong returns associated with the performance of credit carry strategies will unlikely continue. Similarly, as the term premium (yield curve) flattens, there will be less return opportunity for rate carry. 

    A diversified strategy of holding different style risk premium makes perfect sense, but our knowledge about the relative and absolute performance of these strategies that can help with determining any portfolio mix.

    Monday, August 13, 2018

    Graphs worth thinking about for the week - Volatility, uncertainty, and contagion

    Volatility has fallen since the February vol-shock, but the vol-of-vol shock paints a deeper picture of the calm that has overtaken the equity markets. This same behavior is seen in other asset classes. Given the combination of geopolitical risks, economic uncertainty, and policy changes, should we expect this level of calm? It seems unlikely.

    The Turkey debt-currency crisis takes us back to the old policy problems of the 90's. Turkey is bigger and more closely aligned with the EU than some other EM countries that have had currency problems over the last decade, so the chance for a contagion is greater. This contagion effect is more likely if you look at bank exposures to Turkey. While a direct spill-over to other emerging markets is less imminent, expectations may change and reduce lending to other countries. This can be result in an EM liquidity shortage.

    While real rates are higher for many countries, the problem is whether DM banks will lend dollars to these countries and what will be the roll-over cost of existing dollar debt. 

    The equity rally is reaching old age and the business cycle has also aged and seems to be reaching a number of highs, but the real GDP gap is still significant. The cost of the Financial Crisis is still being felt in the GDP numbers. Nevertheless, the old adage applies; business and financial cycles don't die of old age, they are murdered by bad policy choices or a surprise shock. 

    The short-term link between policy uncertainty, economic data, and financial markets seems to be highly variable, but China policy uncertainty has not dampened but is actually on the rise. The China stock market reflects this uncertainty, but the rest of the world still does not seem to focus on the true impact of China on global financial markets.

    Investors are voting with their dollars. Markets are efficient albeit perhaps not as quickly as many would expect. Active managers have underperformed at higher fees and investors have concluded that this is unacceptable. 

    Saturday, August 11, 2018

    Alternative risk premium versus bonds - A choice of factor risks and diversification

    Investors want diversification from their equity exposure. This desire for diversification increases with uncertainty and with expectations of an equity decline. The big question is how or where are you going to get this diversification. The diversification winner for the post Financial Crisis period has been simple, US bonds. Bonds have been an asset that generated a good rate of return with lower volatility and a negative correlation with equities.  You could not ask for a better diversifier. Unfortunately, the investment environment is changing and the benefits from bonds may no longer be available, so there is an increased desire to find new diversifiers. 

    An effective alternative diversifier could be a portfolio of alternative style risk premiums. No investor should divest all of their bond exposure, but alternative risk premium (ARP) strategies may offer a different form of diversification safety. 

    Think about the cause of the core bond diversification boost. Bonds benefited from low inflation, declining risk premium, and central banks that wanted to push rates lower. This combination led to good returns that were uncorrelated with equities. Now inflation is higher, central banks are implementing or contemplating QT policies, and risk premia are expected to rise. The underlying bond factor environment is less favorable. 

    Diversification going forward can be achieved holding alternative risk premia across momentum, carry, value, and volatility to name a few. These alternative risk premiums can be executed through swaps which can be done as an overlay on bonds. 

    Will these style premiums perform better than bonds? It is not clear and looking at past performance may not provide a perfect answers. What we do know is that an investment in a style risk premium will be by definition uncorrelated with market betas. Investors would be switching the risk factors driving returns and that can help if market beta risk is a concern.