Tuesday, December 18, 2018

Yield Curve Inversion Hysteria - Give It A Rest

Everything you have heard about yield curve inversion is true; nevertheless, everything that is true may not harm your investments. Yield curve inversion is a good predictor of recession, and there is a link between this inversion, recession prediction, and equity declines. However, being the first to react to flattening or inversion may not win you portfolio success. 

The important question is determining what the inversion signal represents between current and longer-term expectations. In simple terms, short rates tell us something about current Fed policy, current expected inflation and current economic growth. Longer rates tell us something about Fed policy, expected inflation, and current economic growth, but over longer horizons. 

Hence, after accounting for any term premium, the steepness or inversion of the yield curve tells us something about relative expectations, no more or no less. A greater yield slope slope translates to greater divergence between short and longer-term expectations. An investor just has to ask the simple question, "Do I agree with the relative expectations in the curve?" Given what the market is telling you, the next question is whether you should act on this view today. An inversion in this framework should be view dispassionately.


Yield Curve Impact on Asset Prices - Evidence Does Not Provide Simple 

Monday, December 17, 2018

Risk factors and risk premia - Not the same thing

There is a difference between risk factors and risk premia. This may be viewed as a subtle distinction, but it is important to think about the differences. Factors explain the return attributes of an asset. Those attributes may be either style or macroeconomic factors. Factors provide a description of what drives returns. A risk premium is what an investor receives for taking-on the risk associated with a factor. A risk premium is compensation for non-diversified risk which can come in the form of a style or a macro factor. A factor is a measurement of a characteristic. A premium is compensation for holding a characteristic. Investors want to be paid a premium for a persistent repeatable factor.

Time Varying Alternative Risk Premia - Do You Want To Be Active Or Passive?

A big issue with building an alternative risk premia portfolio is whether you believe that it should be actively managed or whether it should just be a passive diversified portfolio. This is a variation of the old issue of whether there is investment skill with predicting returns. Investment skill is not just isolated to security selection but also can be applied to style rotation just like asset allocation decisions. 

Passive, however, may not mean there is no investment action. Passive portfolio management may include rebalancing and resetting allocations based on a criteria such as risk parity or equal risk contribution. This passive investment is based on the assumption that investors do not have skill at determining expected return, but there is value or skill in managing volatility and covariance.

Active management would represent changing the choice of ARP styles or weights based on some set of predictive factors of return. The active question revolves around the issue of whether risk premia are time varying in a systematic fashion. To answer this question requires a classification of risk premia based on their characteristics and whether those characteristics are predictive.

Risk premia have sometimes been classified in two forms: those associated with compensation associated with the aversion to a specific risk and those that are associated with investor behavior. In the case of risk aversion, the alternative risk premia will include value, carry, and volatility. Investors are paid to hold a specific risk that may be tied to the business cycle or market risk. Those premia associated with behavior will include momentum or trend, and defensive styles.  Investors are paid as compensation for what may be the "bad" behavior of investors. 

There are some premia that are structural and independent of any cyclical factors and others that are time varying and have a relationship with some cyclical factors. We would expect that premia that are driven by risk aversion will vary with changes in perceived risk that needs to be compensated. Premia associated with behavior will change with the environmental uncertainty that causes biases away from rationality. Overall, some premia styles should be more predictable than others.

Some will argue that even if these factors vary over time, it is not possible to make active decisions on when to hold or exit these premia. These investors would argue for passive portfolios that are rebalanced by risk. Others will argue that there is enough information to make these allocation judgments. They would focus on rebalancing methodologies with the potential for risk premia tilts. 

We believe that risk premia prediction is difficult and should be done carefully but there are periods when the odds for performance will be stacked against a specific risk premia style. Measuring and tracking this performance behavior should be rewarded.

Sunday, December 16, 2018

Bear markets - Not unusual, but hard to predict, so stay diversified

Everyone talks about bear markets; however, it is surprising that this downturn definition is so arbitrary. Commentators are somewhat cavalier with their discussion of bear markets. It is a down move of 20% from a high price point. A correction is a down move of 10%. A bear definition could be applied to a individual  asset, a sector, or an asset class. 

Bear markets do occur on a regular basis but there is little clarity on the cause. Bear markets have been associated with recessions, although stock markets usually decline before the dating of a recession. They have also been tied to central bank tightening shocks, but tightening is also tied to recessions. Bear markets are usually worse when there are high equity valuations. Commodity price shocks may generate a bear market and are also associated with recessions. There is a clear change in sentiment when the market perceives a bear environment; however, negative sentiment may just be the outgrowth of the market decline. 

The only way to protect from a bear market is to ensure that you have a diversified portfolio with assets that are fundamentally uncorrelated with equity markets. Diversification across equities will only provide limited protection. Protection comes from holding unique asset classes or alternative investments that are not sensitive to the market risk factor.