Saturday, May 18, 2019

Tiger 21 investors are getting defensive - Cash may not be king but certainly a prince

What is smart money doing?  It is often assumed that smart money is rich, and everyone wants to know what they are doing. Tiger 21 is a loose club or network of wealthy individuals who share investment idea. It is hard to say they represent the elusive smart money, but their allocation decisions provide some data on what is happening to wealthy portfolios. 

The Tiger 21 latest survey for the second quarter shows a relatively large increase in cash holdings from 10 to 12%. This is the highest level in years. Cash yields on Treasury bills are also at multi-year highs and the yield curve is slightly inverted so the cost of holding cash is low. 

Investors are acting rational. If there is a high degree of investor uncertainty and cash rates are attractive, increasing cash levels makes sense. If this allocation is representative what other smart money may be doing, demand for risky assets will decline. Without new money flows, it is harder for risk-on assets to move higher.

Friday, May 17, 2019

Changing the dynamics of enhanced cash - Switch from credit to alternative risk premia

Investors are always looking for ways to enhance cash returns - higher yield with liquidity and limited principal risk. The timing for using different enhanced cash techniques changes with market conditions. Widening the choice set through investing in alternative risk premia may be a way to meet enhanced cash goals without significantly increasing risk.

There are only a limited number of ways to generate enhanced cash returns: duration, term premium, roll and credit carry, and credit premia. An investor can move out the yield curve to take duration risk. This will help the potential total return but at the expense of higher volatility. The investor may move out the yield curve to capture the higher yields associated with the term premium. Roll carry is associated with buying longer duration debt instruments when the curve is downward sloping and capturing the gain from selling their bond at the lower yields at lower maturity. This is diminished if the yield curve is flat or inverted.  Finally, there are credit spreads as compensation for buying riskier debt. There is roll value as duration falls. Money market investors will increase their demand. 

At different times, these yield improvement propositions will be enhanced or diminished. A steep yield curve is a credit time for enhanced cash. Wide credit spreads are also a good time to move out the curve. Similarly, tight spreads and a flat curve is a better time for shortening duration in the front-end of the curve. 

Given the changing conditions for fixed income in front-end of the curve, it may make sense to determine when to breakout of traditional thinking and investing in other types of risk premia. There is a broad set of alternative risk premia across asset classes and styles. Investors can move beyond the rate curve and credit premia choice set. First, these other risk premia have low correlation with credit. Second, these alternative risk premia can be delivered through total return swaps. Hence, these risk premia can be an overlay against a Treasury portfolio. A credit portfolio is a combination of Treasuries plus credit spreads. An alternative risk premia portfolio is a combination of Treasuries plus alternative risk premia. The investor can choose the "spread" or alternative risk to Treasuries. The amount of downside risk can be adjusted based on types of risk premia and the level of exposure or leverage. 

Appreciating the value of diversification as choice improvement tool is a key principle of finance. Anytime there is in increase in the set of alternative opportunities there is improvement in the return to risk choices. Using risk premia beyond rates and credit can improve return opportunities. It may take investors out of their normal comfort zone, but it will help when traditional opportunities are limited.

Thursday, May 16, 2019

"The Emeril Lagrasse Theory" - Practical knowledge and culture is not often transferable

After hundreds of discussions with hedge fund managers, I am still surprised that there is a fear of revealing investment processes under the assumption that someone will steal their ideas and intellectual capital. There are few investment styles that are truly unique and special. What is special is still strategy execution - the practical process of delivering returns. Skill is with the decision-making execution of information and strategy.  

I often use the analogy of the cookbook written by a famous chef. Walk down the cooking aisle of any bookstore and you will see all of these books that explain in great detail the "secrets" of famous chefs. These cookbooks will tell you all of the ingredients. They will walk you through every step in the process. They will provide color pictures of what the dish should look like and will also provide pictures of intermediate steps. Why would these chefs give up their secrets? 

They provide transparency because they know that their practical knowledge cannot be replicated. The reader's attempt to replicate the meal often fail. Once readers see the complexity of the cooking process, they will often just go to the restaurant and enjoy their meal at a high price. Transparency creates value. We discussed this in our previous post -"Technical and practical knowledge - You need both for asset management"

Mike Lombardi in his book Gridiron Genius discusses "The Emeril Lagrasse Theory" as applied to coaching which is also applicable for money management. There are many who have studied and worked for a truly great coach like Bill Belichick or Bill Walsh, but they are often not able to replicate the success of the coaching mastermind. There are many who have studied with Emeril but have not replicated the quality of his cooking. They cannot replicate their mentor's practical knowledge, drive, or culture. These are Emiril's true skills.

We see the same thing with hedge fund start-ups where a junior manager decides to start his own firm. Some are successful, but many are not able to match the success of their mentors. There is intangible practical knowledge and culture that is not easily transferable to others. Investment skills such as culture and drive, whether associated with quantitative or discretionary managers, are not always transferable. Investment managers do not have to hide their investment strategy. The strategy does not make them unique. Implementation skills make them unique. For investors, once strategy is understood, due diligence has to focus on a manager's practical knowledge. Investor should allocate to strategies but back managers with practical skills.

Monday, May 13, 2019

Inflation - Where do we go from here?

Don't worry about inflation - the Fed isn't. Or, the Fed believes there is no value is trying to get ahead of any inflation increase given the relatively tight range for inflation.  The market penalized any fixed income investor that acted on inflation fears.  Any Fed objective function has a higher weight on growth.

The Cleveland Fed has been producing the median inflation rate for years. It provides a different perspective on inflation. It is moving higher, yet that is not a focus by the market.  The fact that the compounded effect of inflation in the 21st century has been substantial for those who do not have indexed wages seems to be missed by our central bankers. While there is talk of inequality by the Fed, the cost of low rates and inflation hurt the poor more than the rich. 

The current bias is that Fed will under-react to any inflation increase. The PCE showing an extended period above 2% lasting for months and CPI close to 3% seems to be necessary conditions. All verbal signals say that the cost of inflation is low relative to any slowdown in growth or decline in financial assets. This may seem obvious for many investors, but an implication is that any Fed behavior different from this current consensus will be disruptive. Any surprise in 2019 will be associated with tightening.