Thursday, December 29, 2016

Listen up hedge funds - You don't perform, you die

The latest hedge fund asset flow report published by EVESTMENT tells a tale of an industry that has become more competitive and is in a period of consolidation. The easy money of being a hedge fund manager is over. Now, you have to earn your AUM through offering a better product. The year to date outflows for 2016 have been $83 billion which is small on a $3 trillion base, but suggests that investors are getting more particular in what they expect from hedge funds. Couple these outflows with the higher level of fund closing and we see a competitive market place which is unforgiving to managers. It does not matter whether you think you have investment skill; poor performance will relegate you to obscurity.

Investors are more willing to rotate their hedge fund exposure based on what they may expect from a style or asset class focus. For example, commodities and managed futures showed a net gain $27 billion in 2016, but these flows may reverse if performance does not come in 2017.

Performance matters for asset growth. If a fund had negative performance in 2015, there were investor outflows. If you have good performance, money will flow in your direction. Given the fact that hedge fund performance does not seem to show memory, investors may be chasing returns. Nonetheless, big or small, if you don't make money for clients, investors will leave and they may not return.

Financial stress down, policy uncertainty up

Don't try and call the direction of the markets with some forecast which will most likely not come true. Decide the environment that we live in and determine what will be the best portfolio to take advantage of it, or as I say often, "You cannot tell where you are going until you know where you are." A key for knowing your economic location is through determining whether there is financial stress in the economy. Stress leads to change. When stress increases or falls, investors will become more risk averse or risk seeking. It is a driver of volatility.

We look at the financial stress indicators from some of the Fed banks (Chicago, St Louis, and Kansas City) as a first pass on financial stress. If these are moving higher, investors will move to a risk-off portfolio. If stress is falling, investors will move to risk-on. We have not suffered from any serious bouts of stress since the Great Financial Crisis, but there have been periods when it has became elevated like the beginning of last year. This was the period of the large equity sell-off. Similarly, we had elevated stress in 2012 which was offset by QE3. Right now, stress is flat and below average. A risk-on mentality should continue with investors.
Nevertheless, we do see a problem with uncertainty the cousin of stress which has moved to elevated levels. Our concern is that this uncertainty has not translated to higher volatility in markets. While the VIX volatility index may move higher without uncertainty, most strong increases in uncertainty is coupled with higher volatility. Consumer and business confidence have moved higher, but this mood may be fragile in an uncertain world.

Follow stress and uncertainty to help determine the current state of the economy. These will be priced into markets no different than economic growth. Perhaps these numbers are subtle, but they set a baseline on whether we are in a risk-on or risk-off environment.

Monday, December 26, 2016

Art, forgery, and money management

Money management has been compared to art. There is a technical skill component to generating returns but there is also an artistic component with how information is weaved together to produce a successful portfolio. Money management can be like art because it may have uniqueness that transcends rules. You can have all of the rules, read all of the books on how to do it, and still not get the results that are expected. Now, we believe that artistic uncertainty can be minimized through good checklists, but we accept that for many, money management as art is real.

Given there is an artistic component, should we expect that there will be forgery of this art? A fascinating article in the FT "How art detectives hunt down fakes" on art forgery led me to thinking about this issue in finance. A forgery is a copy or fake of the real thing. There can be forgery in money management when someone tries to replicate what others have done and pass it out as authentic. A money management forgery can be created through using the words and techniques of someone who has real skill but not actually doing all of the work. Or, it could be trying to copy the style of another manager without adding any originality. There could be some good managers who, like painters, are able to use their skill to replicate what a great master has already done and pass it off as the being reality. Forgeries create a replica of the skills shown by the masters. The forger may use the same tools and same techniques to generate returns, but they really don't actually mimic the real skill. They can come close to a master but not make it exactly the same.

The only way to detect the real thing from a forgery is through deep due diligence of every detail of a work. The same can be said for money managers and hedge fund managers. The due diligence is necessary to detect what is real from a slick copy. The due diligence will tell us if all of the processes and skills are being employed or whether corners are being cut. The forger can be found through the hard order of understanding the artist style and technique. Isn't that one of the key skills of due diligence? Due diligence employs careful analysis to find those money manager artists who have skill and are real and separate them from those who are fake.

Saturday, December 24, 2016

The Phillips Curve - Isn't that an old relationship that does not apply anymore?

Anyone with grey hair is likely to remember studying the Philips Curve in his or her macroeconomics class, yet if you started to talk about the unemployment inflation trade-off today, you would be viewed as some "old school" thinker who is out of touch with reality. The Phillips Curve is an artifact of economic history. Is the Phillips Curve dead, another zombie model that walks around with no useful purpose? No.

This relationship still has value and will be helpful for thinking about 2017 investing. The investor just has to make sure that he accounts for the right variables. In this case, the key is the anchoring of inflation expectations. This anchoring of expectations and the lows sensitivity between inflation and unemployment means that there just is not going to be anything like what was normal in the in the 60's and 70's. Nevertheless, given the current positioning, we are at an elbow with the trade-off. 

Using Ed Dolan's graph from his blog, we can see that 2014 to the present was just a move down in unemployment with little change in inflation. Now we are close to hitting an employment wall, so there is likely a movement up in inflation like we have seen in some other cycles. Inflationary expectations have already turned but should start to accelerate if inflation numbers further turn up. 

What we do know is that as we have closed in on the natural rate of unemployment. There has been a significant increase in the inflation rate if you use the CPI and not the PCE. Albeit not the same elasticity as before,  there is again a trade-off as the slack in the economy has been taken out. We are in a new world where fundamentals matter and old trade-offs that we thought were long dead are coming back to live because constraints are binding. 

We can see that constraints are starting to bind for the Fed when we look at the combination of inflation and unemployment as a target. We are closing in on the bulls-eye; consequently, there will be increased likelihood of Fed action. If numbers are inside the bulls-eye, the Fed will act. Numbers outside the tight bulls-eye, the Fed will wait. 

From Ed Dolan's econ blog

The Phillips Curve and the Fed target bulls-eye will set the tone for what will be relevant for investors in fixed income markets and with Fed action for 2017. Investors don't need to follow Fed speeches; they can focus on the data.

Visualization of connectedness and networks - Moving beyond correlation

Everyone uses correlation to tell a story, but some cutting edge work takes this to another level when it is connected to concepts on networks and topology of mapping connections. Network research is on the cutting edge of understanding systemic risk and how capital and information flows across the globe. It can also be used to help visualize data. The idea that all markets will react together is a just a simplification that can lead to poor thinking about markets. A network approach can help show how markets interact.

I present some of the charts from the paper, "Evolution of world stock markets, correlation structure and correlation based graphs". It was published a few years ago but is still rather obscure. First. it provides some insights on how correlations change through time. Short-term correlation may go through swings based on selected shocks while correlations across longer horizons are more stable. However, looking at longer horizons and across calendar time provides insight on the structural change in connectedness of markets. 

Much of this work on correlations across time and over different horizons is known. What is less clear is how correlations can be decomposed to tell us about network connectedness. This provides a different way of looking at correlation. The use of such tools as Planar Maximally Filtered Graphs (PMFG) can provide significant insight on this "connectedness" of markets. Some of this may seen obvious for many equity markets, but it allows the data to speak for itself.

Correlations are "living" relationships that change with capital flows, opportunities, structural changes, and market events. Understanding the consecutiveness provides deeper insights on cross-asset behavior. I would like to say that I can see these relationships by just looking at a correlation matrix, but I will be lying. Visual displays of data can enhance our understanding of market behavior.

Foreign exchange trading - adding another dimension to alpha creation

The dollar and FX trading is back in hearts and minds of investors. For many, it never went away, but during the Post-Crisis period, there was a fall-out in performance and interest in trading currencies as an alpha source. With limited trends and carry that was squeezed down to zero there were limited opportunities for profit.  If all central banks are behaving the same and growth differentials small, there will just be limited trade opportunities except for periodic short-term dislocations. That dearth of opportunities has changed in 2016 and may continue in 2017 for a simple reason. Economic differentials across countries are back.

Start with carry. Short-term rates which tell us something about relative monetary policy are moving in different directions. The bond rate differential between the US and EU could not be greater. What has been a close relationship has strongly diverged. The dollar/yen carry trade is now seeing significant new money flows. The differentials between EM and developed market bonds also have increases in spread. Money can be made in carry without even touching the important issue of covered interest rate parity not holding with many currencies against the dollar.

Trends are back. Currencies can have long period of trundles behavior. This has not been the case for 2016. After falling for the first part of the year because of a delay in Fed action, the dollar has moved higher with clarity on Fed rate intentions. Classic trend-followers are seeing many opportunities. The simple chart of the dollar shows the strong movement.

Fundamentals are diverging. A currency is a relative price between two countries. When inflation, growth, and monetary differentials increase, there will be currency adjustments. If the fundamentals change, the currency will change. 

Volatility is back. Volatility has increased with the underlings increase in the volatility of fundamentals. The markets saw he large BREXIT reaction and spikes around policy announcements. While the overall trend is still not higher, there are more volatility opportunities.

If there are more opportunities, there will be more potential for alpha generation. Any one manager may not be a profit generator but when the markets are in divergence, gains can be made.

Thursday, December 22, 2016

Fake News, Old News, Wrong News, or Just Plain Old Prices

"99% of the what I read in newspapers is true except for the 1% I have direct knowledge of."

“If you don't read the newspaper, you're uninformed. If you read the newspaper, you're mis-informed.”

― Mark Twain

The world has been abuzz with talk of fake news as if this was a new concept. Fake news has been around as long as newspapers have been printed and before. It has been called gossip, bias, or yellow journalism. Fake news has taken countries to war, ruined reputations, and swindled readers. Like all technological change, it is coming faster and in more forms.

For investors, fake news is something that has to be dealt with everyday. Investors also have to deal with old news. By the time news gets into newspapers, it is usually discounted by the market. What may be left is an interpretation of this news in prices, but not its immediate realization. There is also a problem of wrong news. Data are subject to revisions and much of what is printed are not facts, but the opinions of others. This news can just be wrong. The opinions are not fake, but are not correct. Part of reading multiple papers is to close in on what may be correct. 

So what can investors do in this world of news? Keep it simple, and follow the prices. This is the essence of all price-based systems. Following prices offsets the dark forces of the fake, old, and wrong news read in papers. Prices can be wrong too, but at any point in time it is the immediate weighing of opinions with dollar votes. You can still follow the news and fundamentals provide background and details, but the test of what news is telling us is with its relationship with price. 

Tuesday, December 20, 2016

Paid less for less protection - Your credit markets for 2017

One of the best performing sectors for 2016 was high yield credit which saw a large reversal in spreads with the improvement in the oil market. Credit funding for shale oil exploration and production was in jeopardy with the low oil prices, but the duel conditions of higher oil prices and an improvement in economic prospects have brought  spreads to former tight levels last seen in 2014. Of course, there are other issuers in the high yield market but this move was associated with the risky oil credits.

We have seen this type of tightening in 2003 and 2012-13. Both were periods of improved growth after a slowdown albeit not a recession. In 2003, the tightening was driven by the surge in Greenspan cheap money. In 2012 and 2013, the tightening was associated with the post-European credit crisis and continued cheap money from further QE action by the Fed. 2016 was the combination of higher oil prices, a Fed delay in rate increases, and an economic improvement. The 2009 spread improvement was from a change in post recession risks. 

Further increases in oil prices are less likely albeit downside risk has been limited by OPEC production cut announcements. Right now, the chance for monetary easing is unlikely, so a further continuation in spread tightening is reduced from the drivers of 2016.

What we do find risky is the decline in covenant quality assessments. Investors are being paid less for bonds that have less creditor protection. Simply put, is this the type of risk you want to add to in 2017?

Momentum was great for 2016, but now it may be worth thinking about mean reversion in high yield spreads. 

Monday, December 19, 2016

The Most Important Chart for 2017 - Embrace the Current Uncertainty

There is the foundational view that increased uncertainty will and should lead to changes in our economic behavior. There should be an increased desire for caution. Investments in the future should be smaller or deferred. There should be an increase in the holding of cash versus any risky investment. Actions may be scaled or averaged to reduce potential regret. Risk aversion will impact the return needed to offset the risks faced.  Uncertainty should be avoided or at least approached with caution.

Now, if we look at the new global economic policy uncertainty index from a group of leading academic researchers, we will see it is at all time highs since its inception in 1997. The index is a combination of data used for their popular country indices.

This may be the most important chart for 2017. Forget the economic predictions that are being given for the new year and embrace the uncertainty that we are facing now. This means that maximum diversification is the best form of asset allocation protection. Whatever has been a winner in 2016 should not be assumed to carry-over to 2017. What should be the winner is holding more uncorrelated assets. Embrace uncertainty through diversification.

For more active investing, this means holding divergent strategies and those that have higher convexity. If you cannot predict the direction of the markets, then hold assets and strategies that can make money from extremes or strategies that can be nimble enough to switch directions in the face of change. Hold credit strategies that look for widening opportunities. Look for value under the assumption there is downside protection. Look to global macro and managed futures as divergent hedge fund strategies. Again, this is a time to embrace the high uncertainty through specific choices but not specific predictions. 

Sunday, December 18, 2016

Momentum and mean-reversion (divergence/convergence) research shows combo works

We have often stated that the market move in two modes or regimes, divergence and convergence. Another way to describe this market behavior is through momentum and mean-reversion. Yet, these regimes should not be viewed as independent. They can actually be negatively correlated, but because they have different time horizons, they can co-exist. An older paper looks at combining these two strategies with global equity returns and finds that a combination can lead to excess returns. (See Balvers and Wu in "Momentum and Mean Reversion Across National Equity Markets".)

They form one indicator or model which tries to combine momentum and mean-reversion using a permanent and transitory model framework. The basis for their model is that momentum effects are relatively short-lived (under a year) while mean reversion may occur over longer periods (in some cases 3-5 years).  Different time frames that can be modeled through transitory and permanent shocks can be unified in one model. Under this framework, momentum provides the foundation for mean reversion. Divergent events create the chance or opportunity for mean-reversion. Put differently, momentum will cause or increase the likelihood for a reversal in prices. Using these two concepts together, the researchers are able to generate consistent excess returns that are greater than a random walk or models that just look at momentum or mean-reversion in isolation. These two strategies are actually negatively correlated, so they are truly unrelated and unique. There is room for both these strategies but even better returns are generated when they are coupled together. 

This is a paper that could have been written more clearly, but the conclusions are strong. Looking for and using momentum and mean reversion can both be employed to generate excess returns. The momentum investor should always be considering mean reversion as momentum extends through time, and the mean reversion investor should realize that momentum starts prices on the road to reversal.