Natural gas market - Elasticities are changing and that means more volatility

Natural gas has always been a volatile market and subject to weather shocks; however, over the last few years the volatility and weather shocks have been dampened because of the high storage inventory levels. Monthly volatility has declined by at least 1/3 over the last three years as inventories remained high.  

Inventories serve as a cushion for any shock, but this may be changing according to Matt Piselli who manages a commodity fund (MJP Strategy) for Launchpad Capital Management. Matt has been running money for the Tudor organization and prior as the head trader for Gresham, so he has a good perspective on commodity issues. 

His view is that LNG exports is starting to weigh on the excess inventory now that natural gas is leaving the country at a quickening pace. LNG exports from Sabine Pass have increased from zero to 12% of the region's production in the just 18 months. For these flows to reverse, domestic prices have to reach global rates. Coupled with combined-cycle gas turbines (CCGT) replacing coal as base-load for utilities, there may be a shift in gas elasticities. This will generate a greater price impact for any demand shock.

The important of this change should not be underestimated even with current low prices and inventories within five-year ranges. Research consistently shows that lower inventory levels are coupled with more volatility and whippiness in spreads. A weather shock will create more trading opportunities. This higher natural gas volatility will allow skilled traders to be better rewarded this winter.

Risky assets up and safe assets flat - Investors look beyond any political rhetoric

Talk of tax cuts floating through the halls of Congress coupled with stronger consumer confidence allowed risky assets to continue marching higher. Warnings of overvalued equities, concerns over leverage, and higher geopolitical risks, have not stopped stocks from stronger gains around the globe. For US companies in the third quarter, 76% have shown positive earnings surprises and 67% have had positive sales surprises. The earnings growth rate is 4.7% for the third quarter according to Factset. Positive economics, good company performance, and low volatility all contributed to this continued rally. 

Bonds were generally flat with some positive performance in the credit area and a decline in international bonds after accounting for dollar returns. With further dovish behavior from the ECB and a Fed that is cautious about quickening any pace for rate rates, there is still good liquidity in the markets. Inflation is still below 2% as measured by the PCE even though other selected measures show stronger numbers. Controlled inflation has limited any bond sell-off.

The message from October is the same one we have been hearing for most of the year. Beta investing is in style. There has been little reason to look for diversification or localized opportunities. Investors are being paid to follow market direction and not focus on manager skill to control risk. This will change and the reversal may be swift, but right now there is no clear catalyst for a market reversal.

Interest rates for the ages - "Winter is coming" for bonds but it can take a number of forms

The Bank of England research piece, Eight centuries of the risk-free rate: bond market reversals from the Venetians to the ‘VaR shock’ by Paul Schmelzing, is important reading for any investor. It places the current bond rally which has been going on for over three decades in the long term context of the last 700 years. This bond bull movement is exceptional but not yet extraordinary when look at through history. Unfortunately, all bond rallies will end, but the reasons for ending may vary.

This Bank of England research suggests that bond bears are not just correlated to fundamentals like higher inflation but also underperformance in GDP and equity returns during the 20th century. The author conducts case studies for some of the most recent large bond bear markets in the post-WWII period. He finds that while fundamentals like inflation are a key reason for a bond bear market as in the case of the '65-'70 sell-off, there have been other cases which are not related to fundamentals like the '94 bond massacre or the '03 Japanese VaR shock. The author suggests that central miscommunication or non-fundamentals can also trigger a bond bear market. 

Inflation does not currently seem to be a potential driver for a bond bear market, although the author believes that the '65-'70 fundamental (inflation) reversal may be a likely scenario. Bond bull market trends may last longer than what many expect, but divergences will occur and the reasons may be unexpected. 

Get to know the types of diversification because it matters for long-term performance

"You can't predict but you can prepare."
-Howard Marks

A simple explanation for looking at a portfolio as a bundle of diversifiable risks is presented nicely in the new book, Rational Investing; The subtleties of asset management by Hugues Langlois and Jacques Lussier, two excellent researchers and money managers.

There are three types of risks that can be diversified: unrewarded risks which are the ones that can be diversified through holding a broad market basket, priced risks that are associated with risk premiums, and mispricing risks which have yet to be arbitraged away.

Most investors have a clear idea of what it means to diversify unrewarded risks; consequently, there is a strong current focus on alternative sources of risk and the risk from mispricing. 

Mispricing risks can be taken advantage of over the short-run, but are unlikely to last and will diminish as more investors invest in these opportunities. Priced sources of risk are perhaps the most critical focus for portfolio managers because they represent both the best opportunities as well as hidden risks. These risk premiums can include growth, inflation, and liquidity as well as a host of other factors that may be time varying. Portfolios can be tilted to either take advantage or eliminate these sources of risk once they are identified. These risk premiums will often be time varying with the business cycle, credit cycle, and risk preferences. 

For hedge fund investing, there is real value understanding the risk premiums or mispricings that the managers are trying to exploit. A true alpha producer is able to exploit mispricing, but for many, since these risks are fleeting, there may be a desire to have them diversified away. While time varying risk premium can be a source of return for money managers and hedge funds, the premium is compensation for specific risks and may not be attributed to manage skill. 

Col. Jessup, managed futures, and code red for liquidity

As we approach year-end, it is a good time to think about liquidity and exit strategies from current allocations. Many alternative investments are just not liquid when you need it, even if it is a daily fund. Of course, there is a price or cost with liquidity. Investors may exit but at onerous levels; however, those alternatives that focus trading on liquid instruments will have an advantage over complex strategies or funds that focus on asset that have lower liquidity to start with. Searching for liquidity in a market downturn is a losing game.

CTA manager (former Col Jessup) on managed futures and liquidity:

"Son, we live in an investment world that needs liquidity, and that liquidity has to be provided for by men with trading expertise and liquid strategies. Who's gonna do it? You? You, Lt. Weinberg?

As a liquid trading strategy manager, I have a greater responsibility than you could possibly fathom. You weep for higher returns and you curse managed futures. You currently have that luxury with your illiquid investments. You have the luxury of not knowing what I know; that current low CTA returns, while tragic, probably is driven by a risk seeking environment that will not last.

And my existence as a quant CTA, while grotesque and incomprehensible to you, provides liquidity for your portfolio. You don't want the truth because deep down in places you don't talk about at parties, you want me serving as a liquid investment. You need me to provide liquidity for your portfolio.

We use words like futures, trend-following, and crisis alpha. We use these words as the backbone of a life spent defending something, uncorrelated returns. You use them as a punchline as a reason to not invest. I have neither the time nor the inclination to explain myself to an investor who rises and sleeps under the blanket of the liquidity that I provide, and then questions the manner in which I provide it! I would rather you just did you due diligence said "thank you", placed us in your portfolio as a diversifier, and went on your way. Otherwise, I suggest you sit in front of a terminal and start trading."

Perhaps a bit extreme but the price to be paid for diversification and liquid strategies is a current topic on the minds of many investors. It is not the price when markets rise but the cost when markets are falling. In that case, an uncorrelated fund which trades liquid futures has significant benefit.

VaR - good for a manager, but bad for the markets as a whole - Call it the "Paradox of VaR Risk Management"

...So if there’s a big market sell-off and as a response the VaR overreacts and shoots up, then many investors are kind of forced to sell because they have to stay within their VaR limits and this selling will then be done in an already collapsing market...rigorous use of VaR measures undermines the stability of markets. It’s the type of risk management practice that works well as long as it is not needed; just like Bernanke observed after the credit crisis about their standard models that proved to be “successful for non-crisis periods”.

-Harold de Boer Transtrend 
Opalesque Roundtable series '17 Netherlands

What may be good risk management for any one manager or small set of managers can be bad for the market as a whole. The popularization of VaR risk management techniques sews the seeds of its own destruction. Call it the "paradox of VaR risk management". 

If every manager adjust his positions based on changes in VaR, there will be a feedback loop between the reaction to volatility changes and market moves. If there is a volatility shock, positions will be closed and market prices will be forced lower. This shock will lead to more endogenous trading that will further increase the price impact of the initial shock. Everyone cannot be following VaR strategies or the price link with volatility will be extremely negative and create more volatility.

Another way of thinking about this volatility feedback loop is through the impact of higher portfolio leverage during the current low volatility period. A portfolio that is leveraged to reach a volatility target based on longer-term asset volatilities will need to delever if there is a volatility shock. The chance of a volatility leverage shock increases if volatility stays well below historical means. This can be viewed as a Minsky moment for volatility or leveraged portfolio management. 

This shock impact will also increase if there is no government or monetary support to dampen volatility. We can expect the link between returns and volatility to be higher if our VaR story is true, but we cannot measure the forward sensitivity of this feedback loop. The market will only know it to be true after the next market crisis. 

Curiosity - There is more than one type and hedge fund managers need them all

What makes a good investment manager? One trait not often talked about is curiosity. You cannot find new or unique opportunities if you are not curious; however, the concept or meaning of curiosity for investment management may be hard to define. 

A recent book, Why? What Makes Us Curious, is not related to money management but tackles the issue of what it means to be curious. The author describes four different types of curiosity which can easily be applied to investment decision-making.

A high functioning money manager needs all forms of curiosity to be successful. For example, he needs to be able to notice things and have a sense for when markets are out of alignment or there is an anomaly. He needs to have a desire for continual learning or just the expansion of his knowledge of markets and new research. He needs to also be able to drill deep into a specific problem and not just have superficial knowledge. Finally, there has to be a sense of exploration to try new ideas.

My guess is that most managers have not developed all four types and may follow different curiosities with different level of intensity across their careers. It is truly rare to find the curious manager who can stay that way across long periods of time. So, next time you interview a manager, ask him about his market curiosity.

Formal or Informal predictive procedures - If it is repetitive go with the formal approach

The human brain is an inefficient device for noticing, selecting, categorizing, recording, retaining, and manipulating information for inferential purpose. 
- W.M. Grove and P.E. Meehl 

If those are all the things that the human brain is inefficient with, what is left over? A lot, but there has to be focus on using the brain for the right problems and when to change the thinking process.  

Investment decision-making needs to differentiate between the repetitive tasks for which brains are inefficient  and the unique situations that happen infrequently and requires creative thinking. Often the highest returns and loses are for the infrequent events because they are unexpected or represent a structural change in markets. Identifying and exploiting these opportunities requires something different than categorizing data. If a manager does not have skill with identifying these unique situations, he should stick with developing strategies based on the repetitive tasks and diversify to minimum any infrequent event risk. If he has the rare skill of identifying unique situations, his investment process should focus in this area. 

Predictive procedures for any decision-making can be either formal or informal. Money management investment choices are similar to diagnostic problems in medicine. Decision can be based on unique situational clinical information or statistical data. 

A formal process is grounded in algorithms or rules to categorize market activity and the odds of success. An informal process just like clinical decision-making is subjective, holistic, and based on impressions from past cases. The informal approach is not bad. A subjective approach is just more appropriate for some types of problems.

For money management, we have classified this as the difference between a frequentist approach based on data counts and a case-based approach focused on finding past similar situations. It is important to understand whether a manager has skill in one approach or the other and when switches between formal and informal decision-making will be made. The successful manager is the one who can properly classify the types of decisions to be made and have a process or plan for when to switch from formal to informal decision-making. Identifying decision process switching is not easy and should be an area for focus when evaluating highly skilled managers. 

Risk parity with strong performance, yet global macro - managed futures may be a better choice to offset mispricing risk

The positive performance of risk parity products has been sneaking up on clients after poor returns in 2015. This long-only product have done much better than many other multi-asset hedge fund strategies in the last year with the HFR 12% vol institutional index being up 9.46% through September; however, it has been riding the wave of asset price mispricing or overvaluation.

Risk parity, in a very stripped down version divides the investment world into a simple set of asset classes which are given equal risk allocations. There are no return estimations or expectations so the portfolio can be considered a naive or no-information set of allocations solely based on volatility (or covariance depending on structure). It will compete against other macro approaches that have embedded expectations of relative performance. This naive approach has proved to be superior to more sophisticated approaches in the last two years. In simple terms, the forecasting skills of embedded in macro traders has underperformed the no forecasting skill of risk parity.

It makes sense to review a simple stylized model to describe what is going on. Let's take four assets consisting of stocks, bonds credit, and commodities. Generally, stocks are more volatile than bonds, so a risk parity product will give more money to bonds over stocks. Credit and commodities are diversifying assets.

To understand recent performance, we have to look at the relative allocations when there is a change in volatility across asset classes. Assume first, that volatility declines. In this case, if the risk parity product has a fixed volatility target, there will be an increase in leverage to meet the target. The leverage effect in a falling vol higher returning environment is a significant positive. It has been a strong contributor to performance. If the volatility of equities has fallen relative to fixed income or other sectors, this will cause an increase in equity exposure in a rising return environment. Again this has been a positive effect.

The combination of higher returns in a lower volatility environment generates a positive leverage effect and a change in relative volatility with changing return patterns, specifically higher returns in lower volatility sectors has been a second strong effect. Volatility targeted managers may get a similar effect, but the drag may be forecasting skill. 

If there is a reversal in market performance such that long-only will underperform as the markets move back to fair valuation, we should expect to see stronger global macro and managed futures performance. In the current environment, global macro managed futures may be a better choice if an investor believes mispricing risk will be reversed. 

Understanding investor preferences is not easy - just ask them

The line between recent "exotic preferences" and "behavioral finance" is so blurred that it describes academic politics better than anything substantive. 
- John Cochrane University of Chicago 

John Cochrane, as well as others in finance, has focused on the academic issue of defining preferences for investors at an abstract level, but the issue becomes a reality when trying to extract preferences from investors to help build a portfolios. 

Recently working with some institutional investors, the greatest amount of time was spent not picking the strategy or portfolio elements but defining their preferences. How much upside did they want? How much downside were they willing to take? What is the chance of a tail risk event and how much protection did they want for these rare events? How are their performance preferences measured, holistically, by sector, or by market? How much regret are they willing to suffer from tracking error versus benchmarks? This list could go on. 

Many investors have an intuitive feel for what they want from their portfolio but the exercise of asking for precision in their preferences is very useful. Is it a behavior bias to have more regret or disutility for loses over gains? Is it wrong to focus on recent performance or tracking error on an individual manager? Is the concern about "poor" performance from negative or low correlated assets to equities when stocks go up justified? This are real issues that ned to be discussed with investors.

These preference orderings are not academic questions but the core for understanding investor needs, asset allocation, and recommendations for portfolio construction.

Time series or cross sectional momentum - which is better? Your choice may matter

The marketplace is abuzz with the value of momentum trading, but a closer inspection shows that it is packaged in two major strains, time series and cross-sectional momentum. The traditional trend-following CTA focuses on time series momentum while the most of the equity research and implementation is conducted through the cross-sectional approach. There is similarity between these approaches, but there are also enough differences so that the return profile for each will not be the same.  

Many CTA's now have a hybrid approach between times series and cross-sectional momentum, so it is critical for investors to know the differences. Times series momentum will focus on absolute performance while cross-sectional momentum will focus on relative performance. The times series is only focused on whether a specific market is moving up or down while cross-sectional work will rank markets to buy the best momentum markets and sell the worst. The cross-sectional work attempts to generate a momentum alpha while the times series approach mixes alpha and beta

A recent paper called "Time-series and cross-sectional momentum strategies under alternative implementation strategies" suggests that times series is actually superior because it does not place constraints on the winner and loser portfolio. This research is focused on a portfolio of stock indices, but the intuition can be used to help describe different managed futures approaches. 

Think about this issue through a simple example. Assume that a manager is trading 20 commodity markets. The times series approach will look at each market separately so that if there are 12 markets that are showing positive momentum, there will be twelve long positions. If eight markets are showing negative momentum, then eight would be the number of short positions. The long or short mix in the portfolio is independent of the number of markets traded.  In a cross-sectional momentum model, all the markets will be ranked and if there is a cut-off of say 20%, the top four would be long and the bottom 4 would be short. The rest would be ignored. There would be fewer positions to manage and the number would be set by a cut-off based on the number of markets in the sample. 

The time series approach will have variable diversification given the long and short positions would be dynamic; however, the size of each may be smaller since every market may be traded. The cross-sectional approach will focus on a limited set of markets based on relative signals.  The long and short positions will always be equal.  Hence, there will be less "beta" risk. Nevertheless, the approach that is better will change with market conditions based on the strength of market direction across the set of markets traded. 

An initial reaction would be that you get the best longs and best shorts through the cross-sectional approach, yet there is a problem if the market has a strong up or down bias.  The profitability of momentum strategies may be market dependent. If there is a strong long (short) bias, it will be harder to find short (long) positions. This market tilt makes the times series approach more attractive. Similarly, if the extremes have a greater tendency for reversal, the times series approach may do better. 

The preference for times series or cross-sectional momentum may be a function of the diversification and directional bias within an asset class. There may be diversification benefits form using both approaches. This may be the reason for many CTA's now choosing to blend time series and cross-sectional. However, the research does show that regardless of approach momentum is still a factor worth pursuing. 

If you take away the Fed balance sheet, should the bond premium be negative? Term premium reality

The Wall Street talk is that all markets are over-valued, yet any valuation has to be placed in context. For fixed income, this is not easy given you have to make a judgment on both the real rate of return and expected inflation. Additionally, there is a need to measure the term premium associated with bonds. The premium measures the compensation necessary for investors to hold longer duration bonds versus a series of successive short bonds given the volatility and uncertainty associated with real rates and inflation. The term premium is not directly observable and is difficult to measure but has intuitive appeal.

The Fed of New York provides their estimate of the term premium on a daily basis for different maturities along the yield curve. The premium will change with market conditions but it has been falling since the period of maximum uncertainty in the early 1980's. The term premium has really been declining since the Fed bond buying in their QE programs. Now all of the term premiums are negative. Granted volatility is lower and the Fed has controlled short rates, but a key driver is the expanding balance sheet of the Fed. The Fed as a marginal buyer and one of the top holders of Treasuries has led to the abnormal premium condition.

Given the long-term average and current levels, it would not be unheard of to see term premiums increase well over 100 basis points not including any change in expectations on the real rate and inflation. A slow Fed unwind should minimize any dramatic changes in the term, but that does not change the fact that this risk premium in on the wrong side of expectations. 

Forget the sophisticated models and take a simple Bayesian approach to bond risk. Assume less Fed activity to stabilize the market through constant buying to hold balance sheet levels stable; even if you get the forecast for inflation right which over the next year could be in a range of 100 basis points and you get real rates right which also could be in the range of 100 basis points over the next year, your forecasts could be spoiled by an increase in the term premium as it moves back to normal. 

Term premium adjustment is a headwind against any bondholder. Only bondholders who are short can turn this into a tailwind. A simple investment rule should be - Do not fight headwinds and don't add to markets that may have natural reasons to go down unless your forecasts are extremely strong

Renaissance in global macro - it is all about global disruption and "creative destruction" - Here is one avenue for dislocation

Barron's published a provocative piece from my friend John Curran, The Coming Renaissance of Macro Investing: The petrodollar system is being undermined by exponential growth in technology and shifting geopolitics. Coming: a paradigm shift.  The concept behind this regime shift or dislocation ties together finance, technology, and global trade. Changes in the flow of trade based on shifting patterns of economic growth with disruptions in technology are going to spill-over to financial markets and prices.  Capital flows are reactive to broader movements in power, politics, economic growth, and trade. 

Look back at Schumpeter's concept of creative destruction. Changes happens when alternatives teardown the existing order. The shifts in energy demand, the adjustments in power from seller to buyer, and the disruption in technology that underpin the oil market will all impact capital flows between the seller who receives dollars and the buyer who pays dollars. The last 45 years have been based on trade flows working in concert with dollar flows. If the oil trades moves from west to east, finance with follow. 

My take-away from John's piece is that disruption and creative destruction is an opportunity for global macro managers who trade cross-market linkages. In the language I like to use, macro managers who are divergent traders or long volatility will be rewarded versus those convergent traders who are looking for markets to move or stay in equilibrium. Divergent traders place themselves in a position to make money when market dislocate. An end to a petrodollar world is the type of dislocation that offers macro  opportunities.