Investor Anxiety Is All A Matter of Timeframe

How would you feel about your investment portfolio if you went to sleep at the beginning of the year and woke-up on Friday? What if you stuck your portfolio in a drawer and pulled it out after three months or a year to look at performance?  My guess you would say you were happy and comfortable with your investment decisions, yet there has been a lot of investor anxiety this month. 

The recent sell-off is vivid in our minds. Many have compared this event with some of their worst investment months in their lives, yet over a longer timeframe the events of February may not matter. Our investment anxiety should be proportional to the rebalancing period we use and the time horizon of the investment. We are not saying that the repricing of risk should be ignored but rather it should be placed in the context of portfolio objectives, past performance, and investment horizons. 

Financial shocks can be either endogenous or exogenous - What can we expect?

There was a clear financial shock to the market with the spike in the VIX index earlier this month, but the market has reversed a significant portion of the earlier losses. From the SPY high in January, the market declined about 10.5%. There has been a reversal of 6% so the stock market is now positive for the year and only down 4.5% from the high and down 2% from month-end.  

At the time of the sell-off, there was significant uncertainty and few were advocating the volatility spike as a buying opportunity, but it is important to try and classify financial shocks to judge their potential impact. We classify financial shocks into two types: exogenous and endogenous. 

Exogenous shocks will result in asset price responses to outside information like an economic data surprise or Fed announcement. New information may lead to a revision in asset price valuations. Usually, there is evidence that asset markets will over-react to negative news and under-react to positive news. A bad news overreaction is caused by the need for markets to offer lower prices to attract new buyers. There is an under-reaction to good news because existing buyers will hold positions and a higher risk premium is not needed.  

Endogenous shocks will cause asset prices to react to some event that is associated with actual price activity. It could be a change in prices from selling or buying pressure independent of an information announcement. An example would be a "flash crash" where order flow changes caused significant selling pressure. Obviously, these events are hard to predict and may be tied with an exogenous event. The endogenous event may be a feedback loop that starts with an information event.

When we look at the February volatility spike and market sell-off, there were some events that commentators have used for cause and effect, but there was no single event or information shock that created the sell-off. Consequently, we are having a reversal of the endogenous shocks. However, there may be a reprising of risk because investors are aware of a volatility shock. This may preclude markets from reaching the old high unless there is new information to suggest that valuations can move higher. Classifying the financial shock may help determine the correct action when the next market event occurs. 

The "3 by 5 index card" on what you need to know about the February VIX spike

University of Chicago professor Harold Pollack in an interview a few years ago mentioned that the best money advice can fit on a three-by-five inch index card. He was then challenged to write the card. His financial advice went viral. We follow this tradition by focusing on a simple "three-by-five index card" on the VIX volatility spike earlier the month.

What is your focus? Schwerpunkt - the center of gravity for your investment efforts

“An oper­a­tion with­out Schw­er­punkt is like a man with­out character.”
–Field Mar­shal Paul von Hindenburg

Schwerpunkt is a German word meaning main focus, center of gravity, or focal point. The term came from Von Clausewitz's "On War" and refers to the strategic objective or goal of any military campaign or battle. It is the place of greatest importance against an adversary.

I love this word because it can also be applied to any number of investment decisions or problems. For all the work done to develop the right portfolio or all the techniques used to model decision-making, there still needs a focus on schwerpunkt; what is the essence of what needs to done and what is it that is most critical. 

For risk management, the focal point, is not losing money or protecting principal. All of the talk about risk management principles is important but has to be directed at the goal of protecting wealth. For value investing, it is finding cheap securities that have limited downside and the opportunity for significant gain. For portfolio management, it is finding the highest risk-adjusted diversified returns.

Each investor or portfolio manager may have different goals but identifying their focus should be straightforward, direct, and easily explained to anyone. The essence of investing should be easily understood. Just like in a battle, the center of gravity for winning should be identified and the focus for resources and attention.

Psychopaths are not good hedge fund managers, neither are narcissists - Who would have thought?

Wall Street is filled with characters and "personality". I have met my share, but a key question is whether some of these personality extremes actually lead to better returns. I have written about this in my posting The Wisdom of Psychopaths and Trading. Some have suggested that the characteristics of psychopaths if directed toward good goals may lead to successful outcomes. The core idea is that a lack of empathy or emotion found in psychopaths is actually good for some jobs. Certainly, there is a strong strain of thinking that trading should be without emotion. Hence, personality characteristics such as less emotion or empathy may be good for return generation. You just may not want to have them as your boss.

However, the data suggest that having certain personality traits may actually hinder hedge fund performance. Research published last year that classifies the personality traits of hedge fund managers and then followed their returns shows that psychopaths generate lower returns and narcissists have lower risk-adjusted returns. (See Hedge Fund Managers With Psychopathic Tendencies Make for Worse Investors.) While I have not looked closely at all of the data, it suggests a nuanced story about personality and return generation. Perhaps negative personality traits come out of the woodwork when there are pressures at the extreme, or the psychopath who has to work in a team or with others proves to be a hindrance to return generation.

It does suggest that effective due diligence should go beyond the numbers and make an assessment about the personality and character of the hedge fund manager. There is a critical need for references and background checks. However, we know that psychopaths and narcissists are not always easy to spot given the limited time spent with a hedge fund manager in due diligence.  

There is no question that likability is an important trait for raising money for asset management firms, but we also know that high returns are forgiving for aberrant personalities. After a decline in returns or firm failure, many will bring up personality issues, but that does not help when doing due diligence. 

Nevertheless, the classic test of having a meal with managers still seems to work. It is time consuming, but you learn a lot about a person especially when you see them interact with serving staff. But, is rudeness a disqualification for allocation? I would say yes, but you will be cutting a large universe of managers.

Generating tilts around core bonds - Changing the correlation, yield, and risk exposures to bond sectors offers opportunities for portfolio refinements

Some may say, "A bond is a bond, is a bond". Investors may place risky assets in one category and then have bonds in a less risky category. This dichotomy does not focus on the important distinctions between bond groups and the roles that different bond categories may play nor does it present the possible trade-offs between return, risk, and correlation within a portfolio from different bonds. 

While there has been a movement to unconstrained bond funds, there have not been many good frameworks for thinking about the trade-off within the bond universe. The following graphs provide a view on the issue with bond allocation choices. 

Investors can increase return in credit through holding more risk. Further refinements can be made based on duration, business cycle, and inflation. With more volatility, higher yields, and less intervention by central banks, the dispersion in bond opportunities will further increase.

One could think of the Barclay Aggregate index as the passive no information core portfolio. If there is a no view on bond categories, hold the Aggregate index. Around this fulcrum, investors can move along three dimensions, yield, risk, and correlation to equities as the risky asset.

You can have greater diversification at the sacrifice of yield. You can increase yield through holding more credit sensitive investments at the cost of more correlation with equities. 

There is greater return potential with thinking about bond sector bets around a core allocation. Additionally, investors can adjust their diversification against a risky portfolio through changing bond sector exposures.

Time for commodities but what it is the right choice? Think in terms of risk premiums

Inflation is a growing concern with many investors. Additionally, there is the perception that financial assets are overvalued. There is a need for diversification across other asset classes given the potential for stock-bond correlation rising in an inflationary environment. 

It is time to take a closer look at commodities, but there is a little problem. It is not clear how to best access this asset class. One could buy a single commodity manager or a bundle of commodity managers, or one could buy an index-like solution. These index-like solutions could come in three forms, a beta, strategy, or enhanced index. These strategy and enhanced indices may have characteristics like a diversified commodity manager.

An investor could think that buying a beta index would be easy and would serves as a proxy passive investment in commodities, but the returns across some of the key alternatives would be very fairly disperse. The same would be true for strategy indices which may be driven by factors such as backwardation and contango, or enhanced indices which may include active rules-based long/short decisions. To show the complexity of the index choice problem, we looked at the performance over different time-frames for these three categories as defined by Bloomberg. 

Our table presents four popular long-only indices. Each index will have different returns because each has different weighting across commodities, different roll characteristics, and different maturity blends. There is no one standard for beta exposure in commodities. The return dispersion for a long-only index even over the last year would have been four percent. Over a five-year period, the difference would have been 400 bps on an annualized basis. The cumulative effect of choosing the wrong beta index would have had a devastating effect on any commodity portfolio allocation.

The same could be said for strategy and enhanced indices except the impact would be even larger. In the last year, the dispersion in strategy indices would have been over 12.5%. Over a five-year period, the difference would be over 16.50% on an annualized basis. The opportunity to add value relative to a beta long-only index is positive, but the chance of under-performing is real. 

Holding your commodity risk in a passive investment whether long-only or some set of risk premiums or factors is risky because the returns across different exposures are highly disperse. Over the last five years, commodity asset class returns were generally negative and choosing an alternative that outperforms the beta exposure is no guarantee of positive returns.

Forward-looking expectations may exceed the past performance for commodities, but the choice of what exposures is complex.  Investors will require a strong understanding of commodity dynamics and a willingness to be more active than index investing in stocks or bonds. 

If dollar is down, investors want to look toward commodities

The dollar may be trending down, but investors should also look at the second order effects of what will happen to other markets. For example, a declining dollar is good for long commodity exposure. The long commodity argument is twofold, one, a decline in the dollar makes commodities denominated in dollars cheaper to foreign buyers which will increase demand; two, a decline in the dollar associated with global growth will increase global commodity demand. There are both substitution and income effects.

Now, a dollar decrease will make producer prices for commodities in the US more expensive but the size of the US economy and the demand for raw commodities is falling relative to the rest of the world so this dollar-commodity effect will be stronger as the rest of the world gets larger versus the US.

The dollar link will not be the only driver, but for longer-term asset allocation, it a good relationship that can be exploited. Additionally, the correlation between stocks and commodities is low, so investors gain diversification from holding commodities at a time when they are cheap relative to finical assets and there are higher expectations for inflation. 

Taking a second look at gold during a financial crisis

What would have protected investors during the turmoil of last week?  With all of the major asset classes falling, not much. Declines were a just a matter of degree. There were some selected instruments that did well, but the "correlation to one" effect, albeit not absolutely true, kicked-in for many assets that were supposed to provide strong diversification. However, there was a protection instrument that did provide safety, gold. Although slightly under bond returns for the Barclay Aggregate index through the first twelve days of the month, it has generated gains for the year and certainty beat long-term Treasury bonds.

I have had ambivalent investment views on gold because the research on gold as a safe asset or an inflation hedge has been mixed. It has never been as strong an inflation hedge or safety asset as the gold supporters would have you believe, yet it has been a more effective diversifier than many financial assets.

For an asset that has been studied so closely, there are not definitive answers as to the value of gold investing. However, we can say that it generally does provide diversification benefit given a return profile that is not easily factorized like other asset classes. 

It not the case that gold will match changes in inflation expectations or that it will show positive returns during periods of market extreme. Gold miners do not have the same characteristics as gold. Nevertheless, during extreme down equity periods and financial crises, gold will not follow the same return pattern as financial assets.

Two research pieces are worth reading, one recent work that is mildly supportive of gold as a diversifier albeit with caveats and another that has a more skeptical view. The recent work is "All That’s Gold Does Not Glitter" Gerald R. Jensen, CFA, Robert R. Johnson, CFA, and Kenneth M. Washer, CFA which is coming out in the Financial Analyst Journal this year. The skeptical view can be seen in the work, Erb, Claude B., and Campbell R. Harvey. 2013. “The Golden Dilemma.” Financial Analysts Journal, vol. 69, no. 4 (July/August): 10–42. 

The recent piece provides some good food for thought. One, the link between gold and inflation is very weak. The relationships with macroeconomic variables are not significant. There is little correlation with the VIX and a slight negative correlation with exchange rates. It will, however, offer some protection with respect large down moves in stock; however, this comes with the cost of limited returns during equity gains. In general, gold goes its own way.

Gold could be a good diversifier but it should not be viewed solely as a buy and hold. There are situations when it is worth holding as a store of value but like any asset this should be based on a sense of value.

"Bond Vigilantes" - They were corralled but never disbanded

We have not heard from the "bond vigilantes" in quite some time. The origin of the word vigilante is Spanish for watchman, alert, or guard, and like a watchman they have been out there waiting for the long combination of events. The definition of bond vigilantes is a broad term for bond market participants who impose discipline on the market through focusing on negative fundamentals. Their form of discipline is selling duration or not buying at current levels.

Unfortunately, bond vigilantes have more in common with the grim reaper. They only come out when there is perceived death and destruction in the bond market and are never found lurking around in market rallies. In reality, these vigilantes are closer to Old Testament prophets preaching for repentance from the past ways of excess before there is a market failure. What makes them different from the prophets of old is that they dollars that can impose repentance. For now, we will keep with the well-used vigilante metaphor as they drive a wave of higher rates into town.  

For most of the post Financial Crisis, the bond vigilantes have been held in check by central banks that have controlled rates and the supply of bonds through their active QE programs. Perhaps the last great vigilante signal was the taper tantrum in 2013. 

Now times are different. Private debt investors can now impose discipline on markets when in the past any shortfall in their buying would be offset by the buying of central banks. If bond vigilantes don't like the environment or current prices, they will sell or stop buying until the market clears at a better price. They are the marginal buyers and are watchful of negative events that will make bonds bad investments:

• Inflation which is moving closer to the 2% target and has been trending or threatening to move higher.
• Economic growth which moved ahead of expectations across the globe and is associated with a tightening of the labor market in the US.
• Central banks that are "normalizing" balance sheets and generating an upward bias to rates.
• The fact that there is no risk bond premium and a normalization will lead to a positive risk premium with higher rates.
• Consumer finance and balance sheets that have improved but are generating higher delinquency in selected sectors like student loans.
• Large government deficits caused from a tax cut and increased fiscal spending.

Rate markets may have gotten ahead of themselves given the strong upward momentum over the last few weeks, but the issues that are on the forefront of bond vigilante thinking will not change with any one economic number or in the near future.

Yes, the stock-bond correlation is rising, but let's have some perspective

Many commentator have talked about the fact that stocks and bonds moved together during the current market sell-off as if this is big news, highly unusual and signal of market change. A positive correlation is not the normal relationship we have seen in the post Financial Crisis period, but it may be a little early to say there is a sea-change in market behavior. 

We looked at 30-day rolling correlation as a short-term measure for the period from October 2003 to the present February 2018 between SPY and AGG (the Barclay Aggregate Bond index) ETFs. There has been a spike in correlation but there have been other periods of rising positive correlation. 

We get similar results if we use the Treasury ETF, TLT, for comparison.  We then took the 62-day (3-month) average of these numbers to provide a smooth result for our graph below. We will note that the correlation spike is under-reported given the moving average calculation.

There have been some noticeable extended periods of positive correlation even after the market decline in 2008. In fact, looking over our entire period, 25% of the time the correlation was positive. There even was a period of positive correlation in July of last year. 

Too often market commentators will announce judgment without verifying the facts. It may be too early to say that there will even be positive correlation looking at the monthly data over the last year. 

If fact, focusing on similar daily moves over a short period and making a judgment about correlations using longer-term time horizons and different time scales is dangerous. Our view is that diversification is working albeit not as well as expected using monthly data for asset allocation. In any large market move, return correlations increase. There is more risk, but it is not clear that this will significantly change relationship driving longer-term asset allocation.

Risk parity - When volatility goes up across asset classes the result is painful but perhaps not as bad as some alternatives

Risk parity has had good performance over the last two years with double digit returns after stumbling in 2015, yet the diversification strategy of equal weighting of four major asset classes has been painful this year. Diversification based on weighting risks offers some protection but is not cure for a volatility revaluation.

All four major asset classes, equities, bonds, credit and commodities have declined year to date and for February. There was no diversification albeit any allocation away from equities was a relative winner. A quick comparison of volatility changes since the beginning of the year shows a range of increases from 11% for commodities to 41% for bonds, 123% for high yield credit, and 423% for equities using simple 20-day moving averages. 

A normal 60/40 stock/bond blend will have approximately 80% of the portfolio volatility in equities, so risk parity may have been more protective given a equal weighting of 25% in equity volatility. The key question is whether the risk parity product used leverage to hit a target volatility.

Risk parity managers had to sell a significant dollar amount of equities to get back in-line with longer-term volatility weights. This situation was even worse if the program had a target volatility that would have required delevering to bring portfolio volatility closer to target levels. There will be significant differences in performance across managers given their response to volatility, leverage, target levels, and exposures within the asset class, but by being volatility focused there will be feedback effects that spillover to general market moves. 

Risk parity products may have done what was expected, but a problem is whether investors truly understood what they were buying in a low volatility environment. 

Has SPY - VIX sensitivity changed in the last week?

The talk of the markets is the significant spike in the VIX index and the large decline in equities over the same period.  An important question is whether the relationship between the stock and volatility has changed with this move. A quick answer is no.

I am not trying to run an exhaustive study, but a simple regression analysis comparing the percentage changes in the market index and the VIX. Regressions can be very sensitive to outliers as well as different sample periods, so I compared a five-year period not including the month of February against the last two years with February data. There is no significant change in the relationship. The markets behaved in a manner consistent with the long-term relationship between stock indices and volatility. More work can be done to analyze this relationship, but as a first pass, this is interesting food for thought.

More than just equity volatility, look at bonds - The Big Volatility Revaluation

The highlight of the 2018 is the Big Volatility Revaluation. While not as dramatic, the increase in bond volatility has been just as surprising and has correlated with the VIX index. The MOVE (Merrill Lynch Option Volatility Estimate) is a bond risk index developed by Merrill Lynch using a similar methodology as the VIX of creating an index using the implied volatilities of bond options. This should be a more useful method for determining current market expectations of volatility embedded in prices than backward-looking historical standard deviations.

Notice the bond volatility spike started around the same time as the VIX, however, it is still below the highs earlier in the year. It has seen a 50% increase since the lows in mid January. Stock volatility may be more susceptible to spikes given the bond markets are usually driven more by institutional players than stock markets. 

The increase in volatility of both stocks and bonds has meant havoc for risk parity managers and systematic managers who control risk or size positions based on current volatility. For portfolio risk management purposes, position-sizing could have been decreased this week independent of fundamentals or price moves. 

A longer-term view of MOVE volatility suggests that this current spike is strong but less out of the ordinary relative to equity volatility as measured by the VIX; nevertheless, the current change places the MOVE closer to, albeit still below, long-term moving averages. What is consistent with the MOVE spikes is that they are associated with recessions, financial crises, or Fed surprises. There are also secular trends in volatility such as the post Financial Crisis decline during Fed intervention. A return to normalcy is likely to generate MOVE values that are higher.

There is a tendency for both VIX and MOVE volatility to spike and then trend lower, a pattern that has been found in all markets and historic periods. The market concern should be the revaluation of volatility to higher averages consistent with an environment with more central bank normalcy. The result of a more normal volatility environment closer to long-term average will be less leverage-taking by traders and a general change in asset allocation from less aggressive risk-on behavior.

What does systematic decision-making do? Debias your portfolio decisions

McKinsey and Company published an interesting paper on the use of AI in asset management called, "An analytics approach to debiasing asset management decisions". (Hat tip to Tom Brakke for mentioning the article in his newsletter.) This paper shows the powerful use of analytical tools to extract hidden biases in investment management decision-making. Employing large data sets of manager decisions, companies are finding a wide set of behavioral biases identified in economics present with their decision-making. 

Regardless of how smart the talent, biases can be deeply embedded in decision-making. These biases are often hidden from direct views because there was no systematic analysis of the data.  Nevertheless, if they are found, there is a chance that decision-making can be nudged in the right direction. For example, if there is a confirmation or anchoring bias, the data can find the "bad" behavior, and procedures can be adopted to eliminate them.

This is a great use of artificial intelligence and data mining, but it begs the question of why rely on individual or committee decision-making in the first place with investment management. Systematic investing featured in quant programs, by their very nature, debiases decision-making. If there is confirmation bias, rules can be used to reduce it. If there is a bias to hold losers and sell winners, rules can be developed to reverse this tendency.

This does not mean that systematic programs are devoid of bias. It just means that the biases through a rules-based system are transparent. If they are present, it is because someone put them in the program. Any known behavior biases can be addressed directly. Perhaps the greatest value of systematic investing is not the development of any one special strategy but a holistic disciplined approach to ensure repeatable success. 

What to do in a market sell-off - Don't sell, rebalance and restructure

When asked for money, WC Fields once said, "Sorry good man, all my money is tied up in cash."  

Whenever there has been a large sell-off, many have announced that it is a buying opportunity. There is not denying that in a strong bull market, buying on dips makes sense, but what if this is a transition period? A sell-off does not have to be a buying opportunity, but rather a reallocation allocation period. As of the close on February 8th, 

• Even with a year to date decline with the SPY (-3.46%), investors are up double digits on their SPY equity exposure since beginning of 2017, 18.20%.
• Even with a year to date decline in bonds as measured by AGG (-2%), investors are still up since the beginning of 2017, 1.55%.
• Balanced 60/40 stock/bond (SPY/AGG) blends are down for the year, (-2.88%) but still up since 2017 with returns of 11.54%. 

This is the time to rebalance to long-term allocations if it did not occur at the end of the year and rebalance to alternative investments. Clearly, there are alternatives that have also been hit by the market sell-off. This is not surprising when there is a volatility shock and sell-off. We are not trivializing the losses but for alternative allocations, the issue is the construction of the portfolio or diversification benefits generated on a go-forward basis. 

For systematic managed futures programs, the sell-off has led to selling of old positions, a repositioning of risk exposures, and a change in leverage to reflect the new environment. This restructuring is based on model signals not emotions. The transitions are usually not pretty, but the result is the potential for positive convexity in an investor's overall portfolio with allocations both long and short in a wide range of futures positions across a number of asset classes around the globe. 

Is the market suffering from a definition problem for "hedge fund-like returns"?

The most thought-provoking comment I have heard in some time was "What does it mean to have hedge fund-like returns?". If a manager comes into you office and says, "I will give you hedge fund-like returns", should I be pleased or concerned? 

The statement has little or no meaning. The comment "absolute return" manager also has little meaning other than the manager will try not to lose money. What about risk-adjusted returns, does this have meaning? A good risk-adjusted return is where I get paid more return than the risk I may take-on. For many, producing a two to one return to risk ratio is a very high threshold. Most produce return to risk ratios that are lower than one.

Is there a good answer to these general questions? No. Returns have to be measured relative to their beta, risk-adjusted benchmarks. Simply put, can a hedge fund generate higher risk-adjusted returns relative to holding a market benchmark? Is there alpha with the hedge fund manager against an appropriate traditional investment alternative? The alternative should be better than a traditional choice after accounting for risk. Hedge fund managers should clearly address this issue for investors by being precise on what they expect to deliver to investors.