Making money in fixed income the Gross way -Overweight the key premia

Bill Gross has retired and there already has been research to see if he was the Warren Buffet of bonds. His fixed income track record over the long-run cannot be easily be matched, but a careful study of his portfolio suggests that his gains were generated differently than the classic stock-picker. He may have generated alpha but he did it the old fashioned way in fixed income, he took on more sector risk. See "Bill Gross' Alpha: The King Versus the Oracle" by Richard Dewey and Aaron Brown.

Fixed income is different from equities given the high correlation across bonds. You are not going to be a bond-picker, but a sector risk premium allocator. What he did was focus on risk premia that he could overweight to his advantage against his peers. He stuck to his knitting of focusing the key risk premia of term premium, credit, and mortgages relative to a benchmark. 

There is no magic bullet for fixed income. Investors need to play the rate curve premia, take credit risk at the right times, and be willing to hold a negatively convex sector (mortgages) for higher returns versus traditional fixed income benchmarks which represent market capitalization of bonds outstanding. Gaining this edge is not always simple but it is straight-forward and the Gross edge was playing these premia for all their worth.

Yesterday's logic does not work with today's uncertainty

“The greatest danger in times of turbulence is not the turbulence; it is to act with yesterday’s logic.” - Peter Drucker

Market turbulence just does not happen. There is a catalyst, and the catalyst is a surprise turn of events. Now there are investment surprises everyday, the difference between expectations and realized results. A surprise creating market turbulence is more than just a micro surprise associated with a company but is a signal of a macro regime change. 

Turbulence is an outlier for the set of relationships across all asset classes. It is not just higher volatility but a change in cross-market correlations and relationships. It could be correlations going to one or a change in monetary policy that signals a macro change in liquidity. The change occurs at a time of market extreme like periods of high leverage or market views tilted in the opposite direction that causes significant portfolio rebalancing. The time length of the turbulence will depend on how fast the market can adjust portfolio holdings. A more uncertain cause will lead to a longer period of turbulence. A more radical change will lead to greater amplitude of turbulence.

A regime change means that the model of yesterday cannot be applied tomorrow. The linkages from the past regime no longer exist. Acting with an old model of reality will only increase the cost of the turbulence. Acting with a new model will provide for turbulence profits.

Private equity - The big overweight for high performing investors, but will it last?

The last twenty years have been golden period for private equity investors. Those who held a high overweight to this sector shot to the top of the rankings as shown in a report by Cambridge Associates, "Private Investing for Private Investors - Life can be better after 40%" last month. There is no disputing that private equity has had a great run of performance and has outpaced public investments. Nevertheless, there have been concerns voiced abut this performance after risk, leverage, and liquidity as been appropriately measured.

What is astounding is the high allocation that top endowments and foundations have given private equity investments. Forget about asset class diversification, the long-term top performers have all in big for this asset allocation. These investors may have lower liquidity needs than pensions, but this is a surprisingly high number. There is diversification within private equity across regions, industries, and classes but there is commonality with small cap risks, leverage, and limited liquidity. Private equity investments do not allow investors to easily trade out of your mistakes.

There is risk with trying to replicate the performance of the past through strong over-weights in the future. As shown with the dispersion of returns by asset class, there is significant risk with the private equity manager you pick. Based on the median returns, there is some gain versus risky small cap and small cap growth, but the threat of being wrong with your manager selection is large.

More important, topping up your private equity exposure or holding a 40% allocation is dangerous if you believe we are late in the business cycle. All private equity is not the same, but any downturn will negatively impact these underlying investments. Of course, private equity is not marked to market on a regular basis so investors do not have to face the higher volatility of public investments. Nevertheless, smooth returns on an accounting valuation are not the same as smooth returns on an economic basis. Infrequent marks will create the allusion of diversification that does not exist. This may not be the time to follow the past market leaders.

The Bezos "70 percent rule" for decision-making

A good decision rule to follow is that there are no simple rules for complex problems, but we can learn from others on how to improve our decision-making. 

Jeff Bezos of Amazon fame has diligently worked on the Amazon decision-making process. As determined by interviews and his shareholder letters, it can be boiled down to two key rules:

1. Make a decision if you have 70% of the information you think you need. You will never have all of the information you think you need so just accept it. Find an acceptable information level of what you think is necessary to make a decision and then act. This makes perfect sense in an uncertainty world. We will never have all the facts. A corollary rule is to "disagree and commit". You don't have to get 100% agreement on a decision but the organization has to commit to action. 

2. Get comfortable with uncertainty through flexibility. Don't fret about decisions that can be reversed. Have an exit strategy in case something goes wrongs. Allow for flexibility because you may need it. Make sure you know what decisions can be easily reversed. Don't avoid making decisions. Focus on fixing it, if it is wrong.

Bezos also has strong views on powerpoint. He likes written memos, six pages that can be read before a meeting begins.  "The narrative structure of a good memo forces better thought and better understanding of what's more important than what, and how, things are related," Bezos wrote. "PowerPoint-style presentations somehow give permission to gloss over ideas, flatten out any sense of relative importance, and ignore the interconnectedness of ideas." 

A good trader will be comfortable in a Bezos world. Accept you won't have all of the information you need and be flexible with a reversal strategy.

Thinking about trade BAIT - Where is your advantage?

You are so smart. You have a great trade idea and you know it will be a winner, but there is only one small problem. For any trade you make, there has to be someone else on the other side of the trade. For every buyer, there has to be a seller. So for what you are doing right there has to be someone doing something wrong? That may not be exactly true, but any trader should work under the assumption that his smart money is taking advantage of less smart or "challenged" money. What is your advantage when you make a trade? We have looked at this before in "The three ways hedge funds make money", but I find using the acronym BAIT, developed by Michael Mauboussin in "Who is on the other side?", is a great way to describe this issue. The acronym BAIT stands for the possible advantages of a manager: Behavioral, Analytical, Informational, and Technical.

B - Behavioral - Opportunities based on the behavior of others who make mistakes that lead prices to diverge from value. If there are enough investors who engage in behavioral biases, there are opportunities for those that avoid these biases. Mr. Market can act irrationally, albeit it may be hard to know when this will occur. Taking advantage of behavioral bias still needs a sense of value. Nevertheless, behavioral biases may create patterns in prices that can be exploited. 

A - Analytical -There is advantage associated with analytical skill which is the ability to interpret or weight information differently than the rest of the market. Much information is publicly available so analytical skill is the ability to use the information that is available to all in a different manner to achieve better returns. There is an advantage with the better processing and weighting of information versus others.

I - Informational - Acquiring better information is hard in the current markets. There are restrictions on the dissemination of private information, but there is new information that becomes available. An information advantage can come from speed of use and there is advantage from the use of information that is obscure. There is gain from the aggregation of new and existing information.

T- Technical - There are technical inefficiencies that arise for reasons that are unrelated to new market information. There is informationless trading such as rebalancing from additions and withdrawals that create opportunities for profit. Passive adjustments can provide liquidity or need liquidity from others. Similarly, there are changes in regulation that will lead to rebalancing that offer those unaffected by the regulation opportunities for profit. For example, new restrictive bank regulations may offer opportunities for investors that can provide investment capital.  Flows based on reasons other than new information matter.

The use of BAIT is simple. When you think about taking a trade as the question what BAIT am I using to gain excess return.

The fallacy of extrapolation - A deficiency of forecast imagination

One of the great problems with forecasting is the fallacy of extrapolation. Forecasters love to believe that tomorrow will be like to today and head in the same direction. Whatever is the trend today will continue tomorrow to the exclusion of other alternatives. There is over-extrapolation. 

We don't see change from the status quo. Now, this may be a good naive forecast and naive forecast have been successful in the short run versus other alternatives. In fact, forms of extrapolation are a good starting point for discussion but it is not the end. If economic growth is increasing this quarter it will continue next quarter. A failing economy will continue to fail. This extrapolation view generally creates overshooting with forecasts.

A fallacy of extrapolation with respect to forecasting is different, however, from trend-following albeit they are connected. Trend-following is the use of past prices to determine or measure a signal for price direction. There is  an understanding that when the trend changes there will be a change in view. There is no remorse from change and there is no extrapolation beyond what is the immediate forecast. In fact, although they are, a trend-follower is unlikely to even call his decisions forecasts. 

Forecast extrapolation is an inertia with not being able to see anything but current behavior as future behavior. It is a deficiency of imagination with respect to what is possible. Beating the fallacy requires more choice of alternative economic realities. 

McKinsey & Co on investment management - Embracing advanced analytics only the beginning

A new research piece from McKinsey and Co focuses on the investment management industry, "Advanced Analytics in Asset Management: Beyond the Buzz". This work is not cutting edge. It is straight forward advice that more analytics are being used in the distribution, back office, and the investment process, and investors are going to have to step-up their analytic game. 

There is no question that given the large amounts of data and the high rewards, the greater use of analytical tools is obvious. The quant revolution has started before the Financial Crisis and may be more advanced than other industries. The problem is not the use of these tools but the clarity of the investment goals. Most will just say that the analytics are supposed to help increase returns, but that does not address the true problem. How do you make better investment decisions in an uncertain world?

There are three areas that an analytic revolution will not solve directly:

1. Setting the objectives for fund;
2. Improving the actions from a decision process;
3. Solving problems of unknowns (uncertainty) from non-measurable events.

Increased use of analytical tools is an arms race with other firms, yet many of the techniques discussed in this report such as machine learning are readily available. The skill separator may be the ability to implement new information not creating it. The decision process especially when dealing with uncertainty is more critical than the tools. 

Alan Krueger and the Tough Problem of Happiness

Everyone who has taken a course in economics is aware of utility theory and the desire to have more "utils". Those with a historical focus will recall the deep discussions of early 19th century economist, "utilitarians" and the dismal science. The concept of measuring and auditing happiness has resurged in economic research, but it has been a perplexing problem. The basic idea with both economics and finance is that money can buy you happiness, but the reality is more complex. 

One of the leading researchers working in this area was Alan Krueger who tragically died last week. He was a leading empiricist in economics who generated path-breaking research in many key fundamental problems, and was a strong advocate for using economics to solve complex policy problems. An ongoing research area for him was the study of happiness and its measurement. Interestingly, one of his key collaborators in this area was Dan Kahneman, the behavioral economics expert. 

Empirical research on happiness is actual very difficult. There are a host of problems with measurement and the psychology of happiness is very complex. For example, there is a gap between experienced and remembered utility. There is also a focusing illusion such that when we consider the impact of any factor on well-being they are exaggerated in importance. Researchers have delved deeply into time surveys and measurement of subjective well-being. Given his keen skills as an empiricist, Alan Krueger has been at the forefront of this research. 

From a finance and wealth perspective, his research is somewhat unexpected. His clear conclusion is that money does not buy your happiness. The level of life satisfaction and happiness for those with high income is not different than those with lower income as measured by their actual experiences. Granted there is need some minimum income, but the diminishing gains from income is strong. This conclusion is worth considering as we grind forward trying to add to our wealth portfolios.

The dispersion in hedge fund returns - Differences in style matter

All hedge funds are not created equal as the return box chart shows for the post Financial Crisis period. There is a significant amount of dispersion across hedge fund styles. Over the period 2009-2018, the difference between the best and worst hedge fund category is almost 7 percent after we account for global equities and bonds. 

A general observation is that hedge funds returns are bracketed between global equities and global bonds. In fact hedge funds could be thought of as the halfway investment. Returns will be halfway between stocks and bonds. Volatility for hedge funds will be between stocks and bonds and correlation will be higher than bonds but lower than other equity-type investments. There is consistent strong performance with relative value and general underperformance with quant strategies. with On a risk-adjusted basis, the best strategies are relative value and merger arbitrage. There is no guarantee for positive performance and every three to four years the average performance will be negative. Hedge fund returns are time-varying and seem to be linked to macro environment.

Hedge funds have a "Goldilocks" relationship with volatility. High volatility is not good for returns, but low volatility seems to limit the return opportunities. The average VIX over this period was below 20 percent so slightly higher volatility is good, but once volatility get above 25% there is a decline in performance. As volatility rises above a threshold, the chance for making investment mistakes increases. However, one way to protect against volatility is to look at investing in global macro strategies that will generate an excess return relative other hedge funds when the VIX index spikes.  

The Desire For Private Equity - Return And Yield; But Time May Be Running Out

The attraction to private equity and other less liquid alternatives is clear from the Guide to Alternatives by JP Morgan Asset Management. The return profile is much higher for private equity and debt funds than more liquid alternatives and global bonds; however, the dispersion in returns is multiples higher than what can be expected from other public categories. 

If you don't pick your funds correctly, you could be greatly disappointed and you will not likely be able to exit from your mistakes. The large dispersion suggests that skill is differentiable, so the effort at trying to find the right manager will be more likely rewarded. On average, there is some illiquidity premia with these alternatives; however, there are no guarantees that the average illiquid fund will do well as evidenced by the venture capital sector. 

Within the alternative space, direction lending has been the key winner for yield as non-bank institutions have intermediated the debt markets. The yield difference between equities and alternatives is much tighter when comparing real estate choices.  

The big investment question is whether the higher returns with private equities will continue at this point in the business cycle. A comparison between public and private equity returns suggests that the best days for private equity may have already occurred based on the return differentials between private and public funds.

Where are you getting diversification within alternatives?

All alternative investments and hedge funds are not created the same. There is significant dispersion in their correlations with global bonds and equities. Some are better at diversification and others are good for adding returns. A recent Guide to Alternatives from JP Morgan Asset Management provides long-term correlations for alternatives and hedge funds for the post Financial Crisis period. 

Alternatives have significant value for diversification, but a closer look should give some pause. First, significant diversification gains can be achieved through simple asset allocation with bonds. Second, the diversification gains from equity-like alternatives against global stocks are constrained. The private alternative markets need to generate extra return along with diversification to justify their use. Across all asset classes, the best diversifier is global macro. Albeit it has not performed as well over this period, its broad mandate allows for the greatest diversification benefit. Dynamic allocations across all asset classes can be very helpful.

Correlations across hedge funds show a higher degree of clustering than the broader set of alternatives. Global macro and quantitative strategies have the best diversification benefit within the broader set of hedge fund categories. The lower returns over the ten year post Financial crisis period have contributed to this low correlation, but these two styles lend themselves to effective diversification given their unique and broad mandates.

  

As portfolio diversifiers, alternatives and hedge funds still represent key value for portfolio construction, yet care is still needed for the style and manager selection process. This message is not new but needs to be constantly reinforced.

Risk premia investing versus hedge funds - Worth a look

As we better understand the return generation process, we are able to dissect any set of money manager or hedge fund returns into its component parts. At a high level, any money manager can be divided into a set of risk factors or premia and alpha or skill. As a general conclusion, researchers have found that as investors get better at identifying risk factors, the size of alpha declines. We are able to attribute more returns to specific risks so the amount that is leftover as skill declines. 

Additionally, as we find that hedge funds returns are associated with specific identifiable and repeatable risk premia, there is a greater desire to change the fee model based on the risks taken. If the majority of hedge fund returns are associated with compensation for specific risks taken, the idea of paying incentive fees seems odd. The incentive fee eats into the return compensation for risk. The incentive fees should be paid on alpha or the uniqueness of return generation and not on the risk exposures. 

Investors should pay for and celebrate alpha skill, but pay a different price for specific risk exposures. We are not arguing that money management for specific risk premia should be free, nor should the dynamic management of risk premia be dismissed as easy work, but there should be a better awareness of the different types of work associated with fund generation.

There is now a wide-range of alternative risk premia (ARP) that can be obtained at relatively low cost through the swaps market. A close look at some of these risk premia portfolios suggests that they provide similar and in many cases better returns than what can be received from hedge funds. These risk premia can be structured as a rules-based investing at a price that should be lower than the normal fee schedule.

We compared the average return of ARP indices across asset classes and multi-strategies for asset class as well as an average of these two HFR ARP categories against some broad-based HFR hedge fund index categories. While not an extensive time series analysis, the recent returns show that ARP average returns are comparable and in many cases better than average hedge fund returns. The mapping between the hedge fund indices and ARPs has not been done through regression, but the general concept shows that bundled risk premia can give the same return profiles as hedge funds. 

ARPs can be used as a core strategy for liquid alternative investing and hedge funds with specialized skills, or unique strategies that cannot be easily replicated through rules can serve as satellites. Invest in the best hedge funds, but if they cannot be found, use alternative risk premia delivered through total return index swaps.

  

Get out of the binary world - Focus on probabilities, baby!

One of the key problems with decision-making is that it is often simplified into either/or choices. "Yes/no", "Go/No-Go", is how we often focus our attention and make decisions. Life is easy when problems are framed as either black or white. For example, the Fed will either tighten or not tighten. Employment will either increase or decrease. The stock market will either rise or fall. These are phrased, in the end, as binary actions. Seldom will you hear a market pundit provide anything other than a binary choice problem. Forecasting is often viewed as being so hard that getting just the direction right may be more than enough to be successful. Unfortunately, framing uncertain forecasts as a binary problem is both near-sighted and flawed. 

Thinking in a binary world does not allow for a richness of details and choice in forecasting. Thinking about forecasting in terms of probability is more important. Don't frame the problem as, "I think the Fed will be on hold." Think or believe in something like, "The probability of a Fed "no change" at its next meeting is 70 percent." Placing the forecast in terms of probabilities changes what action can and should be taken. This is even more critical when looking at questions that can have a range of possibilities. You could say, "The change of employment growth being below 180,000 and the market expectations is X% and above 180,000, (1-X)%. Probability estimates can be done for a range of employment numbers to form a distribution of forecasts. This is harder but it allows for more investment insight.  

The response to a forecast that is a flip of a coin is very different from a belief that the chance is 70% favorable. In the first case, it may not be worth taking a bet. In the second case, the size of the bet may be large because the odds are favorable. By thinking in probabilities, the size of the bet will be more effectively managed. This applies even to what may seem like a yes or no question. It takes time and effort to think outside a binary decision world; however, once a pattern of thinking is established, the process becomes easier.

Many argue that being right more than 50 percent is not the measure of a good trader. Good traders can have a success rate below 50% and still make money. That is absolutely the case. Good risk management can offset forecasting errors. Holding winners and cutting losers can allow for lower forecasting skill, but increasing forecasting skill will only improve and not detract from performance.  The best way to improve this skill is to focus on the odds of forecasting. As you receive new information, there is a shift in the probabilities, not just a shift to either yes or no. Stop binary thinking and focus on the odds.  

Naturalistic decision-making permeates investment world

Gary Klein is one of the great researchers in practical decision-making; however, he has been overshadowed by the behavioral bias revolution and the more popular work of Nobel prize winner Dan Kahneman. That is unfortunate and should be rectified. Klein focuses on naturalistic decision-making; the fact that decision-making in real life is significantly different than anything in a controlled environment.

In the natural world, there is value with shortcuts and intuition that would be scoffed at as biases by those who work in controlled research environment. Biases may exist, but some are a response to settings in the real world. Experience from the past exercise of judgment is useful for making more efficient and quick decision when time and uncertainty are critical factors. For those interested, Klein synthesizes natural decision making in a short article. 

Natural decision-making is often representative of those who are either discretionary or systematic traders. A natural decision-maker is flexible and fluid with his decision and does not fit a theoretic foundation like maximizing expected utility based on assessing all probabilities. The discretionary trade is a natural decision-maker who uses his set of experiences to drive action when faced with new situations. Many investment decisions may not easily lend themselves to traditional decision analysis. Hence, intuition is valuable. We make the distinction between countable and non-countable decisions. A problem that can apply large amounts of countable data is more efficiently solved using quantitative techniques. Problems that are not able to use countable data require different skills and decision-making.  For example, reacting and profiting from central bank commentary is more art than science and requires an ability to connect events with future responses differently.

Nevertheless, even systematic traders may have to use experience, rules of thumb, and some shortcuts in order to effectively react to fast moving uncertain events. Any model building may require throwing out some information and limited the analysis to a manageable process.

Building models is a complex process that requires speed to offset uncertainty. Assumptions have to be made. Shortcuts taken. This is based not on expediency, but on a desire to get things right. Take the simple example of a trend-follower who is faced with limited information, volatile markets, and a requirement to control risk. It may be more effective to focus on analysis of price over trying to incorporate all alternatives. This is especially the case when the fundamental information is not readily available or provided with a lag.

While some have viewed natural decision-making at odds with behavioral biases, we argue that reality by be more nuanced. In a complex and uncertain world, there is a necessity to find useful shortcuts based on experience to increase decision efficiency. These approaches need to be scrutinized for their effectiveness but should not be dismissed as inappropriate solely because it does not fit the steps outlined for formalistic decision-making.