Credit risk - Profitability more important than leverage

There should be concerns about the amount of corporate leverage in the economy, but if there is no catalyst credit event, current risk is limited. We are not downplaying potential credit risk, but there needs to be focus on the right issues that will drive corporate bonds spreads higher. 

If corporate profits fall, there will be an increase in the high yield default rate. Follow the profits, and with profits moving higher, default rates have fallen. See Moody's Analytics, "Benign Default Outlook Implies Profits Will Outrun Corporate Debt". If the profit environment changes, credit risks will respond.

Debt as a percentage of profits is more important than debt as a percentage of GDP. The size of the debt to GDP may not forecast defaults but it does tell us the potential for severity if there is a profit decline. Consequently, following forward guidance on earnings may give an early signal on potential default and widening of spreads. Currently, earnings guidance has turned negative, yet we are seeing that earnings have been more robust than forecast last quarter. For the first quarter, approximately 2/3rds of companies reported earnings or a revenue surprise. Nevertheless, earnings guidance has turned negative for the first time in two years. This suggests that we may be on the cusp for changes in spreads. 

Bending the return curve with rebalancing using trend-following

Rebalancing has become an important tool for portfolio management. Nevertheless, the return impact of rebalancing will be affected by market return patterns. Regular rebalancing is a mean-reverting strategy. For example, if there is a simple 60/40 stock/bond portfolio, stronger stock performance will cause the allocation to deviate from the strategic allocation and lead to a higher allocation to stocks over bonds. A rebalance will take money away from the better performing asset and give to the underperforming asset. It sells winner and buys losers on a regular basis. See “Strategic Rebalancing” by Granger, Harvey, Rattray, and Van Hemert

Rebalancing may seem like an innocent enhancement strategy under normal times, but if there are trends in markets, rebalanced portfolios will show poorer performance than a buy and hold strategy. It will affect drawdowns and volatility. Take the simple market extreme during the Financial Crisis, rebalancing would have continued to add exposure to stocks even during the extended downturn and take money away from the better performing bonds. In essence, a rebalance strategy generates negative convexity for a portfolio.

A frequent rebalancing strategy is like selling straddles. Alternatively, trend-following is similar to buying straddles. Hence, incorporating a trend component with rebalancing will change the portfolio return convexity. There may be a middle ground whereby rebalancing is done in conjunction with following trends.  This may allow the best of both strategies. If markets are trending, delay rebalancing. If they are not trending, follow a regular rebalancing schedule. 

There is a simple marriage between rebalancing and trend-following that is consistent with holding winners and not giving to losers. This will offset the impact of rebalancing drag. While the impact of strategic rebalancing will be minimal during periods of calm, there will be strong benefit if we move to extremes. Applying discipline will allow for positive portfolio convexity at the right times. 

How many animals should be in the factor zoo?

Investment factor growth has exploded to the point that are now close to 400 identified through research published leading finance journals. This factor explosion has been called the factor zoo and it is overcrowded. A careful review of the statistical testing procedures will tell us that it is highly unlikely that all of these identified factors will be true. Many are statistically significant only by chance given a multiple testing problems. Additionally, if we impose transaction costs on these factors, their profitability will be diminished and in many cases not useful. 

Campbell Harvey and Yan Liu has written extensively on the statistical problems with the testing of factors and the incentive problem that is inherent with academic research. Negative papers are not published and papers that show "significance" may have been subject to the extensive testing of alternatives. There may be too many false positive. This requires increasing the threshold for significance. When these thresholds are applied, the factor zoo declines significantly.

The authors have now generated further work with the their paper "A Census of the Factor Zoo". It provides a google sheet list of all of the factors that have been studied over the last few decades. This information is now available to the public. See Factor Census https://tinyurl.com/y23ozzkc. They are suggesting a citizen science project that allows researchers to add to their database. This is google link is very informative and useful for any researcher who want to study factor investing. Understand the zoo and make better decisions.

Factor Investing - Not as easy as many expect

Factor investing currently is at the forefront of asset management, yet like many hot topics in finance there has been exaggerated claims on what return and diversification benefits investors will receive. Factor investing is a significant advancement for decomposing risks and building unique portfolios of risk, but investors need to be aware of a number of potential pitfalls. A recent working paper describes some of these key pitfalls. See “Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing” by RobArnott, Campbell Harvey, Vitali Kalesnik, and Juhani Linnainmaa. The authors delineate three areas of concern.

Investors can form exaggerated expectations on what can be the potential return performance from factors. Some have described a “zoo” of factors. There are now hundreds of factors that have been analyzed and reported in the academic literature. Nevertheless, many have been hard to replicate, show performance return declines after being researched, and have failed when tested out of sample under realistic market conditions. These poor results may be from data mining, not accounting for transaction costs, poor design, and potential crowding. There are successful factors that have stood the test of time, yet even their performance has been time varying and may be less successful factor after accounting for all costs. Don’t be disappointed if actual returns are less than what is reported in academic studies.

Factor downside risks may be greater than what would be expected under assumptions of normality. Some strategies are subject to negative skew, and tail risks, in general, may be greater than what may be expected in a normal world. There may be large drawdowns that are somewhat masked when looking at long-term returns. A strategy that is focused on one factor will of course have more focused risks than what may exist with a market portfolio. This downside risks do not mean factors should be avoided. Rather there should be extra focus on tail events. Focused risk management is essential if you are going to focus on factor investing.

Factor may look like they are unique and have low correlation with market portfolios and with other factors; however, factors can see increasing correlation with different shocks. Some factors will be sensitive to volatility shock, market extremes, the business cycle, or inflation. Some factors show negative convexity while others have defensive properties and positive convexity. Stress testing factor portfolios is essential. 

Tempering expectations for factor investing will actually help investors build better portfolios and lower any potential investor disappointment. Knowledge of factor pitfalls will only strengthen their long-term use as an alternative method for adding diversification and tying returns to specific risk premia and financial drivers.

Risk Management - Controlling what you have not thought of

“Risk is what’s left over when you think you’ve thought of everything.” - Carl Richards from "Risk Management" by Morgan Housel October 4, 2018

"Real risk is in the error term, what is unexplained after we factorize asset returns."

"If I can measure it, I can hedge it." 

If you know your market beta exposure, you have good choices. You can either accept the risk or hedge it. If you know your market beta exposure and this beta explains a significant portion of the variation in returns you can have comfort that the amount of surprise will be limited. 

If you have an asset that has some market risk but a large portion that is unexplained, the risks you face are different. You still can either leave the market risk exposed or hedged, but the majority of the risk cannot be explained. Hence, it cannot be truly hedged. You can conduct further analysis to measure the risks from other factors but you may still be left with a high percentage unexplained. You may have thought of everything with respect to your risks, but there is a lot leftover.  

Your choice now is either to diversify away this idiosyncratic risk or do nothing. Diversification is a good strategy but not satisfying because you may hold more assets under the expectation that these unique risks will offset the unknown. It is a strategy based on failure to measure and a failure to explain. Your focus has to be trying to reduce the amount of risks that are not obvious which has been a problem faced by almost any decision-maker.  

"The secret of all victory lies in the organization of the non-obvious" 

- Marcus Aurelius

Cognitive Priming and Trend-following - Not a Bad Thing

Cognitive priming is a real effect that has often not been discussed with investment decisions and behavioral finance. Suggestions can be used to steer the behavior of investors.  Priming is the use of stimulus to create a memory effect or create a temporary increase in accessibility of thoughts and ideas. It is the non-conscious use of memory. It could be used to increase both positive and negative thoughts, ideas, and behavior. Businesses have constantly used priming in advertising to help steer or suggest positive memories. Psychologists have tested priming for years and find that the power of suggestion or linkage is real and extensive. At the extreme, think of Christopher Nolan's movie Inception on the idea of implanting ideas in memory.

Priming can be occur with how investment ideas are presented or focused. This can be both good and bad. We are primed by the ideas we hear in the news, through the research we read, and through talk with peers. Priming can occur with alerts. These simple forms of priming are not surprising. 

I suggest that there is another source of priming that we do not give much thought - trends. A trend that flashes on a screen is a priming device. If you tell someone the price trend or show them a chart with a trend-line, there is an immediate memory imprint. Investor thinking is now filtered through this prime. Many will be stuck thinking that they want to be a long the trend. They will focus on looking for confirming evidence. Of course, there are others that want to fade a trend but again they are primed through the price action. If trends have continue or have memory, then many investors will be primed to think that trend-following is profitable. This is not system of trading but the memory response from seeing the trend priming. Nevertheless, there is the added effect of potential herding.

Many have highlighted the evils of priming. That does not have to be the case. Primed events help focus attention and in a cluttered world, gaining attention may be a good thing. What is critical is appreciating that cognitive priming is occurring.   

Liquidity - Investors should be concerned

If there is an adverse market move and you want to change portfolio allocations and sell some securities, will you get a fair price? Any of the downside situations that will be faced by investors will face a shortage of liquidity. This is different than thinking about illiquid investments where the knowledge concerning illiquidity is known. 

More important is the vanishing of liquidity for instruments that are usually liquid. Every investor should be prepared for a liquidity surprise. Like entering a theatre, the critical risk manager knows where are the exits. This issue is antiseptically discussed in the Global Financial Stability Report of the IMF for April 2019 as a "Special Report: Liquidity in Capital Markets". It is a problem but the report does not sound an alarm bell. 

Two issues jump out when thinking about market liquidity. One, the market structure that provides liquidity has changed radically since the Financial Crisis. It does not have the capacity to serve all investors who may want to sell in a crisis. High frequency and electronic trading makes liquidity in a crisis more fragile and the spread of technology is not equal. The trading future has come sooner for some. Two, the concept of market liquidity is fluid. Some asset classes are more liquid than others and market liquidity last year is the not the same as this year.

Market liquidity is dynamic. By some measures and for some markets, liquidity could be better than a decade ago, but there are some clear hot spots. Traders break up orders to reduce the price impact of trades and high frequency market-makers can make tight bid-ask spreads, but a shock can cause this liquidity to disappear quickly. 

Investors should conduct a liquidity assessment. If there is a liquidity flash crash, how will you assess this risk? How great a deviation from fair value will you expect from a liquidity shortfall? Is your portfolio protected against a liquidity shock? Given a specific shock, walk through what will be sold, how will it be sold, and what is the expected impact. Liquidity is like water. The price is low until it is really needed.

Be a Coach Belichick 5-tool Investment Leader

He (Bill Belichick) is a five-tool leader, adept at strategy, tactics, preparation, execution, and what you might call situational intuition, the rare ability to know which among the first four is required and when.  

- Mike Lombardi Gridiron Genius: A Master Class in Winning Championships and Building Dynasties in the NFL. 

This comment about New England Patriot coach Bill Belichick should resonate with any good investment manager. Coach Belichick is also noted as a teacher who is constantly trying to improve himself and those around him. Every manager should strive to be good at all five tools especially with  knowing when to employ each one effectively.  

It actually is hard to find good managers who have mastered all five tools. Strategies are often poorly defined and without a strong philosophy of how to exploit opportunities in the market. Some managers who can articulate a strategy are not good at the tactics of making money. Others are less effective at preparation which in many cases is the research necessary to exploit tactics. Preparation is often thankless. There are good analysts but these analysts are not always good at execution, which is a specialized skill. Of course, there are limits on our time so the most important skill is understanding the current situation and what skills are most needed at any time. Some problems require focus on execution while others need more preparation. Good managers know how to switch their attention. 

Managers should engage in a leadership tool assessment to determine what they need to work on to be more effective. This assessment should be a part of an annual review. Of course, Coach Belichick might give a grunt and just say, "Do your job." 

Declining market competition never good for futures markets

Few will disagree with the idea that competition through a diverse set of independent traders is good for futures markets trading, but this issue should be broadened to the subtle impact of general competition across firms in the economy, not just the futures markets themselves. There is a growing set of recent research that suggests that the US is becoming less competitive and dominated by fewer big firms. See the Kansas City Jackson Hole Conference in 2018, “Changing Market Structure and Implications for Monetary Policy,” as a sample of the work. 

This growing industry domination may not rise to the level of classic monopolies but more likely oligopolies where the majority of business is controlled by just a few firms. Their control of pricing and market structure can be significant and this will have an impact on price discovery, firm flexibility, and hedging costs for both producers and consumers.

Less competition is not good for markets which have futures contracts because the price of the underlying commodity will not be determined by a large number of diverse buyers and sellers. Price discovery will be driven by off exchange behavior. Hedging will occur away from the exchange. Marketing decisions will have less flexibility. Strong vertical integration will lead to internal risk management mechanisms that will reduce transparency. Some firms will be disadvantaged through the redistribution of risk at non-market prices.

There are fewer firms that market and control grain exporting. There are fewer meatpackers. There are fewer oil refiners. The list can go on. In the cash markets, the farmer, cattle rancher, coffee bean producer have limited choice for selling their product and may have limited choice from where to buy their inputs like seed and fertilizer. Buyers and sellers are both seeing increased concentration and those with less size are left at a cost disadvantage. This requires further consolidation as risks are shifted between players. While there may be less volatility from the lower number of players, the information obtained through the competitive forces of futures trading is diminished. Each industry is unique and a high level discussion may not do justice to the structural changes faced, but increased concentration will hinder the competitive price process.  

The large banks will not make an issue of reduced competition. They have been at the forefront of consolidation. There is growing concentration of clearing in futures trading and banks have large lending books with industry market leaders. Trade groups will not advocate for more competition because they are either dominated by large firms or do not have significant market power. Consumers are fragmented groups that do not appreciate concentration issues when they see so many brands in their grocery stores. Market regulators are not concerned with broad issues of consolidation as long as there is not market manipulation or excessive positions. Exchanges have consolidated so there is little choice for trading marketplaces. More work should be conducted on the impact of market concentration and industrial organization to determine whether market concentration has gone too far.

The end result is that concentration continues with perhaps little notice by the market participants until there is a critical concentration that reduces the ability of smaller players to navigate the market structure.

Monetary regime change - A crisis catalyst is needed

If we review the first quarter financial performance, the dominant macro theme was the change Fed policy actions. The same could be said about the EU. No increase in rates and no strong trend to normalization. The new macro focus is on the choice of Fed governors. 

More important than any policy comments or change in Fed governors are the long-run changes in monetary regimes. These regime are extended periods of dominant policy choices. The regime themes drive the behavior of financial assets. Quantitative easing has been the dominant theme for the last decade and attempts to reverse this theme have hit a wall.

These themes drive central bank choices only to be discarded when they prove unable to address current problems or the world is punctuated by geopolitical upheaval. Wars cause monetary regime changes. Financial crises require changes as the policies of old are found to be inadequate. Central bankers only change their dominant policy when change is forced upon them. Failure and disruption are necessary for change. Without a liquidity crisis, don't expect a new regime. We muddle forward.  

The dual mandate Fed - Central bank independence has been a constant battle

Is the Fed independent? Should it be independent? Has independence been an important topic in the past? More specifically, should new Fed governors be biased to economic growth, consistent with current fiscal policies over expected inflation, focus on price stability? The current discussion associated with new Fed governors is nothing new. The Fed has always fought for as much independent as possible, yet the Fed is a creature of Congress. 

Investors should not forget that the Fed has been under the dictates of the Humphrey-Hawkins bill for over 40 years. The objective of this bill was to ensure that the Fed was focused on full employment as well as inflation and coordinate with the other branches of government. That was not always the case. Humphrey-Hawkins was spawned from the Civil Rights Movement. The objective was to make the Fed more focused on the public interest of employment over the inflation interests of bankers and the money class. This interesting history was described in the pamphlet "The Full Employment Mandate and the Federal Reserve: Its Origins and Importance" written by affiliates of the Center for Economic and Policy Research and the Center for Popular Democracy  

The current policy discussion is actually more than just having the president pick Fed governors that will follow his policy bidding. It is also deeper than whether the Fed will continue to lean toward growth over inflation fears. This issue is greater than change any mix between hawks and doves. 

We don't have bias on what should be done. We do have an interest in the choices made because of what will happen to financial markets. Our greatest fear is not with any specific policy bias as much as a fear that the Fed will continue to have a history of poor forecasting.  The impact of forecasting mistakes will only be amplified when there is a policy extreme. A temperate Fed will mute poor forecasting. Caution is good, yet no action can be dangerous. In an uncertain world dominated by poor prediction, a tempered central bank may be best for markets. A strong bias coupled with forecast errors only means that the end result will be a more extreme market reaction when the errors are revealed.  

Factor Momentum - An important property for portfolio building

An investor who buys the top performing factors and sells the poor performing factors will improve the portfolio performance comprised of different well-known equity factors. This momentum is not the same as the well-known stock momentum factor and seems to be an independent property of investment factors. Momentum can be found almost anywhere within the investment world.

As shown by Gupta and Kelly in their deeply researched paper, "Factor Momentum Everywhere", there is time series persistence in most equity factors. The authors studied 65 different characteristic-based factor portfolios that have all been documented in leading academic journals and found that the majority has persistence that is meaningful. See their paper for the complete list of factors analyzed.

Some may think of this evidence of persistence as just an interesting anomaly. The importance of momentum is not just in the underlying assets but also in the risk factors that define returns. Nevertheless, this property has important implications for portfolio construction. Investors can time factors and construct improved dynamic portfolios over a static factor allocation. 

Their time series factor momentum portfolio (TSFM), which bundles all the factors with momentum, has both strong alpha and a high Sharpe ratio. This time series effect is much stronger than what would be found through a cross-sectional approach across factors. 

As found with other momentum models, this effect is present for many different look-back specifications. It is strong in the short-run as well  as for longer-term memory structures. Factor momentum is a robust effect. A significant allocation to TSFM also is present when forming ex post tangency portfolios. 

This research suggests that there can be exploited persistence when forming portfolios of alternative risk premia that proxy factors. It provides a simple framework for increasing exposure to positive performers and selling those factors (risk premia) that have shown recent negative performance. As a macro-focused manager, I am interesting is studying whether this persistence is also present with other asset class factors. If factor momentum is everywhere, investors do not have to be limited to volatility or risk equalization portfolios. Momentum used as an expected return measure and coupled with optimization can improve portfolio performance. 

Any one momentum/trend look-back period is good, but ensemble modeling is better

A new paper from the smart researchers at Resolve Asset Management, "Global Equity Momentum - A Craftman's Perspective" shows the value of ensemble modeling for momentum and trend-following. Their careful research suggests that there is nothing inherently wrong with trying to find the best look-back specification for a trend and momentum model. Many specifications work and this is a testimony to the robust nature of trend and momentum styles. Nevertheless, the dispersion in performance relative to a median can be quite large. This style may work but if you happen to have picked the "wrong" look-back period you will be disappointed. This suggests that choosing the median look-back across a broad range of choices makes sense, but investor can do even better if they blend or diversify momentum/trend timing approaches. 

Instead of just looking at the historical record, the folks at Resolve ran extensive bootstrap analysis coupled with hundreds of variations to provide distributional properties on the look-back choice set. Many specifications seem to work and generate positive returns with good information ratios, but a better approach is to blend timeframes. Timeframe diversification will reduce risk and dispersion relative to a median specification; consequently, blending look-back periods is an effective way of reducing underperformance or regret. There are well-defined approaches for this blending through the use of ensemble techniques.

Many modelers have intuitively known that time scale diversification works and have incorporated this knowledge in forming more robust trend-following and momentum models, yet few have done the exhaustive work to truly study the value of diversification. As important, the Resolve researchers have shown how to develop a robust approach to find the best ensemble over some ad hoc blend. Their application to a well-known data set and modeling approach for global equity momentum should satisfy even the most skeptical investor that there is a value with being a model craftsman. 

The problem of decision choice - Investors don't look at enough alternatives

Paul Nutt, a leading decision-making researcher - Only 15% of the case studies saw decision-makers actively try and seek-out new options than what were available at the outset. Only 29% of organizational decisions contemplated more than one alternative. (From Farsighted by Steve Johnson)

There is more to decision-making than "whether or not".

Too often decision-making is bereft of choices. Everything is condensed into a "go or no go" decision, or just an act of rejecting the choice that is placed on the table. This is just a choice between one change and maintaining the status quo. Think how limiting decision-making is under this simple environment. Yes, limiting choices simplifies problem-solving but it also limits opportunities.

It is not easy to develop alternative choices. We naturally like to limit our choices because our ability to process multiple pieces of information is limited. We also have a problem with processing alternative models that may be in conflict. Alternative models require acceptance of disorder when we prefer an ordered world that follows a few simple rules. So what should an investment manager do?

When presented with a single choice, ask for more. What are we forgetting? Ask for the choices that were eliminated from consideration. However, the most important requirement is not the choice of action but expanding the forecast choices. Investment choices are limited because the environmental choices are limited. Ask for alternative realities. For example, if we believe that the Fed will not raise rates in 2019, there is a limited set of choices for action. If you accept that there can be alternative realities where the Fed may act to raise rates, albeit unlikely, the investment choices are greater and more complex. The set of choices is a function of the set of assumptions used. Change assumptions and choices change. Ask for different assumptions and see if choices change. Along with increasing the choices is a requirement to handicap their likelihood. More alternatives are good, but the likelihoods of alternatives are not the same. 

Increasing choices goes back to basics - look for alternatives and weight them by their probability of success. Increase choices of forecasts and increase choices of action. Map a set of forecasts into a set of actions.

Focus on liquidity before jumping on the PE bandwagon

A well-known GP has been known to say that PE performance “isn’t a return until you can buy a beer with it.”  - Chris Schelling

Following this beverage analogy, liquidity is required to slake our thirst for funds to smooth consumption. Wealth is generated and stored to offset needs that cannot be met with current income. 

Liquidity means being able to sell investment with immediacy at a known price. That beer has to be in the refrigerator and ready for immediate consumption. One of my leading concerns for 2019 is liquidity. To be truthful, liquidity has always been one of my leading investment concerns. Liquidity can come in many forms and it does not mean that everything can or should be sold at fair value on any day. It does mean that there should be limited structural and market restrictions on the access to invested money.

Liquidity is the ability to gain access to cash. For any portfolio with different levels of liquidity, a financial crisis means that you will have to sell liquid assets first which will change the risk composition of the portfolio.  Portfolio imbalances as a response to cash needs are normal. Investors accept low returning cash for a portion of the portfolio to minimize imbalance risk and liquidity costs. However, an extended downturn that impairs income will require more funds from wealth which increases portfolio tracking error.

Patient money can invest in less liquid assets and take the portfolio variation risk from different liquidity levels. This is the key reason why endowments can load up with private equity in ways that cannot be done by investors who need more liquidity. Patient money does not have to worry about short-term business cycle risk. Patient investors can look beyond portfolios built to support consumption smoothing. Of course the money manager has to convince a board of trustees that patience is a virtue with potential mark-to-market pain.

Our core concern with PE investing is that the desire for higher returns will mask the need to focus on liquidity. The risk is especially present when we are potentially late in the business cycle. Do a liquidity stress test assessment before focusing on further private equity investing. 

Strong first quarter returns for selected alternative risk premia

Selected alternative risk premia showed strong performance during the first quarter. There is significant tracking error with the HFR risk premium indices versus individual bank risk premia swaps, but they can provide some suggestive rankings. This strong performance should not be surprising given the large reversal of with equity beta and the strong moves in global bond markets. A couple of major themes emerged for the first quarter centered around positive equity beta risk and falling volatility. 

Volatility strategies that do better when volatility is normalized after a spike performed well. Given the link between ARP performance and volatility, the declines since December were good for these indices. Concentrated risks in credit also did well as spreads declined significantly with the reversal in equity market risk. Carry strategies that are often correlated with equity market risk and volatility also performed well. Momentum long/short neutral strategies were hurt from rising short returns and rotation across sectors. Long-only momentum (smart beta strategies) performed better in the first quarter. A stable environment for the second quarter should allow risk premia strategies to generate further returns.

With market risk, so goes hedge fund performance

Hedge fund performance was dominated by the exposure to market risk as those fundamental equity funds that held more market risk dominated style performance. However, the average returns mask the large dispersion across styles. We still use indices for analysis because it does provide some information on what the average investor may expect. For example, while CTAs were down, on average, for the first quarter, anecdotal evidence from managers sending me reports show some up in the double digits for the first quarter. Winners made big money in the last quarter.

Call it luck or call it skill, the huge differences in performance were based on two key factors - one, long equity beta exposure going into the new year, and two, long fixed income exposure globally especially in March. Faster models made money. Discretionary traders who pounced on the changes in central bank thinking, or those who over-weighted fixed income were winners. If you got those two trades right, you made your year in three months. If you missed this or were late to the party, you are playing catch-up and having calls to explain performance to clients. 

A dirty secret for hedge fund management is that investors don't want any hedges during big market up moves, they want performance. Underperformance during large market beta moves requires an explanation from managers.