A cov-lite recession - The impact of more lenient credit terms is not positive

Credit markets have changed significantly since the Great Financial Crisis (GFC). One major adjustment has been the use of covenants to protect lenders and bind the behavior of borrowers. In the last crisis, cov-lite loans were less than 5 percent of the total. Now, cov-lite is well over 85 percent of the total institutional loans. 

We have not had a recession, financial crisis, or a credit downturn since this structural change has taken place. We have no history with what will happen in a cov-lite environment. Loans with limited covenants cannot serve as potential tripwires for credit deterioration. A new paper provides some useful information on what may be possible. See "Consequences of Cov-lite Loans" by  Demerjian, Horne, and Moon.Their work shows how much the market has changed over the last decade. 

Determining the impact of changes in loan covenants is not an easy topic to research. There are a number of conflicting theories associated with agency problems between lender and borrower. A breach of a covenant is a technical default that can be addressed before there is a default. 

The main concern is that there will be more risk to lenders given there is a decline in monitoring of the borrower. The cov-lite trend has been a part of the movement to have more standardized loan features to make them easier to securitize into CLO's. Loans with more and varying covenants will be harder to bundle. 

The authors find that cov-lite loans are more likely to default than loans that have more covenants, and these loans take longer to default because there are no intermediate signals of financial difficulties that will trigger action, all else equal. The end result is that cov-lite loan contracts will have a higher financial costs. 

If we look at the current environment, there should be strong credit concerns. In a covenant heavy loan, there will be accounting triggers that will send signals to lenders on impending liquidity issues and signals to borrowers to make income-increasing decisions to avoid technical default. If a technical default is reached, lenders can then take action to force a change in borrow behavior, or engage in activities to protect their loan from further loss. 

Firms that have liquidity shortfalls against covenant terms will require restructuring. In a cov-lite environment, action can be delayed, but with consequence of further loss for the lender. A problem deferred is not a problem eliminated. We may think there will be an overall loan problem because loan terms are more lenient versus the last financial crisis.

Cockroach Theory or "It's just one darn thing followed by another"

“In the world of business, bad news often surfaces serially: you see a cockroach in your kitchen; as the days go by, you meet his relatives,” - Warren Buffet 2003 annual letter

"Wirecard and the Cockroach Theory" from my friend Alex Ineichen refreshes the thinking of Buffet on this topic. The idea that bad news evolves slowly but sequentially is important when looking at all markets.

The Cockroach Theory can be applied to macro markets as well as company cases. An outlier piece of bad news can be an indicator that other bad news is coming. Outliers can suggest a change in direction. Investors can be positive and just look the other way when they hear one piece of bad news. News could just be an outlier, or investors can assume it is a clue or a snapping of twig that gives us a warning of more bad news. Applying the Cockroach theory suggests that time series outliers should not ignored but respected as a clue for change. 

The fundamental direction of any market does not just reveal itself all at once. There may be some clear exceptions with policy changes, but for the most part, any crisis or change in direction is revealed one piece at a time. For example, the increase in state COVID19 cases could just be an outlier, or it could be the beginning of a trend change. Investors have to open to an alternative model. 

Perhaps this sequential thinking is the value of nowcasting and employing real time data. It allows for seeing and assessing new events quickly not based on a past distribution but on new evidence.

Most new data fall within expectations and most new information is noise. Most would like to believe that the status quo will be maintained. The Cockroach theory can be viewed as a Bayesian expression dealing with change in a time series market model. There is a prior distribution or belief, but new "bad" information or evidence can create a new belief. Investors have to accept the likelihood for change. 

Equity risk factor performance has switched since March

Long short equity factors are time varying and will change with economic conditions. This is easy to see when investors look at 2020. A winning portfolio in the US and Europe consisted of stability and momentum. Since the pandemic shock, value and quality have been the best performing factors. In Europe, momentum, value and quality have performed better. Counterpoint mutual funds provides this information through their factor scoreboard. 

Fundamentals affect risk factor just like they affect market betas, albeit sensitivities are different. You may not be able to forecast these fundamentals, but it is still important to understand how economic shocks will impact return performance for alternative risk premia.

See also: 

Macro risks and equity risk factors - Building unconditional portfolios is risky

  

What hedge fund return expectations should we expect for the next 10 years?

How have hedge funds performed when you look at 10 years periods? The answer may surprise you. This certainty raises some big questions on whether these investments have the same benefits touted earlier.

Hedge funds showed strong performance for the 1990's when the market was much slower; however, these absolute returns have not been seen for the last 10 or 20 years. Hedge funds, as measured by the HFR indices have shown only modest annual returns for the last decade. The relative performance versus an equity benchmark has switched to negative levels. Correlations have also risen over this period except for the HFRI Macro Index which has significant variation through time. (Source: Janus Henderson "A Case for Multi Strategy") 

What can investors expect over the next decade? This is one of the key questions for any asset allocator. Will hedge funds look like the 90's or the last decade? Can hedge funds create alpha to keep up with market exposure? Given the competition and size of the hedge fund markets, the likely bet is that returns will stay close to 20 year averages. Of course, expected returns for markets betas are also supposed to  be low, so the best guess is similar absolute return and better relative returns. This is not a pretty forecast if pension discount rates are still expected to stay around seven percent.

Eisenhower decision matrix; balance urgency and importance - Old school still works

Let's go old school with a useful decision matrix from Dwight Eisenhower, Supreme Allied Commander in WWII, head of NATO, president of Columbia University, and president of the United States. This matrix simply looks at the 2x2 combination of what is urgent versus what is important. Classify everything you do based on its importance and urgency. If it is important and urgent, put it at the top of the list. If the issue is neither important nor urgent, place it at the bottom of the list or eliminate it. 

If you are having problems juggling different tasks while at home during this pandemic, fit your work into the Eisenhower matrix. It is effective although you still have to get the work out the door. 

When the next crisis comes - 3 strategies for protection

The threat of a further crisis recession may have fallen, but we are far from being in robust growth environment. Any recovery may be slower than anticipated given the slow lockdown adjustment process. Additionally, a recent BofA survey states that 80% of portfolio managers believe equities are overvalued. There is still a "wall of worry", even if the level of anxiety has fallen. Active preparation for the next negative market event or crisis should still exist and be at the forefront of any asset allocation adjustments. 

Portfolio construction for the next crisis should focus on three guiding principles which have been explored in the paper, "The Best Strategies for the Worst of Times: Can Portfolios Be Crisis Proofed" The Journal of Portfolio Management 2019.

• Momentum (trend-following) works in a crisis - This is an effective strategy choice for the simple reason trend-followers are long/short global diversifiers that provide convexity when markets change. The good news for 2020 is that trend-following worked albeit not as well as expected given the sharp turn-around after the end of March. Another dynamic strategy is to increase exposure to the quality factor when a crisis threat increases. 

• Following a flight to quality strategy is effective - Switching to bonds and safe assets when markets turn negative or maintaining a core holding is a core crisis principal. The safe assets are a barbell to risky assets held in the portfolio.  However, the flight to safety rule for bonds has not been stable and the current low yields place a safety drag on any portfolio. The same stability issue exists with holding gold.

• Always protecting for bad times with "put" insurance may wipe-out the good - Investors must be prepared for bad times but paying for "insurance" through a put strategy is costly. A strategy of hedging with puts can be especially costly when there are long periods of "good times". A key risk is being out of the market during good times that last longer than bad times or paying for protection that is not necessary. Of course, if an investor knows whether insurance is necessary, then there is limited risk.

These principles may seem obvious, but it is a good place to start research and focus attention. The questions are clear: 

• How much trend/momentum exposure should be held? 
• What are the risks for holding safe assets? 
• What are the costs of downside option protection?  

Too much choice and no decisions - A story of hedge fund manager selection

The paradox of choice is a recurring problem in marketing and decision-making that has not been fully explored within institutional investment decision-making. The paradox of choice states that if there are more alternatives to choose from, it will less likely that a consumer will make any choice.

Look at all of the mutual funds and ETF choices available to investors. Look at all of the hedge fund choices. All have been developed to offer more alternatives to investors, so they have better return opportunities, yet the science supports the view that more choices leads to paralysis and fewer choices. In a competitive market, the suppliers of choices will not volunteer to close and reduce the choices, so it is up to the  investor to solve the choice problem. 

Investors always have the fear of regret. Too many choices and an investor believes that he will likely make the wrong decision; therefore, avoid playing the game. There also is the Hick's Law of reaction which states that more choices will reduce the reaction time for any decision. Too many choices can be overwhelming.

Investors will institutionalize limits on choice to make life easier; however, they need to be aware of what they are doing when they impose restrictions on choice. Investors form decision trees of restrictions to limit their choices, bind behavior, and reduce regret.

For example, if you say that there is a firm rule that a hedge fund manager has to have a three-year track record, you can eliminate all new managers. Have a strict operational due diligence, and more managers are eliminated. Have a minimum AUM requirement and even more managers will be eliminated. You are bound by institutional choices without regret. The field has been narrowed without the drama of having to choose. If you use a consultant, you can have them cut the list to a manageable number so a decision can be made. Investors bind themselves to all for better decision freedom.   

Is this behavior rationale? Yes, by a standard that a formal process is used to focus on a limited set of managers. The binding behavior allows for more efficiency. Is this optimal? No. Good managers will be excluded. However, if the funnel is too restricted the choice tree can be widened. It is a practical heuristic to solve the problem of too many choices, yet it generates financial inefficiency. 

Switch to the value factor strategy - Case analysis provides encouraging evidence

When will value strategies outperformance? There has been a long period of value underperformance versus growth, and value factor returns have continued to decline. Now we are seeing a recession with an overvalued equity market, so it seems normal to ask whether this economic combination will lead to a value strategy benefit. 

There just are not many bear market recession combinations, so there are only a few scenarios or cases that can be studied. The Research Affiliates folks, who always do high quality research, explored the potential benefits of value at key markets junctions like today by reviewing some past scenarios. See "Value in Recessions and Recoveries". They identify six key cases for study and break these into two types, fundamental driven and bubbles with fundamentals. This represents a very small sample, but it is still worth looking at the value strategy performance.    

The results from looking at the bear market, the subsequent two years, and the full period shows that there is a better than 2/3rds chance of gaining excess returns from holding value over a cap-weighted index over the full period. If an investor focuses on value when there is a bubble and bear/recession combination, the return gains are even more significant.

Value compares well with other factor strategies especially if the market is in a bubble environment similar to what we may be facing today.

We have looked at the empirical research on the value strategy in a past post (see "Value is still not an investment opportunity". The current macro factors for value are not compelling, but the Research Affiliates scenario research suggests that a value strategy is worthwhile if we look into the future recovery. 

Value still not an investment opportunity

Most investors want to be value players. The stock market by many measures is overvalued so the desire to buy value stocks or hold the value risk premia is strong, yet the numbers do not support holding this style. At some point this will change, but investors looking for the turn-around will have to stay on the sidelines at least until there is evidence of relative trend improvement. 

Analyzing a set of fundamental and macro factors associated with value comes to a clear conclusion that the environment is not right for value. Low inflation, low rates, low (negative) growth, poor fundamentals, poor structural environment, and bad technicals make for a poor value environment.    

Ergodicity, economics, and the real economy

The finance and economic worlds are not ergodic. Got it. This is a very important concept especially when we are faced with highly uncertain events. This concept should be getting more attention and investors should appreciate what this means at a high level.

It can best be explained through a simple example. Play Russian roulette with one bullet and a six-chamber gun. The odds of getting shot are 1 out of six. If a thousand-person sample repeats the process, the likelihood of being shot will be the sample average. However, if you played the game 1000 times is a row, you would be shot well before you reached 1000 tries.  

An ergodic process would have the same result cross-sectionally versus through time. The expectational average and the time average will give you the same result. No difference. Yet, in finance, economics, and gambling, most systems are non-ergodic. While there may be only a 4% chance of company bankruptcy in any year, the likelihood of going bankrupt over 20 years is much greater than 4%. Ergodicity is one of the important concepts that drive the views of Nassim Taleb.

Thinking through ergodicity is especially important when discussing risk. For example, wealth is not ergodic. An investor may believe that the growth of his wealth has some expected value given an average return, but if we walk through time, wealth can go to zero even though we have a positive expected value. A gamble may have a positive expected value, but you may go bankrupt without getting that expected gain. Risk through time is path dependent, and there is an absorption barrier, bankruptcy. Consequently, thinking about growth of wealth is as important as thinking about expected return. These concepts are well-explained by Ole Peters in his work, Ergodicity Economics.

I am not presenting the subtly of this work justice, nor am I presenting all of the implications relative to current thinking on risk and utility. The focus is on the simple concept that economic systems are path dependent. Wealth is sensitive to paths and you can lose everything even for positive bets if you play the game over time. The real world can be painful because we don't get the benefit of large samples of repeated play. Ole Peters says it nicely, "Ergodicity takes the story out of history." 

Macro risks and equity risk factors - Building unconditional portfolios is risky

Our knowledge concerning equity factor investing has increased immensely over the last few years which has a great impact on how factor portfolios can be constructed. Clearly, we are much more aware of the time varying properties of these factors, but more importantly we have a much better idea of the macro factors and regimes that impact these risk premia. This work tells us that unconditional portfolio construction is risky. The correlations between equity factors change. The diversified portfolio over the long run or at a given point in time may not be the risk faced tomorrow or in a different macro environment.

This thesis on the macro risks associated with equity factors has been extensively researched by the folks from Scientific Beta and presented in the Journal of Portfolio Management paper, “Macroeconomic risks in Equity Factor Investing”. 

The changing correlation relationships between equity factors is a sizable problem. While the correlation across equity factors seem low, there is a large variation between the correlations during good times and bad times. Not accounting for the changing correlation across macro environments creates portfolios with higher potential risk.

The idea of equal-weighted or equal risk weighted is not wrong, but we actually have more information on factor behaviors such that a portfolio that accounts for macro factors can be easily structured and can improve performance. The equal-weighted portfolio makes sense if investors are dealing with stable correlations across factors or there is no useful information on the time varying behavior of factors. Investors may not have skill to dynamically adjust macro risk, but they should be fully aware of these risks and account for macro surprises with portfolio construction.


Equity factors are sensitive to both bull and bear market conditions. Additionally, these factors are sensitive to other macro variables beyond the market environment. Investors should be able to diversify or tilt exposures based on knowledge of these macro sensitivities. 

The table below shows the sensitivities of factor premia, size, value, momentum, low risk, profitability, and investments, to a set of seven different macro state variables. Some factors which have low pairwise correlation actually have similar sensitivities to a given state variable. For example, low risk and profitability are both affected similarly to shocks in dividend yield.

The research looks at the sensitivity of the premia versus different regime models and finds some surprising results. For example, the low risk factor premia will have some of the widest return spreads across regime indicators. Low risk is not the same as stable returns.    

The impact of macro factors on diversification is significant. In the example below, two factor premia that seem uncorrelated can have a strong risk regime dependency that impacts risk. In this case, high profitability and momentum have a similar dependency during risk tolerance regimes while high profitability and value have the opposite dependency. The portfolio risks are vastly different. 

While it is intuitive that some equity factor premia will be more highly correlated during some regimes and to specific macro risks, this research demonstrates the strong portfolio effects from not accounting for macro risks. What is even more surprising is their result that if an investor controls for one type of regime effect, a portfolio can still be very sensitive to a different regime effect.

There is a whack-a-mole problem with macro risks. If an investor controls one set of macro risks, another set will appear. However, an investor will always be worse off by not knowing the conditional risks that  are present with seemingly uncorrelated factor premia. 

First Impressions Matter - A New Important Bias

Of course everyone involved with investments does deep research. No one would make important decisions on first impressions. Wrong. We now have proof of what you may have been told by your parents when walking out of the house on a first date or a job interview, first impressions matter. 

A thought-provoking piece of research shows that analysts are biased by their first impressions. Looking at over 1.5 million firm-analyst observations spanning over 30 years, the researchers of “First Impression Bias: Evidence form Analyst Forecasts” found that the first impressions of equity analysts have a lasting association with their future forecast behavior of a firm.

Analysts who have a positive (negative) first impression will have optimistic (pessimistic) future forecasts. Firms that have higher positive first impressions will have higher target prices and more likely "buy" recommendations. This impressions will fall over time, but negative impressions last longer than positive impressions. While other researchers have shown that there is a greater emphasis on recent information, this research suggests that there is a U-shaped relationship with events. There is emphasis on first impressions and then an emphasis on more recent events.

While this research is interesting for trying to discount the value of analysts, the impact of an impression bias effect can be much broader. The choices made by investors with respect to hedge managers selection may also be biased by first impressions. If this research on first impressions is true, a good or bad impression when meeting a manager will have a long-lasting effect. If you think the manager is smart, you will give them the benefit of the doubt. If you are not impressed by what you see, their presentation is likely to be tossed into the discard pile. 

Given all of the information that investors see on any given day, judgments often have to made quickly, yet those quick first judgments may bias any future view. Guard against first impression bias. 

Momentum and turning points - Working through corrections and rebounds

Momentum has proven to be an effective strategy that has shown consistency over the long-run, but it is not without risks - turning points. One of the most informative papers on momentum and the risks of turning points was produced late last year, but this work has not been given enough attention. See "Momentum Turing Points" by Garg, Goulding, Harvey, and Mazzoleni. This is an exhaustive work on turning points and momentum strategies but is an easy read and provides a clear picture of the return and risk potential for time series momentum portfolios. 

This paper's elegance is with its simplicity. The authors look at the simple combination of fast (1-month) and slow (12-month) momentum models. If the two strategies are positive (negative) and in agreement, the market is in a bull (bear) environment. If the fast is negative (positive) and the slow momentum is positive (negative), the market is in correction (rebound). The market can be classified as being in one of these four phases. These states actually can be translated to different economic regimes, risk environments, and survey surprises. Hence, momentum can be associated with different economic states and risk appetites. 

Some of the interesting findings from this research:

1. Intermediate speed momentum strategies will have a higher Sharpe ratio than slow or fast strategies.

2. Momentum strategies at all speeds have a positive average exposure (long over short positions), but market betas are lower than expected with slow and intermediate betas being close to zero and fast speeds showing negative beta estimates. 

3. The alpha from momentum strategies can be divided into market timing and volatility timing with market timing representing 2/3rd of the alpha and 1/3 associated with volatility timing.

4. The momentum strategies show varying tail risk benefits base on their ability to adjust to corrections and rebounds. 

5. Turing points from up to down have properties different than turning points that move from down to up. There is more likelihood of type I errors (false alarms) during a correction while there will be a missed detection or type II error during rebounds. These properties can be exploited by a dynamic strategy between fast and slow momentum.

5. These momentum results hold across international equity markets.

We can stop with all of talk about crisis alpha or discussion about the special features of trend-following as if there is some return magic. Follow some simple momentum, learn to get out of the way during corrections and rebounds and just be disciplined. Regardless of turning points, this is a great simple way to run a portfolio.

Barclays hedge fund survey and COVID19

How did hedge fund do during the COVID19 scare?  A simple way to analyze their performance is through a quick comparison for the first quarter of 2020. The numbers from Barclays Investment Bank suggest that their performance was consistent with past events like the Eurozone Crisis, the 2015-16 correction, and the 2018:4 periods. Hedge funds are not immune to market declines but will have a muted response. In this case, the MSCI world index declined 21.1% but the HFRX declined 8.2% or 39% of the equity decline. A similar comparison can be done for bear markets. Hedge funds offer lower volatility and market exposure. The numbers do not tell a story of absolute return but muted returns.

A quick survey look reported in May shows that investors have a desire for more long only equity, less fixed income and more balanced expected exposure in hedge funds and illiquid alternatives relative to last year. 

These survey numbers are consistent with the market moves we have seen over the last two months. Hedging and diversification are out, and market exposure is in. 

Turning points kill trend-following performance

Markets trend higher and trend-followers should make money. Markets trend lower and trend-followers should make money. The transitions or turning points are the problem. There will be periods of giveback and execution delay while the new trend signals are found. If there are more turning points or reversals, returns will suffer. This enemy of trend-followers is all well-know, but a new paper documents the cost of turning points. See "Breaking Bad Trends" by the researchers at Research Affiliates and Campbell Harvey of Duke University. The elegance of this paper is with its simplicity. 

The return impact of turning points is devastating for exploiting trends. Using a simple approach of comparing 12-month to 1-month return direction as an indicator of a turning points, the researchers find that as the number of turning points per asset increase the performance from a trend strategy declines. When the number of turning points for an asset reaches six within a year, the median Sharpe ratio falls below zero. This is intuitive but can be used as a good starting point to explain why trend-followers may lose money.  

The second graph shows the portfolio performance versus a weighted average number of asset turning points per year. There is a negative linear relationship between portfolio returns and turning points by year. The more recent periods have shown more turning points, on average, for markets. This performance pattern is similar to what has been found with trend-following managers. Asset turning points have become more frequent in spite of the fact that many markets have become less volatile in the post-GFC period. 

Their final graph is surprising. The static trend strategy seems to be independent of volatility. If you believe this graph, the work was done carefully and well-documented, the idea that trend following is a long volatility strategy is called into question. It does not matter what is the volatility environment. The turning points matter more.

The switching between long and short momentum trends has increased in recent times and has an appreciable impact on static trend-following. The paper offers further analysis on how to adapt to turning points through a dynamic approach to adjusting to changing trends. This is a fruitful area for further research. The challenge for trend followers is to find ways to adapt to these turning points. In fact, investors should spend less time on how trends or found but how managers adapt to the turning points.

Understanding the financial cycle - Look for where risks will materialize

The researchers at the Bank of International Settlements (BIS) have spent a lot of time developing the concept of the domestic and global financial cycle. This work has advanced our understanding of capital flows around the world.(See, for example, "Global and domestic financial cycles: variations on a theme", "A tale of two financial cycles: domestic and global", "How important is the Global Financial Cycle? Evidence from capital flows") 

I want to focus on what is a key concept of this work, the idea that risk across the financial cycle is not high or low but is rising and then materializing. The materializing of risk leads to changes in behavior which will cause the turning points in the financial cycle. While this distinction may be viewed as subtle, it is critical for investors who want to be prepared for swings in the financial cycle.

Whether a domestic or global financial cycle, changes in the financial environment are manifested through the flow of capital to risk-taking ventures. Excessive capital flows can occur when there is greater credit availability for risk taking above what is necessary to support economic growth. Credit allows for higher leverage and generates increases in collateral prices as asset valuations increase. Risks will build given the availability of cheap money, higher leverage, and increased valuations. 

Investors need to focus attention on those places where risks will materialize. This is not a function of looking at macro variables but studying specific markets which will be affected by capital flows and overvaluations. Macro risks are the summation of increases in the risks of individual market sectors. Investors who want to make money need to analyze the micro flows and how they will be affected if there is a macro catalyst. This could be at the country level, a domestic financial cycle, or at the global level, when capital is cheap across all countries.

The amplitude of the financial cycles has gotten higher because the Fed and other central banks have fueled credit expansions. When risks have materialized, which would have created market retrenchment and risk avoidance, central banks have furthered the credit expansion to stop the adjustment process. Macro-prudential and regulatory policies have been used as an offset to plug leverage problems while maintaining credit expansion. The post GFC period saw an increase in banking regulation to cut leverage excesses only to now have them appear in other market sectors, CLOs, cov-lite lending, and other forms of shadow banking. Cheap credit from the Fed fueled the global financial cycle and the great EM leverage increase. 

Volatility has fallen, yet this is not a measure for an investor's focus. Eyes should be on the risk builds and where they will materialize. Investor focus has to be on the largest beneficiaries of the great post GFC credit expansion and look how an adjustment will play-out given the current round of central bank stimulus. 

What is normal volatility for bond markets when the only major player is the Fed?

We use the CBOE MOVE index for 10-year Treasuries as a good measure for volatility expectations, similar to the VIX for equities. It is an option-based measure of market volatility expectations. The MOVE index in March reached levels last seen during the bond temper tantrum; however, these index numbers never reached the levels seen during the Great Financial Crisis. The spike was also lower than the bond jump in 2003. 

The MOVE volatility index is now lower than late 2018 and mid 2019 levels and currently does not suggest an abnormal market environment. The MOVE will increase on the latest unemployment numbers; however, can we really say the world is now normal given trillions of Fed purchases of Treasury debt and similar increases in Treasury issuance. 

As fast as the Treasury issues, the Fed buys and the private market participants are not the marginal buyers or sellers. What we can say is that a flood of central bank liquidity and large Fed purchases will dampen any change in expectations from private investors. There are only price information signals on central bank behavior, nothing more.