Sector dispersion on the rise - A sign of active management on the rise

August showed growing dispersion across styles, sectors, countries, and bonds. For example, there was almost a 5% difference between holding the emerging market and value ETF's (EEM-IWN) For sectors, there was an 8 percent differential between energy and technology (XLE - XLK) and a 3.5% difference in bonds between long-term Treasuries and high yield (TLT - HYG). 

The major theme coming out of August was the mixed message of holding bonds and emerging market stocks as opposed to risky US stocks. You could think of the EM stock bond combination as a barbell around large cap US stocks. Nevertheless, these mixed messages are unlikely to continue. The pessimism embedded in bond investors versus global optimism cannot hold for long. The central bank policy meetings in September may clear up these issues.

Global equity markets, especially emerging markets, again added value to portfolios while the more domestic sensitive styles like small cap and value continue to lag. The diversification benefit of holding a global portfolio has proved to also be an excess return generator. 

 Sector dispersion has increased significantly which we believe will have a positive impact on active managers. The differential between energy and technology sectors is now over 35 percent. The differential between health care and finance is over 12 percent. There has been significant return value with choosing the right sector allocation.

 The country return differentials are also large. The returns have been benefited by currency gains. Although this month was negative, South Korea has still generated strong gains in 2017 in spite of all the geopolitical risks from North Korea. 

Holding duration in bonds has been a winner for the month; however, the combination of foreign duration risk with currency gains have been especially favorable for this year. High yield showed the largest underperformance for the month and has underperformed closely aligned Treasury duration portfolios. 

Trend and breakout signals across a number of time scales still show value with holding country and bond risks which can be accessed in futures and ETF markets.

Managed futures post gains on bond and currency trends

Many CTA managers posted gains for August based on strong bond moves in the US and up trends in European fixe income. Currencies continued to add to profitability albeit the decline in the dollar has a flatter slope than previous months. Gold trading was profitable for those who traded it in tandem with currencies. Equity index trading was a more difficult sector given mid-month spikes in volatility and a reversal in direction during the second half of the month. Commodity trading was mixed for many managers with profitability associated with market allocation and style of trading employed. Oil trended lower while refined products and natural gas were slightly up for the month. Hurricane Harvey volatility affected position-taking at the end of the month. Industrial metals have continued their summer upward trends which has caused renewed interest in this sector.

Managers with bond heavy allocations were stand-outs this month.  There are perfect conditions for managed futures when a major market sector shows a strong trend with little volatility surrounding it.  Hence, the strong gains. This was only further enhanced with currency trends that have showed similar characteristics. A core sector gain can be further enhanced through satellite positions in less liquid sectors. 

September news and policy issues suggest that one of these trends may be reversed, but right now there is not likely to be significant position changes. Trends last long then expected, but extremes are often reversed and sometimes trends die of old age. This is when the quality of managers are tested. 

Agent-based finance and investing - Exploiting more than price is important

The book, The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber touches on the important idea that markets are driven by a diverse set of agents who have different objectives, levels of rationality, rules for making decision, and market power. The book makes a strong case for throwing out the existing theories that often rely on representative agents in order to more effectively explain the messy business of modeling financial markets. 

I am sympathetic to the main points presented by Bookstaber, and hearken back to the older age industrial organization work that focused on the dynamics and structure of players in a given industry. The description of the environment and how institutions enact is critical to understanding the dynamics of markets. Changes in regulation, adjustments in market practices, and the employment of market power all lead to situations which could not even be imagined in a world with atomistic similar agents. The representative agent approach, by assuming everyone is the same, naturally leads to market efficiency stories. There is no room for diverse behavior. An agent-based approach allow for ebbs and flows in efficiency based on the weight of different market players. 

More important for quant modeling, an agent-based view of markets focuses on more than just prices to help make better investment decisions. I have always been of the view that "prices are primal" and this is the best starting point for any market analysis. Price analysis can often be enough for finding market trends and making investment decisions, but secondary sources of information may be helpful for reinforcing price signals and identifying turning points. 

A classic example of using an agent-based approach to help with investment decisions is using the commitment of traders from the CFTC. The quality of the data has improved over the years with a finer breakdown of users categories and less delay in reporting. It is still not real time and there is significant noise in the data, but strong changes and extremes  in positioning is a good reinforcing tool to price behavior. 

The soybean chart of managed funds positioning provides a good story of when money was getting short and when it was reversing in response to a price increase. By itself it is not a good signal but with price, positioning information can reinforce what is happening in the market. This is especially true at extremes. Of course, given the availability of the data, many simple filter tools like the commitment of traders have to be recast in order to create an edge. 

The agent approach can be used to generate market context and color and can be further refined to include large trades, volume, and open interest. Given the success rate for trend trades is usually less than 50%, tools that condition or filter signals are extremely useful. 

August performance - Living in a bipolar world of safety and EM risk-taking

Global returns in August were unusual because of the bipolar behavior across market sectors. The strong performance on the long-end of the Treasury curve coupled with the negative returns for small cap and value suggests there was a flight to safety by investors, yet one the best performing sectors was the riskier emerging markets sector.

While there was an upward revision for US growth in the second quarter, the greater uncertainty concerning tax reform or cuts has weighed heavy on gains in equities. The switch from sell-off to return improvement during the month could be linked to a change in sentiment on this key issue. Negative sentiment concerning tax reform sinks the market while stories about a consensus for tax reform pushes the market higher. This issue focus uncertainty is not present in emerging market equities where good growth continues. International investments generally performed better on the dollar decline; nevertheless, as the currencies like the Euro move higher and seem especially stretched, there is a concern that it will negatively feedback on sales for these foreign companies.

With the end of summer, the focus is going to be on monetary policy with key meetings at the Fed and ECB in September. The Jackson Hole conference was a bust with respect to newsworthy announcements. The investment themes developed during the summer concerning overvaluation and policy direction will continue to be front and center for the fall. Still, the markets have shown a surprisingly level of stability given geopolitical and economic risks.