Alternative risk premia performance mixed for May

Returns for alternative risk premia for multi-style swaps which include a bundle of different risk premia categories like carry, momentum, and value have performed well this year, but these swap portfolios showed mixed performance across asset classes in May. Equities styles, as measured by the HFR indices, were down slightly with value and carry declining but low volatility and low beta strategies doing well in the declining market beta environment. Rates did well based on the strong bond rallies around the world. Currencies styles were mixed. Momentum strategies did well, but currency carry was a drag. Currency carry has shown to be correlated with equity market beta. Credit was hurt as spreads moved with the decline in equity beta. There is more dispersion with credit risk premia in these indices because there are less bank swap products. Commodity multi-styles were positive; however, many strategies underperformed based on the wide return variation in different commodity sectors. Overall, the multi-styles strategies were negative for the month.

Alternative risk premia have low correlation with market beta, yet that does not mean that there is no correlation with the market. There is good diversification but when there is a large market decline, ARP returns for a number of strategies will be pulled lower. The composition of the portfolio makes a difference when there is a large market move. As expected, more defensive strategies like momentum/trend and low beta did better in these environments. Our overall impression is that ARP portfolio returns were consistent with expectations.

Strong bond rally but we have seen larger in last decade - Largest since Fed tightening

The current bond rally is strong. Investors are discounting a global slowdown and further trade wars that will trade. There is no question bond investors have turned pessimistic and there is a growing flight to quality, but this move should to be placed in historic perspective. We have seen larger one month and three month moves in terms of basis point declines and we have seen greater percentage declines in yields. Two-year yields changes are less volatile than during the transition between quantitative easings. The 10-year yields have exploded to the downside earlier in this cycle only to reverse direction. This is the largest bond rally since the Fed switched to tightening.

The declines in PMI during 2012-2013 were more dramatic than the current decline, but we do not know whether this economic decline will continue. We could be in the middle of a further PMI fall, so we can easily see further yield falls. 

The market pressure on longer yields places more pressure on the Fed to act given the potential for further inversion. Two cuts are being priced in this year. Whether holding cash in an inversion or playing for a further bond rally, there is a strong case for further switching from risky to safer assets. Even if you are uncertain about economic direction, cash is attractive and safe. 

Academic (public) and hedge fund (private) alternative risk premia

There are many ways to classify alternative risk premia that are developed by hedge funds and bank swap desks. The simplest categories are style and asset class. Styles can include value, carry, or momentum, and asset classes include equity, rates, commodities, carry, and credit. However, another classification method is through where the risk premia idea originated. There are two major sources, academic research and trader idea generation or implied risk premia. These could be classified as public and private alternative risk premia.

The academic path is simple. Research on factors or risk premia from academic working papers is weaponized into an investment or trading strategy that can be implement through a variety of markets. A hedge fund or swap group will read the research, breakdown the work into components that can be replicated, and convert this work into a repeatable set of rules. The investment idea is not proprietary but the conversion process requires quant and trading skill. The implementation or practical knowledge may be considered proprietary. 

Unfortunately, some of the latest research states that after working papers are published or the research enters the public domain there is a significant and economically meaningful decline in the expected returns. Once the idea is out in the market, excess returns are arbitraged away. Crowds reduce the excess returns found in the research.

The second path for alternative risk premia comes through research done by hedge funds or banks and is not in the public domain. This is often in the form of firm-specific hedge fund strategies. This is a tradable and repeatable idea that a manager can believe is unique and requires special execution skill. There may be an economic foundation for the idea, but it may not have been explicitly tested in academic research. These ideas have often focused on volatility trading and replication of fund strategies like trend-following. If developed and marketed through a swaps desk, the investor is more directly dependent on the back-testing of the bank. 

The academic work is more public and subject to crowding from investors following the strategy as the idea is disseminated. The trader idea generation is private to the firm originating the idea but subject to the more unique risks associated with specialized construction. There is a trade-off of receiving a generalized risk premia versus one that is unique to the firm who generates and constructs the risk premia. The private (non-academic) risk premia requires more investor analysis and more trust in the bank swap desk construction and execution team. Our view is that the academic risk premia should be preferred albeit the crowding issues must be addressed. A trader risk premium requires added return to compensate for their structural uniqueness  

May market performance - Rotation from stocks to bonds based on trade war worries

Risk-taking seems like it is ready to be on summer hiatus. Nevertheless, a simple look at the data suggests that the stock to bond rotation seems a little overdone. The difference between stocks and bonds (SPY vs TLT) was over twelve percent, yet the economic data does not suggest a slowdown shock. Investors are reacting to two major themes permeating the global economy. The response to these themes is uncertainty since both issues are still unresolved. 

Trade wars are not going away anytime soon. In fact, positions are solidifying and there does not seem to be any sense of compromise in the air. Tariffs are increasing and widening over more goods. Alternative policies are also being discussed as further war responses, and tariffs are now being used as a tool for foreign policy in the case of Mexico. Costs will increase, margins will tighten, and consumers will retrench. While, in the case of the US, import are still a small part of the economy, these tariff wars extract a toll on consumers, impact capital expenditure plans, and hurt forward earnings for many firms.

The global economy is looking like it will be slower than expected. There may not be an immediate recession, but the concerns from the fourth quarter of 2018 have returned. While housing may be softer, durable good weaker, and retail sales slightly lower, the overall tone in the real economy does not look bad. Conference Board and the University of Michigan surveys both show strong positive views from consumers. The labor market is still very strong, and leading indicators and PMI numbers still suggest positive growth. Signals are more mixed than priced by markets.

This uncertainty is making global macro investing so difficult. There is not much different from 2016 when industrial production was negative but there was a continued strong labor market. Prices reversed after data became more consistent. Bond markets are pricing in two rate cuts in Fed fund futures and the inversion suggests that bonds are more negative than policy-makers. Growth and trade wars will have to get worse for these forecasts to be realized.