Rational Ignorance and Asset Management - Trend-following signals information attention

Trying to keep up with all of the information and news generated every day is a daunting task. There may not be enough hours in the day to even assess all the analysis that is generated let alone doing independent research. There are many questions that should be asked to determine how to allocate time reviewing information. 

How many analysts should be followed? How many strategists should be read? How much time should be spent reading news? What if important news is missed? What if what news highlighted or studied proves inconsequential? These relevant questions which impact our knowledge or ignorance will affect performance. Some information will be used and while other information is going to be discarded or ignored.

Some information or news is more important than others. If it is repetitive, it can be measured, tracked , weighed, and followed, but a lot of news is new and infrequent. Allocating time and effort should be spent on unique information which can often be more impactful because it is a surprise, yet the majority may just be noise. The cost of being informed or ignorant is important. 

For example, time spent on knowledge acquisition has been an ongoing area of voter study. The impact of a single vote may be small versus the effort to become informed. This cost is a reason for why voters show "rational ignorance". Voters may remain ignorant or uninformed because the cost of being informed may outweigh the impact of their vote. The cost of being wrong or right may be much greater for an investor, but the calculus of deciding whether to be better informed or stay ignorant is still an important decision. 

Classic economic orthodoxy states that an investor will conduct a cost/benefit analysis with respect to the acquisition of information, yet this does not answer the question of how rationally ignorant or informed an investor should be when faced with uncertain information and outcomes. There needs to be tools to fight the effects of ignorance and help focus attention. 

So how do investors fight ignorance or engage in successful rational ignorance?  We know that trying to learn everything will not work. The simplest solution is to invest passively and hold the market portfolio. This will allow an investor to receive the market risk premium without having to acquire information. A perhaps better solution is to not acquire information but measure the impact of new information in the market through trends. 

Trends serve as a signal of impact of information. Trends are the aggregate effect of the action of investors from their assessment of information. There is the assumption that others are information gathers, but the basic premise is simple. Use trends as a highlight for new information activity. If there is no new information, there should be limited trends. If there is a trend, it signals there is information activity that is worth our attention and focus. 

For some, the trend identification is enough information to act. There is no need to find the primal information. For others this serves as a catalyst for further inspection. By definition you will be late to market response to information, but it provides a low cost method for sorting through large sets of data. Trend-following can break the cost of information ignorance.

Trend-following with and without volatility scaling - Two different worlds

Trend-following seems generate positive returns across all market sectors and over long time periods. There may be stronger and weaker periods of performance, but the long-term historical record is trend favorable. However, there is some conflicting evidence with how successful trend-following is measured and structured. Not all trend-following is alike, or more importantly the historical success is partially an artifact with how the tests are conducted. 

Care has to be applied with determining how to best form a times series momentum or trend program. For example, the exhaustive study "Time Series Momentum" by Moskowitz, Ooi, and Pedersen found positive value from trend-following when structured with volatility scaling. A subsequent paper "Time Series Momentum and Volatility Scaling" by Kim, Tse, and Wald analyzed similar data and found that trend-following is no better than buy and hold when there is no volatility scaling. Their criteria for trend-following success is the measurement of alpha from a multi-factor enhanced Fama-French-Carhart model and a comparison with buy and hold alpha for a wide variety of markets versus a multi-factor model. This is not the same as saying that trend-following generates positive returns. 

How risk is managed matters, and the use of leverage is critical with futures trading. Not using the leverage in futures diminishes performance and alpha potential. The figures below show relative performance between scaled and unscaled alpha versus a buy and hold position. This research also finds that when buy and hold also scales volatility the gains from time series momentum is diminished, and the performance of cross-sectional strategies while positive will show differences in relative performance when there is volatility scaling. 

This has been an ongoing issue for discussion with trend-following managers. Do you volatility scale or not? Use risk parity or not? I see both sides of this argument and have been of the view that sizing based on volatility is useful but if overdone it can conflict with the goals desired by a trend model. 

Not surprising, the value-added for investors is in the details of how risk is managed, markets are bundled, and leverage effectively used. Investors should pay a premium for portfolio management expertise. The discovery of trends is critical but the true differentiator among trend-following firms is the management of risk. 

The ultimate goal of trend-following is to provide positive convexity versus a target benchmark. Convexity gains are focused during periods of market dislocation and not as obvious during long periods of return analysis attempting to measure alpha. Risk adjustments that diminish portfolio convexity harm this core goal, yet volatility scaling will improve overall portfolio characteristics in the long-run. 

Commodities will be subject to weather shocks (La Nina) - Opportunities for divergence

The Climate Prediction Center's Oceanic Nino Index shows cooler waters in the Pacific Ocean which is having an impact on global weather. The index is headed to decade lows which will translate into strong moisture and temperature differentials. There has already been an impact on some commodities, but this may spillover to the spring. 

Supply shocks will lead to stronger agricultural trends because supply cannot be easily be replenished. Agriculture supplies are inelastic in the short-run. We cannot predict the strength of any trend, but odds for a price divergence are better when potential shock conditions strengthen. The current forecast from Columbia University's International Research Institute for Climate and Society shows some potential weather extremes. 

That said, past La Nina events have not had an appreciable impact on, for example, Brazilian crops in the past, see cropprofit.com feature on ENSO cycles. This is the challenge for speculation, there is a risk set-up situation, yet the opportunity may not present itself until prices start to move. 

Always about the uncertainty - The good and bad in business survey data

Macro market valuation has to consider uncertainty with any longer-term assessment. The Atlanta Fed Survey of Business Uncertainty provides good expectational information that can help with this assessment. The survey asks business managers their 4-quarter ahead expectations for sales and employment growth as well as an assessment of business uncertainty as measured by the 4-quarter standard deviation for sales and employment. December number were recently published and contain both good and bad news. 

The good news is that the smoothed value for sales revenue and employment are still moving higher and the business uncertainty is falling for both series. This data suggest that businesses are looking through the current COVID case increases. The bad news is that sales revenue will still be below the average for the three years before the COVID shock. Employment growth looks to be at or above the prior three years. However, uncertainty, albeit below the high earlier in the pandemic, is still at high levels and suggests that businesses are still not sure of the environment a year from now. 

While monetary and fiscal policy are providing tailwinds for markets, the direction of the real economy is still far from certain.