Bear markets are unavoidable - So what are you going to do about it?

How often should you expect equity bear markets? Using the global diversified MSCI EAFA index, we calculated the number of bear markets, moves down greater than 20%, and corrections, move down greater than 10%, since 1970 by decade.  (Hat tip to Ben Carlson of "A wealth of Common Sense" for providing the raw data for developing these charts.) The numbers suggest that you will get 2-3 bear markets per decade. The number of corrections or bear markets total 4 to 7. The average decline of the bear markets is variable. The 2000s decade was horrible with two bear markets more than 50%. 

Bear markets will occur. This is why there is an equity risk premium. We already have had three EAFA bears this decade even with all of the liquidity help from central banks and the recorded low volatility. 

The answer to these bear markets is simple, diversify; nevertheless, a global diversification strategy for equities will not be enough. There needs to be smart diversification that looks across many asset classes or risk factors. For example momentum/trend-based hedge funds have the significant advantage of going both long and short based on price direction. With this strategy, bear markets can be turned into an opportunity instead of a cost. Strategy diversification does help. 

We are currently in an EAFA correction, so the portfolio protection solution is all the more important. Hold broad exposures across asset classes and strategies.

2/20 fees - DOA, dead on arrival - The changing market structure for hedge funds

The film noir, "DOA", had a great premise - a man staggers into a police station and wants to report a murder - his own. He was poisoned and had a limited time to find his killer and why. The hedge fund industry 2/20 fee schedule is dead. Some managers may not know it yet, some are in denial, but it happened and now it is just a matter of sifting through the suspects to find the killer. 

Most observers think customers are the drivers who forced a change in fees. There is no question that large investors have been pushing lower fees on managers, Managers can accept the fee reductions because they have economies of scale, but I will suggest a different premise; the competitive forces outside the hedge fund industry.

The key forces today are not from within the hedge fund universe albeit that is happening, and the forces are not just from investors albeit they have gotten smarter and have demanded more from managers. Banks are the key competitor through their swaps desks which offer alternative risk premium indices. 

Since Dodd-Frank, banks have looked for other sources of trading income. Offering swap products is a direct threat to hedge funds that are often generating returns through a combination of alternative risk premiums (ARPs). The banks can offer ARPs at low cost, high liquidity, and full transparency. Pricing can be a simple fee embedded in the swap index. The banks get flow, fees, and customers. Investors face a money center rated bank versus a hedge fund which will be significantly smaller. These "generic" products often match or better the performance of hedge funds and provide better terms. 

Hedge funds who are competing for the institutional market have little choice but to lower fees to similar levels offered by bank swaps. A hedge fund does not have to just argue that he is better than the other hedge fund down the street but that he is also better than an ARP index that is being offered by a big money center bank. Institutional investors can play these added competitors against each other to ensure the best price and product. The survival of premium pricing is only through specialized hedge fund skill. Tell me how 2/20 or some variation of management and incentive fee can survive?

If you need something to give you investment worries this weekend, this list will do it

The employment report for June was positive with both job creation strong and the participation rate higher. This is reflected in the stock market, but there are still growing clouds of economic and financial concern. 

Call it the curse of being a fixed income guy, but as we start the second half of the year, I am focused on some major headwinds that can dampen any further increase in financial asset prices.

Alternative risk premium indices - Providing insight on what is possible in the ARP space

HFR, the hedge fund index provider, announced a new set of indices based on alternative risk premium strategies generated from banks. This is a major advancement in transparency for investors and shows the strength in this growing sector of investing. 

ARP has mainly been the domain of hedge funds, but that has changed over the last few years as banks have become more aggressive at offering a wide range of total return index products based on rules used to describe specific alternative risk premium. Bank products now compete directly with hedge funds and provide risk premium strategies with low costs, transparency, leverage, and liquidity. The battle between banks and hedge funds is on.

Investors now have an enhanced number of choices. They can buy hedge funds as bundled risk premium products with a manager adding their skill and allocation expertise or buy a set of swaps to replicate specific risk premiums as generic return generators and use their own skill at building the portfolio. The core question is simple. Do you need a hedge fund to provide these risk premiums or can you obtain them from banks as index wholesalers?

The chart above shows the 1-year return and risk for the set of risk premium indices offered by HFR which are each a weighted average of similar ARP indices offered by different banks. All of the indices did not generate gains in the last year. In fact, many showed that ARP investing over the last year was difficult especially in the volatility strategy space; nevertheless, there have been a significant number of positive returning ARPs which have reasonably low volatility. These ARPs can form the basis of a good diversified portfolio that can replicate the behavior of hedge funds. This is worth tracking especially against hedge funds which have not performed as well as expected.