Alternative risk premium versus bonds - A choice of factor risks and diversification

Investors want diversification from their equity exposure. This desire for diversification increases with uncertainty and with expectations of an equity decline. The big question is how or where are you going to get this diversification. The diversification winner for the post Financial Crisis period has been simple, US bonds. Bonds have been an asset that generated a good rate of return with lower volatility and a negative correlation with equities.  You could not ask for a better diversifier. Unfortunately, the investment environment is changing and the benefits from bonds may no longer be available, so there is an increased desire to find new diversifiers. 

An effective alternative diversifier could be a portfolio of alternative style risk premiums. No investor should divest all of their bond exposure, but alternative risk premium (ARP) strategies may offer a different form of diversification safety. 

Think about the cause of the core bond diversification boost. Bonds benefited from low inflation, declining risk premium, and central banks that wanted to push rates lower. This combination led to good returns that were uncorrelated with equities. Now inflation is higher, central banks are implementing or contemplating QT policies, and risk premia are expected to rise. The underlying bond factor environment is less favorable. 

Diversification going forward can be achieved holding alternative risk premia across momentum, carry, value, and volatility to name a few. These alternative risk premiums can be executed through swaps which can be done as an overlay on bonds. 

Will these style premiums perform better than bonds? It is not clear and looking at past performance may not provide a perfect answers. What we do know is that an investment in a style risk premium will be by definition uncorrelated with market betas. Investors would be switching the risk factors driving returns and that can help if market beta risk is a concern.   

New research on loss aversion is causing me to think deeper - Worth a closer look

I have been a close follower of behavioral economics research. This broad research is insightful and has caused me to think deeper about how to make better decisions. It has certainly reinforced my belief that using algorithms to make decisions is better than discretionary judgment. However, I have read a series of recent papers that have caused me to take a closer look at some of the core behavioral beliefs that have been established in this area. See the work of Dan Gal and Derek Rucker in the Journal of Consumer Psychology and the recent article in the Observation Section of Scientific American, "Why the Most Important Idea in Behavioral Decision-Making Is a Fallacy: The popular idea that avoiding losses is a bigger motivator than achieving gains is not supported by the evidence".

A core behavioral economics foundation concerning risky choices is the concept that loss aversion has a strong influence on behavior. As simply put by the original authors, Dan Kahneman and Amos Tversky "Losses loom larger than gains". The relative pain from a loss is greater than the gain from winners, and this asymmetric view is more than just a function of risk aversion. 

The disposition effect, driven by loss aversion, states that investors will hold losers and sell winners. It has become a bedrock behavioral view about investors and is a core reason why many managers have stop-losses in models to counter-act this bias. 

Now we have research that calls into question loss aversion as the core reason for these effects both from a theoretical and empirical point of view. There is clear evidence that contradicts loss aversion, but it has either been dismissed or ignored. Loss aversion is a description of behavior and not an explanation of behavior. This research is not offering an alternative to loss aversion but rather a commentary on its usefulness and explanatory power.

This new research may not completely change minds on the importance of loss aversion, but it does tell us that loss aversion is a subtle concept and should be employed with more care. How we evaluate decision outcomes is very sensitive to a reference point that is often the status quo. The set-up of the problem influences results that suggests that any general conclusions concerning loss aversion may be suspect. 

According to Gal and Rucker, 

"In general, it can be stated that the name “loss aversion” represents exceptional branding from the perspective of enhancing the idea’s intuitive appeal as everyone is essentially averse to losses (just as everyone is attracted to gains). This good branding might have led researchers to identify phenomena as being supportive of loss aversion even though the phenomena, while involving losses, do not involve comparisons of the impact of losses relative to equivalent gains. As discussed in the previous section, examples include the sunk cost effect, the disposition effect, and others." 

This research is subtle and may not change an investor's decision-making, but it is a testimony to careful thinking about problems. The obvious may not always be correct and a simple narrative is not always applicable to a wide set of problems. 

Do I worry about the pain from trading loses? Yes. Should I take extra steps to reduce downside "pain" more than what would be the case given my level risk aversion (specifically account for loss aversion)? I am less sure. Accepting conceptual uncertainty may make for decision-making.

Prophets of Doom continue with negativity - Now what?

Ben Bernanke, former chair of the Federal Reserve. “In 2020, Wile E. Coyote is going to go off the cliff and look down.”

Alan Greenspan, also former head of the Fed. “There are two bubbles: a stock market bubble and a bond market bubble.”

Scott Minerd, Guggenheim Partners chief investment officer. The market “is on a collision course with disaster” and the catastrophe will hit in late 2019, with stocks losing 40%.

Jim Rogers, founder of the Quantum Fund. “When we have a bear market, and we are going to have a bear market, it will be the worst in our lifetime.”

From Forbes 4 Financial Savants Warn About The Great Crash Of 2020 Larry Light

These four experts are telling us doom is ahead. Call it Wile E. Coyote moments, double bubbles, bear of bears or a collision course with disaster, the prediction is the same - wealth destruction is coming. These are the usual doomsday stories. They may be right but there seems to be a natural bias to the dark side. We seem to like it and pundits keep feeding us these narratives. 

"I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage." - John Stuart Mills 

If you say the world has been getting better you may get away with being called naïve and insensitive. If you say the world is going to go on getting better, you are considered embarrassingly mad. If, on the other hand, you say catastrophe is imminent, you may expect a McArthur genius award or even the Nobel Peace Prize. - Matt Ridley

"Only pessimism sounds profound. Optimism sounds superficial," - Teresa Amabile

"For reasons I have never understood, people like to hear that the world is going to hell ...yet pessimism has consistently been a poor guide to the modern economic world.” historian Deirdre N. McCloskey

"Optimism appears oblivious to risks, so by default pessimism looks more intelligent." -Mogan Housel

Experts traffic in negativity, but this may not help the portfolio manager who has to make investment decisions to increase wealth and protect principle. Conservative investing to avoid these dark scenarios has cost investors real money. So what is the best course of action? 

We offer some simple solutions.

1. Discount the negativity. Realize there is a bias, so discount the general level of negative commentary and focus only on the change in negativity.


2. Find the alternative story. For every negative story, there should be a well-defined positive alternative. Find that story and see if it counters the negative. The same can be said for positive stories and finding the negative.

3. Diversify. Diversification is the only cheap alternative to protect against negative events. Diversification may come in the form of building portfolio with assets that have low correlation or forming bar-belled portfolios between cash and risky assets. 

4. Follow the trend. If there is high subjective uncertainty, follow the market trends that serve as a weighted average of investor opinions. You will be subject to reversals, but trend-following with some form of stop risk management creates option-like pay-offs that may serve investors well. This strategy should be tied with diversification.

Read the doomsayers, prepare for the possibility, but don't be burdened with negativity.

Charts that give me fear and calm this week

What did we learn from the February volatility shock?Volatility has trended lower and the same trades are being put into play; short volatility. Looks like the market has a short memory.

The signals for potential credit risk -
Can we support the market debt if there is no slower GDP growth? 

The growth in credit since 2008 is stunning -
Latest research states that credit growth is key indicator of future financial crisis.

Warren Buffet’s favorite macro measure -
Total market cap to GDP is reaching all time high. Perhaps the global nature of US first can allow for high number.

This recession risks low -
Model is not at elevated level, but is actually declining.

Yet, earnings numbers are attractive - 
Forward looking - Can this get much better?

China Reserves not keeping pace -
This is the level necessary to support the economy under a currency crisis. It will grow with the size of the economy and current account.

Strong decline in yuan -
This offsets the effects of a tariff but not one for one.

The flows tell the story - 
Improvement in EM capital flows has had a positive impact on some currencies and risks.

This has been a great trade but what is the upside -
Spread tightening in July helpful for high yield but what is the return to risk going forward?

Using principal components  as an asset allocation tool -
Look at PC1 can tell you where there are common risks and places to gain diversification.