Moving from traditional assets to alternatives - Trying to stabilize Swiss conversion rates

If you keep rates low enough, investors will respond. Unfortunately, the response may not be what is expected. One of the macro objectives with forcing rates negative is to get investors to become bigger consumers; however, you can also get investors to be bigger risk takers or at the minimum different risk takers from expectations. For pensions, there is not saving versus consumption choice. In a lower rate world, pension have three options: collect more funds for future liabilities, cut pay-outs, or find new investments to offset the lower returns from traditional assets. 

According to the consulting firm Complementa, Swiss pension funds have increased alternative allocations beyond 10% with a range of new investment choices. These alternatives are for pensions that are often fully funded; however, the conversion rates that set the annual amount paid have been falling. If alternatives can boost or stabilize yields, then the conversion rate can stabilize, which will be good for pensioners. 

The finance behind alternatives is actually simple. Add alternatives and a pension can expand the efficient frontier. New return and risk opportunities become available. Some may increase risk while others will decrease risk or increase return. The role of the pension manager is to find the alternatives that fit within the return to risk objectives; low correlation and stronger stand alone returns. 

Antifragile alternative risk premia portfolios - Not easy to structure

Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure , risk, and uncertainty.

The antifragile loves randomness and uncertainty, which also means— crucially—a love of errors, a certain class of errors. Antifragility has a singular property of allowing us to deal with the unknown, to do things without understanding them— and do them well.

By grasping the mechanisms of antifragility we can build a systematic and broad guide to nonpredictive decision making under uncertainty in business, politics, medicine, and life in general— anywhere the unknown preponderates, any situation in which there is randomness, unpredictability, opacity, or incomplete understanding of things.

From Antifragile: Things That Gain from Disorder by Nassim Taleb 

The value of factor investing has been well documented. A diversified portfolio of alternative risk premia can generate good returns with controlled risk that are uncorrelated to traditional assets. Investors get paid from holding risks different than market beta. Yet, the core or primal problem that investors want to solve with alternative risk premia is very simple. How do you more than diversify but also protect a portfolio against left tail events?

The idea of trying to protect against left tail events is a less colorful way of saying that investors are looking for antifragile risk premia. I cannot say that there is a such a thing as an antifragile premia. By definition, a risk premia is compensation for risk taken, but the behavior of risk premia will differ across market environments and the business cycle. Premia that do better when market risks are high are valuable. Hence, they will not receive higher stand-alone returns. 

Investors are now digging deeper into the characteristics of alternative risk premia to provide diversified portfolio that have tilts to specific risks or are structured to have more potential downside protection. Some risk premia are pro-cyclical while others have pay-offs that may be more counter-cyclical. 

Some of the simple solutions to a fragile environment are costly. A program of buying puts is one possibility, but there are clear option premium costs. Switching from stocks to Treasury bonds has been a good diversification alternative since bonds serve a as flight to quality asset. However, the costs for holding bonds has risen with the decline in yields. Now bonds that serve as the flight to quality asset have negative yields. 

Still, we classify some alternative risk premia as being antifragile friendly.

Good for when there is expected fragility: 

• Non-predictive strategies like trend-following (times series not cross-sectional) 
• Long volatility that will improve when volatility rises
• Non-carry strategies 
• Flight to safety / liquidity - Treasury bonds 

Good for when markets have reached maximum fragility: 

• Carry 
• Value
• Mean-reversion 
• Short volatility 
• Illiquidity 

While there is not single risk premia that can be viewed as antifragile, there are combination of alternative risk premia that can be bundled into portfolios that can perform better under market stress. This is an important area for further research by examining the properties of alternative risk premia under different market conditions.

Be like Honda - Portfolio management as a production process

Systematic return management has a lot in common with running a factory. Return generation is a structured production process. Raw inputs such as macro and firm information as well as risk components are put together to provide a functioning product, the portfolio. This product is expected generate consistent returns with controlled volatility. Production quality is measured by whether the portfolio delivers the expected risk and return performance. The portfolio managers who are engineering the product try to create a repeatable process that prove consistent. Managers can improve returns by adjusting the production process.  Investors gain insight on the quality of the manager by monitoring their ability to implement an efficient production process. 

Honda Motors is one of the great automobile industry engineering success stories. Honda's success is based on the dynamic leadership of its founder, Soichiro Honda who focused on key principles for the firm's success. The core values of the firm are rooted in deep production knowledge and a questioning processes. For a great read on the firm, see Driving Honda: Inside the World's Most Innovative Car Company by Jeffrey Rothfeder. 

The key philosophical driver for Honda is sangen shugi, the three realities of "see it with your own eyes". While it did not originate with Honda, the firm has fully embodied these principles. The three realities are: genba, focusing on the real place where value is created; genbutsu, focusing on hand-on to go and see for yourself; and genjitsu, focusing on finding what is true through facts.  Knowledge comes from understanding local conditions. Know the details from the source. There is also the word monozukuri, the process of making things, which is critical to understanding what is built. 

To understand a car, you need to understand the making of the car. To understand portfolio management requires understanding the return generation process with deep detail. If you don't know all the processes for building a portfolio, you don't know the portfolio and you cannot deliver a good product.

Honda also developed the management idea of a "waigaya" or the group meeting to solve problems. But, this is not the same as just having a committee meeting. The waigaya is driven by four principles, all are equal, all ideas are disputed, the group owns the idea, and the group must come to a precise decision. These meeting can be controlled chaos but the idea is to focus on a problem and a solution and not on management structure. The lowest person in the group will drive the decision if it works. 

There, of course, is more to the success of Honda than just manufacturing philosophy. Some of their key management principles include:

• Focus on individual responsibilities
• Value simplicity over complexity
• Decide on facts not theory
• Minimize waste
• Keep the organization flat
• Employ autonomous and ad hoc design
• Engage in perpetual change
• Have cynicism of conventional wisdom
• Set unambiguous goals 
• Borrow freely from past innovation 

Now, close your eyes and think about these principles and the core idea of sangen shugi. These are all of the same ideals that you would expect from a high performing hedge fund or money management firm regardless of size. 

Financial Repression is Here - Helicopter Money and MMT Coming

Jim Reid's new study of The History and Future of Debt for Deutsche Bank details the explosion of debt over the last decade that is unprecedented in a non-war period. These large debt levels have not pushed economic growth higher as expected or desired. Monetary policy has pushed rates negative on trillions of debt to jumpstart growth and reduce the cost of financing, yet these monetary innovations still leave many thinking we are in secular stagnation. These monetary policies are consistent with past efforts to control the cost of debt after WWII through financial repression. 

Financial repression is often given a simple definition, an economic environment where policies are used to push or keep interest rates below the rate of economic growth. This was the case for 1946-1980 and again the case for the post Financial Crisis period. If global economies continue down the path of financial repression, the impact on asset returns will be meaningful. Look at the 1946-1980 period.

Leverage got global economies into the Financial Crisis mess and that has not changed. The debt trajectory may have slowed but the direction is still the same. There are sectors that have controlled debt growth, but the allure of low interest rates make borrowing all the more tempting. 

This debt growth has occurred even during a period when many countries have engaged in fiscal austerity. The net result is a world awash with debt but limited growth to pay for what was borrowed. 

Fiscal policy and thus more debt may be needed to end the growth malaise, an endless debt cycle. Monetary policy has not been enough even with $15 trillion in debt pushed to negative interest rates. The policy prescriptions have now centered on more QE or some form of "helicopter money" and modern monetary theory. Helicopter money can be considered the next level of quantitative easing whereby the monetary authority dispenses with buying bonds and focuses on increasing money more directly to the economy. Modern monetary theory (MMT) is a framework that turns conventional fiscal and monetary policy on its head. The government has the ability to spend or make injections to the economy. Taxes are a withdrawal from stimulus. The net result or imbalance has to be financed through either borrowing money or just increasing currency in circulation through accounting. The MMT crowd will say that if there is economic slack, then a direct increase in money will not be inflationary and will help with growth. Since we do not have inflation, their argument is that there is slack that can be financed with money without any dire consequences.

This debt study shows there are no easy answers and the thought that we will be anywhere near normal in the next few years is a pipe dream. Unconventional monetary policy and greater fiscal policy is most likely ahead. The impact is more financial repression and sub-growth interest rates. This is not a good prospect for investors even if in the short-term there is a gain from increasing bond prices.