CTA style dispersion higher - These are times when the pain from regret grows

Investors do not want to suffer from regret or  making a decision that proves to be wrong relative to  set of alternatives. Formally, regret is the emotional response associated with the value difference between a made decision and an optimal decision. The potential pain from regret will increase within a hedge fund style choice if there is greater return dispersion within the style category. Dispersion will increase the difference or penalty between any choice and the maximizing choice. 

There can be a wide set of alternative managers to choose, but the hope is that the investor's choice will be close to or above the median. Investors may use a min-max strategy to reduce the ratio of pay-offs versus the best or median choice. 

It should be expected that return dispersion will increase if there is higher market volatility; however, that also means regret will also increase with volatility. Higher dispersion occurs when there is higher market volatility because small differences in strategy may translate into greater differences in manager return. For example, the CTA's category an include everything from trend-followers, to carry and value managers, to market sector-focused managers. A cluster of the best managers may have different style than those in the bottom decile. The regret may have more to do with the choice of style within the CTA category over choosing a bad manager.  

If there is an increase in return dispersion like found in 2008 and 2020, the cost of being wrong, either by manager style or skill, may be especially high. These are the times when regret increases and there is higher frustration with hedge fund managers. It may not be the fault of managers. There is just more pain from regret.

Chart and table from All About Alpha:

"HEDGE FUNDS AND 2 ECONOMIC CRISES: FOCUS ON SYSTEMATIC AND ALGORITHMIC HEDGE FUNDS" 

Do you want a stable or variable beta for your hedge fund?

Do you want stable or variable market betas from your hedge funds? This may seem like a simple or even a trick question. Of course, an investor should want stable betas. If you have a stable beta, the gains from diversification can be well-defined and easily measured. Portfolio structuring is relatively easy in a stable world. However, there may be a good case, under certain conditions, for a variable beta.

Adding hedge funds to a portfolio may center around three questions. One, how much return do you want? Two, how much diversification would you like? Three, how much convexity will you get? 

A stable market beta below one will provide diversification. Under a stable environment, the return alpha can be measured. A variable beta (regression coefficient) makes it harder to measure the diversification gains or determine the true alpha production, but it does provide the potential for positive convexity. A hedge fund that can generate more beta when the market returns are increasing and less beta when market returns are falling has  some very useful properties.

It looks like systematic CTA's, especially trend-followers, may have this property. Generally, CTA's have a long-run low correlation with the market beta, but it also can have positive convexity through its trend-following models. If the CTA adds more relative long exposure to equity indices during rising stock prices, the beta for the fund will increase.  The hedge fund generates is positive convexity. In the example, a variable beta is the benefit from trend-following with exposure to equity indices. The variability and sensitivity to market factors is critical for hedge fund selection.

The graph, which highlights systematic CTA's, shows falling and low beta during the GFC and during other periods of equity weakness. It also shows a wide range between .8 and -.3 during the post-GFC. Beta variability is desired if it is tied to correctly taking advantage of the market direction.  

Chart and table from All About Alpha:

"HEDGE FUNDS AND 2 ECONOMIC CRISES: FOCUS ON SYSTEMATIC AND ALGORITHMIC HEDGE FUNDS" 

Great quarter for stocks - Now what?

If I told you that the equity benchmark was up over 20% for the quarter, and global stocks were up close to 17%, you would respond that economic fundamentals were through the roof. The pandemic and lockdown shock came in March and we are now reversing the market constraints, but it looks like we are facing a "square root" and not a V-shaped recovery. 

The second quarter was the market of disconnect. With massive liquidity injections and fiscal stimulus, a bounce should have been expected, yet a return to anything like normal seems a stretch. The third quarter see the market of economic reality. 

• The GDP nowcast for the second quarter from the Atlantic Fed has improved but there is no mistake that the economic shock was severe.
• The New York Fed nowcast shows a positive third quarter but nothing that will offset the second quarter shock.

   

Concern should still focus on the simple law of uncertainty. If there is more uncertainty, spending will slow, cash will be raised, and investment decisions will be delayed. Save cash, and delay decisions until tomorrow.

• The policy uncertainty index has reached all-time highs. 
• The business uncertainty index shows a small improvement for sales growth while the capital investment and employment growth indices are surprisingly stable.

Uncertainty causes decision delays. Sales will fall,  and capital goods will not be purchased. Investment plans will be scuttled. No amount of new money will change this reaction. There is no discount factor that will make uncertain cash magically more positive. The animal spirits of optimism will have spoken. Realize that if uncertainty is resolved and is more pessimistic, the impact will be worse.

Investors were given a gift from central banks, a chance to get their asset allocation houses in order. This gift should be effectively used to protect from downside risk. Of course, the cost of significant derisking is high, but switching to factors and styles that are more defensive is still the right choice in a more normalized world that is not further shocked by policy.

A cov-lite recession - The impact of more lenient credit terms is not positive

Credit markets have changed significantly since the Great Financial Crisis (GFC). One major adjustment has been the use of covenants to protect lenders and bind the behavior of borrowers. In the last crisis, cov-lite loans were less than 5 percent of the total. Now, cov-lite is well over 85 percent of the total institutional loans. 

We have not had a recession, financial crisis, or a credit downturn since this structural change has taken place. We have no history with what will happen in a cov-lite environment. Loans with limited covenants cannot serve as potential tripwires for credit deterioration. A new paper provides some useful information on what may be possible. See "Consequences of Cov-lite Loans" by  Demerjian, Horne, and Moon.Their work shows how much the market has changed over the last decade. 

Determining the impact of changes in loan covenants is not an easy topic to research. There are a number of conflicting theories associated with agency problems between lender and borrower. A breach of a covenant is a technical default that can be addressed before there is a default. 

The main concern is that there will be more risk to lenders given there is a decline in monitoring of the borrower. The cov-lite trend has been a part of the movement to have more standardized loan features to make them easier to securitize into CLO's. Loans with more and varying covenants will be harder to bundle. 

The authors find that cov-lite loans are more likely to default than loans that have more covenants, and these loans take longer to default because there are no intermediate signals of financial difficulties that will trigger action, all else equal. The end result is that cov-lite loan contracts will have a higher financial costs. 

If we look at the current environment, there should be strong credit concerns. In a covenant heavy loan, there will be accounting triggers that will send signals to lenders on impending liquidity issues and signals to borrowers to make income-increasing decisions to avoid technical default. If a technical default is reached, lenders can then take action to force a change in borrow behavior, or engage in activities to protect their loan from further loss. 

Firms that have liquidity shortfalls against covenant terms will require restructuring. In a cov-lite environment, action can be delayed, but with consequence of further loss for the lender. A problem deferred is not a problem eliminated. We may think there will be an overall loan problem because loan terms are more lenient versus the last financial crisis.