Alpha and beta - There is always a connection

Within every alpha there is hidden beta. 

Within every beta there is a hidden alpha. 

If you cannot find the beta in your alpha strategy or the alpha in every beta, you are not working hard enough....

The largest investment mistakes associated with alpha strategies are assuming there is no beta in the excess returns. There is always beta risk, and not knowing where it is will be costly. The beta may only be in the tails of the distribution, or the beta may be associated with a specific regime. There are market and macro factors that drive almost every alpha generation strategy. You must look for it and accept that it will be part of the return generation process.

Similarly, for every beta strategy, there is a way to extract some alpha through the structure, execution, and timing of a trade. If you want market beta there are several ways to extract it from the market. For example, in fixed income a specific duration can be achieved through buying a bond or a barbell of two bonds. Both can have the same duration, but each will have a very different return profile. There is hidden alpha, or an opportunity to generate alpha in a beta trade.

Of course, there is the question of measuring beta and alpha. There is always potential alpha based on the measurement of beta risk. One man's benchmark creates another man's alpha. 

Alpha is also a function of the market regime. The market regime defines how much alpha is achievable. A strong alpha strategy may be only be present in a specific regime like a recession or low inflation environment. All alpha is conditional. You must find the conditions.

 

Narrative should support data - Data should not just support narrative

 

A problem with fundamental discretionary macro is that data is often used to support the narrative when the reasoning should be reversed. Narrative should support the data analysis. From data comes narrative, not the other way. 

There is an issue if a manager has a narrative in his mind and then searches for data to confirm what he already believes he knows. That may work at times, but it is not an effective strategy.

If you believe inflation is transitory, you will look for data to support the transitory story. If you believe the Fed will pivot, you will look for data to support the pivot story. The causality should be reversed.

Following data first is more difficult. Inflation is higher than average over the last decade and inflation is generally mean reverting; however, we may have little evidence on the speed of adjustment. Saying inflation will fall is not an easy conclusion. We may believe that the Fed does not want to push the economy into a recession, but we may have little evidence on their current reaction function. Most times we may have to fall back on the idea that we don't know or cannot make a good prediction. We often rely on a narrative as a substitute to an answer that we don't know. 

The focus should be on systematically reviewing data and forming some likelihood towards an event. This is the essence of systematic global macro. The narrative are the words around the data analysis.

 

Dollar trends and regimes

There are long-term trends in the dollar. These trends have been controlled or adjusted at time through intervention. Intervention may work in the short run to arrest the speed of trends, but intervention without a change in policy will result in a direction change. 

The dollar has been on one of its fast uptrends in history, yet we are now seeing a reversal based on the expectation that the extreme monetary hawkishness will be moderated. It is yet to be seen whether this is true, but a reversal in monetary policy will lead to a dollar reversal.

Is this important? Yes, it is critical because an extended dollar rally places stress across all global markets. The Fed is the liquidity provider to the world. The dollar is the oil in the engine of commerce. Regardless of what some commentators think, there is no current substitute that meets the criteria of a reserve currency. This may change but not today and not tomorrow. Perhaps in the future.

A reversal or stability in the dollar will be good for the global economy and relives the pressure that "something might break".

 

Trend-following - A solution but not a panecea

 

"CTA claims of being superior to other forms of risk mitigation are exaggerated because (1) the past performance has been dominated by persistent long positions in bonds over a decades-long period in which interest rates declined to effectively zero, and (2) the convexity with respect to equity moves is less effective than direct tail hedging." See Can an Allocation to CTAs Move the Needle?

I disagree.

If the trend in bonds is for lower yields trend-followers will be long bonds. If the trend for bonds is for higher yields, trend-followers will be short bonds. There is no angst. There is no doubt. A trend is a base case, and it is indifferent to the rate regime. Less money was made in shorting bonds over the last 40 years because there were fewer short bond opportunities.

Yes, the convexity with respect to equity moves is less effective than a direct tail hedge, but the cost of being wrong is less. If you know that equities are going lower, you don't need a hedge; you need a sell order. A tail hedge needs to get the direction, the magnitude of the move, and the timing right. An equity index trend moves only needs to get the direction correct.

The more important issue with this paper is that small allocations to CTAs will not have an appreciable impact on return or volatility reduction and holding a broad portfolio of CTA would have had strong periods of underperformance during the 2010 decade and the 1990's. The numbers do not lie. Trend-following will work but the impact is a function of the size of exposure. Trend-following like all strategies will fall in and out of favor. The periods of underperformance can be long, but that is part of the cost of buying convex strategies. There must be large moves to make these strategies attractive.