Sunday, May 20, 2018

Correlation changes across stocks - An important risk for all portfolios

The average correlation across stocks (intra asset class) has important implication for portfolio construction and for active management. The chart below from Wisdom Tree shows average stock correlation since the Financial Crisis. It has been subject to sharp increases followed by declines. Our general view, consistent with this data, is that if there is a single factor macro event, there will be a corresponding increase across all stocks. 

There is a an ebb and flow of macros events which affect the amount of any factor explaining stock variation. It does not have to be a negative event. There has to be a singular event that is perceived to impact all stocks. QE1 and QE2 were these types of singular events. The Taper Tantrum was another as well as the anticipation of the end of QE. Finally, the volatility shock of February 2018 was the most recent and perhaps the most severe. Events that will affect all stocks will increase average correlations.

The need for hedging and for global macro investing is increased when these correlation shocks occur. If an investor is on the right side of these shocks, which could either lead to higher or lower prices, it is profitable. If an active investor has built a diverse portfolio and is on the wrong side, performance will suffer. (Ongoing research is trying to match the changes in correlation with hedge fund performance.) 

It is clear that when correlation goes up across stocks there will be a corresponding increase in implied option volatility for stock indices. There is less stock diversification within the index, so there is a impact on the index volatility. Additionally, the uncertainty and its resolution concerning a macro event will add to the overall index volatility.

There is a need even for stock pickers to have a macro view or have an appreciation for the changing correlation from macro events. For portfolio construction, picking alpha generator managers within equities may lead to heightened risk from correlation spikes. This risk requires diversification in to strategies that may focus on macro events.

Thursday, May 17, 2018

The countable non-countable (quant vs narrative) problem - Focusing on what is important for investing

"Not everything that can be counted counts, and not everything that counts can be counted."

- Credited to  William Bruce Cameron instead of Albert Einstein from Cameron’s 1963 text “Informal Sociology: A Casual Introduction to Sociological Thinking” although it was supposedly written on a blackboard by Einstein.

Knowing what to count is an important skill for any quant manager. You will never be able to count everything, and everything that has or can be counted my not be useful. One objective of statistics is to engage in data reduction so you will not be overloaded with counted stuff. Too much counting and there is no ability to understand what is relevant. More importantly, in a complex dynamic investment world, counting may not be enough nor will it always lead to the best answer. (See Living in a VUCA world - This is the core problem for investors.)

There are event that can be imaged and can occur but cannot be counted. First, there are events that have not yet occurred. Second, there are events that do not occur often enough to create a meaning full count. For some this is the need for imagination. For others we call this the need for narrative. Others can call upon scenario analysis to address this shortage of counts. 

The fact that there is a need for non-countable thinking means there is a role for narrative and story-telling. This is the place where the science of finance ends and the art of investment begins. Nonetheless, this grey area between quantitative analysis and narrative is an uncomfortable area for investment analysis. A pure quant strategy leaves itself open to problem of dynamic behavior and swings in sentiment. Leaning to far into the area of narration creates an investment process that is not repeatable or measurable. 

Wisdom in investment management comes from the experience of knowing what to count and is countable against knowing what should not be counted and should be subjective measured against theory or specific events. The storytelling and narrative is on the surface easy, but hard to do well. Most like to hear and tell story although the action within the narrative is often ambiguous. For most investors following the count is better albeit harder to implement. It forces rules and measurement for dealing with a risky environment. A perfect process will blend counting with narrative.

Give me some metrics! Beware of those metrics

Is investment management a science - Use the "narrativeness" test

Narrative and numbers - You need both for effective forecasting

EM vulnerable to shocks? "Taper Tantrums" and getting ahead of the curve

Emerging market stocks and bonds are facing difficult times in 2018. Emerging markets may have looked like potential outperformers at the beginning of the year, but they have now fallen below respective US stock and Treasury indices. This sell-off has been further enhanced by the negative economic events in Argentina. Higher volatility, rising interest rates, and a refocus on core fundamentals are all affecting investor outlooks for EM investments.

Perhaps EM is reacting to a new "taper tantrum". With the Fed raising rates and starting to sell balance sheet, credit markets are starting to adapt and adjust to a new monetary environment. Regardless of forward guidance or the level of gradualism, the impact of Fed policy is to taper the liquidity of the past. Is the reaction a tantrum or just the likely response to this change in direction?

The reaction to declining performance and what is perceived to be a more difficult fundamental environment is as expected. EM flows for both equities and debt have clearly been negative. These outflows place pressure on currencies as well as debt and equity markets. Charts are from IIF blog/twitter.

The earlier positive outlook for EM was driven by better growth prospects, but rising rates have dampened growth momentum in the past. The above trend growth in both emerging and mature markets will not last as growth will respond to the higher effective Fed funds and general reversion to the mean. Fed tightening usually translates into lower forward growth rates with a lag. 

Given a potential decline in liquidity, specific country scares like Argentina, and a reversal of trends to the downside, there is a flight to quality with EM. Those countries will poorer growth, credit, and current account deficits, will see stronger deterioration. 

This situation becomes scary after a review of the composition of the cross-border debt. The US has an especially strong allocation to emerging and frontier markets versus other countries. If there are further EM declines, US investors will more likely be harmed

Additionally, the ability of EM countries to weather this sell-off is made more difficult by the fact that EM borrowers have an increasing amount of debt that matures in the next few years.

While there have been strong advocates for long-term EM investing, rising US rates is a good time to review the quality of the holdings. After a country shock like Argentina, there are usually two reactions. First, there is general reduction is exposure to EM. Second, there is a new focus on fundamentals. This is the time to rebalance based on stronger credit, current accounts, and macro fundamentals.

We have seen this story before. Fed raises interest rates and credit starts to tighten, even if it is on a relative basis. Money flows out of riskiest alternatives usually when there is catalyst negative event, and portfolios are restructured to find safer alternatives. The size of the sell-off or the amount of restructuring may differ this time, but an end of EM herd behavior starts the break-up.  

Wednesday, May 16, 2018

The single most important chart for any portfolio manager or investor - The power of diversification (low correlation)

Global diversified, multi-strategy, multi-asset class, portfolio of alt risk premiums, portfolios of traders - it does not matter what is the combination - Get more diversification and you will be a winner.  When someone says "diversification is the only free lunch in finance", the phrase may not truly resonate as well as a picture, and the picture above says it all. I can honestly say that for all of the educating in investments, this picture is not used enough. This chart was generated from the smart folks at Resolve Asset Management. (Adam Butler @gestaltU - More can be found in their informative book Adaptive Asset Allocation.)

Start with a simple return to risk of .3 for one asset and start adding asset classes that have the same return to unit of risk but different correlations. The power of diversification is explosive when correlations are low. There is nothing to get excited about if there is high correlation across assets classes, but it should cause any investors or portfolio manager to jump out of his chair if he starts adding in low correlation assets. You can literally double your information ratio if you can added those low correlation (.1) asset classes. 

Of course, the picture represents ideal conditions. There is some bad news with this free lunch. It is hard to find. You will not find many low correlated asset classes and those return to risk values can be volatile. The incremental improvement is strong with the first few diversifiers but there are diminishing returns after that initial boost.

In a practical sense, the first asset class you add to an equity portfolio will be bonds. It has been the great diversify for the last decade or two, but once you get beyond bonds and commodities, the ability to find those low correlation assets becomes much harder. This is the true value of alternative strategies

One of the great portfolio advantages with adding hedge fund strategies and alternative risk premiums is that these strategies will have lower correlation against core equity and bond indices and thus will provide strong improvement in information ratios. Hedge fund strategies allow for more "free lunch". 

What does this chart mean in reverse? if there is an increase in correlation across asset classes, the return to risk will fall even if the return to risk of any given strategy stays constant. This is will be the incredible shrinking free lunch and is why it is so important to find strategies or investments that have stable correlation relative to traditional asset classes.

Return is critical but hard to forecast. Volatility is important and leads to downside risks. Unfortunately, many forget the power of covariance and its impact on diversification, yet this is component to portfolio construction that can have a strong impact.