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.

Monday, May 14, 2018

Financial conditions are not suggesting stress - Be optimistic?

The Office of Financial Research (OFR) Financial Stress Index is not showing any signs of a problem in financial markets albeit conditions worsened in February. It is notable that all sectors, credit, equity, funding, safe assets and volatility are closer to post Financial Crisis lows than the spikes in 2011 and 2016. Of course, the construction of the OFR stress index only includes financial spreads or price information and no fundamental information. Prices may lead economic financial stress and can be a cause of stress but it does not tell us about the drivers of financial pricing. 

Financial condition indices from Fed banks have not shown a return to the lows at the beginning of the year. These indices overlap with the many of the components of the OFR index but have different weighting schemes as well as different components. The Chicago Fed Financial Conditions (NFCI) Index has the broadest set of data and also uses macroeconomics adjustments for their ANFCI index. These broad indices show a similar pattern to the other stress indices. The Chicago Fed National Activity Index has increased in volatility and has failed from highs but still is in positive territory.

The financial conditions have been tame for almost eight years except for a period between QE's in 2011, the Taper Tantrum, and early 2016 after the end of the Fed zero interest rate policy. While the volatility spike from February has not been reversed, stress levels suggest market calmness. Market concerns and risks may be on the rise, but these concerns have not yet been displayed in financial price relationships.

Sunday, May 13, 2018

Give me some metrics! Beware of those metrics

I have been one of those "if you cannot measure it, you cannot manage it" types. Most quants are like this, but there are limits to measurement or trying to fit qualitative characteristics into a measure. Difficulty does not mean that attempts should not be tried. Most will admit that measurement is very useful in some areas of study but have to be more tempered in others. Jerry Muller, in his book The Tyranny of Metrics, explains the potential problems of a culture that focuses too deeply on measurement. This is a good counter to the always measured to manage crowd.

Muller provides a breakdown of the recurring flaws of metrics. These flaws fall into two areas, the distortion of information collected by the analyst and the gaming of information by the persons being measured:

  • The distortion of information problem -
    • Measuring the most easily measurable 
    • Measuring the simple when the desired outcome is complex
    • Measuring inputs rather than outcomes 
    • Degrading information quality through standardization 
  • The gaming of information problem -
    • Gaming through creaming
    • Improving numbers by lowering standards 
    • Improving numbers through omission or distortion of data 
    • Cheating 
The author describes measurement and gaming problems with colleges, schools, medicine, policing, the military, business, finance, philanthropy, and foreign aid. It is everywhere, so every analyst should appreciate the problem of measurement. You will be gamed. Measurement changes incentives. You will measure the wrong things. Use your numbers, but beware of your numbers. 

Saturday, May 12, 2018

Information usage and decision-making as a simple global macro classification scheme

How do you classify global macro firms? There are a wide variety of hedge funds that call themselves global macro so a classification scheme may help distinguish possible return patterns.

One simple method is through the type of information used and the decision-making process employed. Information usage can be either restrictive or broad-based. A restrictive information usage framework could be limited to only price data. This is the focus of trend-followers or those that look at cross-asset spread relationship. A broader-based set would use fundamental information from a wide variety of sources. This could include monetary and real economic data.

The other dimension for global macro classification is through how decisions are made given the information provided. Decisions could either be systematic or discretionary. Both may be disciplined and have rules, but the systematic approach will have a direct mapping from data to action while the discretionary approach may be more situational or flexible on all possible actions.

If this 2x2 framework is employed, it is easy to see where there is concentrated global macro behavior. Quadrant II will be where most trend-followers spend their time. The classic global macro managers will either be in Quadrant III and IV. These managers will differ on the amount of information employed. What is missing are global macro managers which fall into quadrant I. In this quadrant there is wide use of information, both price and fundamental, and systematic decision-making. This approach should have a smoother return profile relative to trend-followers and may react differently than discretionary global macro managers. You will not find many of these global macro managers.

This is not the only way to think about classifying or separating the difference in global macro managers, but it provides a simple approach on two useful factors. By this classification measure, global macro investors should keep a look-out for quadrant I managers.

Global macro investors need to know the liquidity environment - Global liquidity shortages and international recessions

A focus of global macro investing is looking for general factors which can have an impact across markets and countries but are displayed slowly in cross-asset relationships. Macro traders watch closely global and local financial conditions such as monetary liquidity as good indicators for potential switches between risk-on and risk-off environment. They also look for changes in credit conditions as a signal of potential shocks across local financial markets.

Research has found that the Financial Crisis was worsened by the high level of international synchronization especially in credit growth prior to the fall in 2008.  The large fall in real and financial activity that was related to a global liquidity shortfall. 

Liquidity shortfalls will have not only real effects but also impact investor and consumer sentiment. Tightening credit spills over to investor pessimism. (See Fabrizio Perri and Vincenzo Quadrini "International Recessions" American Economic Review 2018, 108(4-5): 935–984.) Their charts of the Financial Crisis show the growth correlation between G7 countries and the similarities in macro behavior. What is clear is that the high correlation was preceded by the downturn in credit markets. 

Financial integration means that local liquidity shocks may have less impact because capital can flow from other sources, but when there is a global crisis the impact will be more synchronized and severe. Hence, following global liquidity is key to tracking potential tail risks in financial markets. Financial integration means that we get less diversification from holding international equity and bond positions. When there is a negative shock, investors are nothing to get the diversification desired or expected. 

While following the Fed is a necessary starting point for global liquidity monitoring, the behavior of all large central banks have to be integrated to get a good picture of global liquidity. The integrated approach means that Fed rate rising has not spilled-over globally because other central banks are continuing to provide liquidity. The current key liquidity consideration is what will be the actions of the ECB, Bank of Japan, Bank of China, and Bank of England. 

Friday, May 11, 2018

Living in a VUCA world - This is the core problem for investors

Most investors cannot clearly articulate why investment management is so hard.  There is the superficial response that it is hard to beat a benchmark, but there is less discussion on why. Of course, costs are very relevant but the difficulty is also associated with the environment faced by investors.

A deeper meta-view for how the financial world works is needed to help describe the risks and challenges of investing. There is an expression that is used by the US Army to describe battlefield conditions or strategic environment for planning - VUCA, (Volatility, Uncertainty, Complexity, and Ambiguity). VUCA more aptly represents what investors face. This acronym is far more descriptive than the Clausewitz idea of a "fog of war" and serves as a good starting point for describing the investment world and the difficulties faced when making decisions. 

VUCA is a deeper description and more illustrative of the often quoted language teaser by Donald Rumsfeld:

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know. 

Investors live in a VUCA world. The VUCA description for the environment provides a richness concerning the investment problem that is not captured with just saying that investors are faced with higher volatility or that there is a chance for black swans. Volatility tell us the behavior of prices, but does not tell us much about the decision problems we face navigating the investment environment. It is highly important and relevant as a measure of risk but it does not tell us what may cause the environment to be more volatile or why risks may increase. Saying that black swans may occur and that we will be surprised is all true, but does not provide insight on why we may be unprepared for these unknown surprises.

Describing the environment as VUCA provides more nuance on the type of risks faced by investors. It incorporates both the measurable within volatility and the subjective and not easily measured or countable with uncertainty. Complexity tells us something about whether the investment environment can be simplified or easily described while ambiguity provides a description on that which cannot be easily modeled. Ambiguity tells us that there are competing models that can both explain the facts but cannot all be right. Complexity tells us that no single factor or small set of stable factors can explain the variation in returns.

We are now seeing this concept of VUCA incorporated in broader strategic planning. (See Harvard Business Review, "What VUCA really means for you.") I am not comfortable with the definition applied to VUCA in this case given the focus is on business strategy and not the investment environment, but the table does highlight some of the key points that investors need to think about within a VUCA framework.

VUCA focuses on the idea that there are two dimensions to strategy problems: how much do you know about a situation and how well you can predict the possible results of your actions. This ties knowledge with results in a way that most investors do not usually frame. 

The VUCA framework for describing the investment environment needs to be further operationalized, but it does provide a good starting point for discussion. Talent and costs are key drivers for investment success but they are limited by the environment faced. In a more ambiguous, uncertainty, and complex environment, success is more difficult to achieve but is also more likely for those that are prepared.

Wednesday, May 9, 2018

Bitcoin futures - has it saved bitcoin trading? Not clear from the evidence

I have been studying the impact of futures on cash markets for decades, so I was very interested in the new short piece of research, “How Futures Trading Changed Bitcoin Prices” FRBSF Economic Letter 2018-12 May 7, 2018 that was published this week. 

I have been watching the development of bitcoins, but I don't partake in bitcoin trading. If pushed into a corner for an opinion, I would say that bitcoin trading is excessive and overly speculative. Bitcoins as a concept may have exceeded its reality.  It also may be too early to have trading of a derivative on this cash market with many outstanding questions on how to best run this market. 

Nevertheless, now that futures trading has begun, we should study how the bitcoin cash market may or should change. This recent research, however, is a good poster piece on the fact that correlation many not mean causality. Bitcoin prices have fallen since the inception of futures trading, but that does not imply that futures were the cause. It could be, but it has not been truly tested. If careful research is not done on this topic, then emotional biases will drive the discussion and not facts.

The authors show no understanding of the role that futures markets have played in increasing the efficiency of cash markets. More importantly, they have no sense of the rich research history on the impact of futures on cash markets. There is little structural discussion on the role of futures to complete markets when there are high costs for shorting or trading in general. Nor was there extensive  discussion on the role of price discovery through futures markets with the authors only paying lip service to recent work on financial innovation. 

Perhaps more research is pending, but there is little evidence to make any strong judgments on the value of futures trading to control the excessive prices seen in bitcoins. There is a need to understand the impact of futures on a fragmented cash market where the pricing is based off a reference index which may not be inclusive of all trading.

Futures have proven in most markets tested to increase market efficiency, dampen volatility, and improve market transparency. There are clear structural and regulatory advantages from having trade done on a transparent exchange. 

Futures play a significant role in the financial system and not fully defining, reviewing, and testing of how this role is played is a disservice to the futures markets and all those who rely on the Fed to provide useful information and research on any policy debate. 

Tuesday, May 8, 2018

Mind the Gap - Simple Global Macro Relationships to Watch: Policy Differentials

Simple frameworks are effective with global macro investing. They set the tone for discussion and focus attention on the big issues. Look at the monetary/fiscal policy mix across countries to get a good feel for macro imbalances. These imbalances tell us something about current growth and future policy. Policy gaps are intended to close output gaps. 

There will be a divergence in price trends when there are divergences in policies. If there is a wide policy gap, there will be the potential for wider divergences in global price differentials. When there are larger price differences, currencies which are relative prices will also move. 

Of course, these divergences will not last forever, albeit they may often let longer than expected. When expectations change concerning the direction of the gap, there will be a "crash" in trends. This is a basis for momentum crashes. 

Nevertheless, policy divergences are a current foundation for investor tilts in a global portfolio. This is especially true when the policy gap does not match output gaps. If there is no output gap to match the policy gap, the differential will play out in capital flows and excess price moves. For example, assuming the output gaps are similar, a tightening or rising rate environment will lead to currency appreciation. If there is an increase in deficits or a debt to GDP gap relative to other countries, there will be upward pressure on growth, currency appreciation, and further pressure on rates. 

The US is reversing QE which may not be having a strong credit tightening effect just yet, but will have upward pressure on rates and currency versus countries that are still following QE. Similarly, there will be rate, currency, and equity pressure if debt to GDP is growing versus other countries where it is falling. 

These pressures do not define the movement of financial prices but provide a prior or conditional view of what should happen. The investors know has to find a better alternative story to fit the facts or follow this trend in policy differentials.

Saturday, May 5, 2018

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

"Narrativeness" may be defined as the quality that makes narrative not merely present but essential. It comes in degrees, and there are narratives without narrativeness. Since the time of Leibniz, Western thought has favored models in which abstract scientific laws would ideally account for everything in nature and society (the ideal of a social science) and in which narrative would therefore be, at best, merely illustrative. But a number of thinkers have presented forceful arguments that such an ideal of knowledge is a chimera. Darwin, Dostoevsky, Tolstoy, and others have insisted in the ineluctable need for narrative because genuine contingency exists and time is open. 

-Gary Saul Morson, 

Lawrence B. Dumas Professor of the Arts and Humanities; Professor, Slavic Languages and Literatures

Is economics a hard science? What makes the humanities the humanities? Are some social sciences more "science" than others? These are tough questions that academics have been asking for some time. These same questions could be applied to investment management.

An interesting test or thought experiment has been developed by Morson and written about in his book with Morton Shapiro Cents and Sensibility: What Economics Can Learn from the Humanities. The science test is determining the amount of "narrativeness" associated with a discipline. If the discipline can be explained without words or a narrative, then it is a science or has characteristics of a science. If the discipline has to use a narrative to explain itself, then it is not a science. 

There is no value statement in saying some type of study is a science and others are not. There is room or need for narrative. Storytelling helps us be human. However, we can better define a discipline and make a judgment on those that try to pass something off as science when it is actually based on non-testable narratives.

There is emotional attachment and engagement with narrative but not with science. If we gaze upon the night sky and only think about orbital rotation we will not be moved in the same way as a discussion of our smallness in the universe. The narrative will be remembered after the equations are forgotten. People will use the narrative to win hearts and minds when the science may not convince by itself. 

Still, it may be valuable to apply the narrativeness thesis to investment management. Is it science? For some, the quants, it is. For others who are discretionary managers, rules and laws cannot be applied to what they do, it is a narrative. Some investors demand or want only a science. Some managers cannot explain what they do without narrative. Where it gets interesting is when quants use storytelling to explain their models or when storytellers try to suggest their opinions are a model or a theory. Just telling a complex story or using a "model" to explain the current economic environment may not be science. 

The problem in investment management is that it has both the science of testable models and the language of narrative. Additionally, the narrators often use data and the quants often use storytelling. This forces the investor to do the heavy work of separating true data analysis from potential false narratives. In that sense, investment management is a netherworld of near-science. 

The five "whys" and investment management - Finding the root cause

I came across in some old papers the Toyota Industries solution to finding the root cause of problems, the 5 whys. It is a simple and useful tool. Sakichi Toyoda, the father of Toyota Industries, developed this technique to solve manufacturing problems, but it could easily be applied to any investment problem or due diligence issue. Ask why five times. 

Yes, be like the annoying children who are always asking why to their parents. Put differently, ask core questions repeatedly to get at core answers. It is often taken for granted that whatever is the first answer to a question is all you need. That would be a mistake. More information usually lies beyond the first answer. Follow-up with a second why then follow-up with a third, fourth, and fifth why. Drill deep.

Our example below suggests how a very simple five why conversation may evolve.

In hedge fund land, if you are talking with a marketer, he might get through the first and second whys. If you talk to a good manager, he will be able to answer a third and fourth why. The real good managers, who truly knows their strategies, will be able to answer a fifth why or beyond.

When doing your own analysis, the five whys can serve as a check on how deep you are thinking or what is your level of logic used to generate an answer. If you cannot generate a good answer to five whys, then you have not thought about the problem enough.

Sakichi Toyoda created a car company noted for quality control. Even now the Toyota company is an adherent to kaizen, a philosophy of incremental improvement which is driven by the idea of deep questioning, the 5 whys. It can work for any investor.

Friday, May 4, 2018

Some sector dispersion within equities but fixed income down across the board

There could be a desire to look for special patterns within April performance, but the only clear theme is the risk associated with holding bonds during a rising inflation expectation and tightening Fed environment. These issues spill-over to the dollar which affected affects the performance of international stocks.

Emerging markets faced a difficult month after looking like it was the equity sector of most promise earlier in the year. Growth is still expected to be higher in EM; however, it generally the case that EM will be higher and more volatile than developed countries. 

The strongest sectors for the year have been global equities (EFA) and growth (IWO). Growth has been driven technology and strong earnings that have exceeded analyst estimates for the first quarter. 

April was a difficult month for most fixed income sectors with high yield being the only one that produced a positive monthly return. All fixed income sectors are down for the year with the exception of international bonds which got a tailwind from the weaker dollar, but even that support has changed in April. While the rationale for the sell-off has been focused on inflation, TIPS have also generated a negative return year to date.

The equity sectors showed double-digit differences with energy almost up 9.5% and consumer stables  declining over 4%. The only winning sectors for the year are technology and energy. 

Country specific returns showed the greatest gains in core Europe while Asia and Latin America country indices lagged behind. For the year, the two weakest country returns were with Canada and Australia, heavy commodity exporters. The biggest winners have been Italy, France, Brazil and Mexico. Perhaps these are large reversals from poorer performance last year. France is going through labor reforms. Brazil has faced political issues and Mexico has seen trade volatility.

While we like to look at themes across these sectors, the most important take-away is that diversification matters. A core portfolio diversified across styles and sectors is the safest way to build a portfolio if there is no clear market view. Tilts within this core will be related specific views when the investor has an information advantage. By definition, these times of information advantage should be infrequent. 

Thursday, May 3, 2018

Hedge fund performance positive but weak for April - Most YTD returns underwater

Most hedge fund strategies were positive for April, but the average return was less than 50 bps. There were two negative outlier strategies with fundamental growth and merger arbitrage. Generally, the higher monthly volatility and dispersion created a mixed environment for return generation. Year to date returns suggest that it has been a difficult four months for most managers with average loses much larger than the average for the winners and only 7/19 strategies producing positive returns.  

In spite of the difficult last four months, 12-month returns have still been positive although these returns are below the discount rate used for many pensions. Only equity hedge and fundamental growth were close to the 7% target. The area of most difficult performance has been the event driven strategies. Money has stilled moved into hedge funds, but investors are expecting stronger performance than what they have seen recently.

Wednesday, May 2, 2018

The sell-off of bonds and dollar strengthening are the two leading trends expected for May

Our sector trend indicators, a combination of different trend length directions added across markets within a sector, show some significant changes from last month. This represents opportunities for May but also why some managers showed mixed performance for April. 

The two biggest sector changes are with bonds that moved to strong down trends in the US and currencies which fell almost across the board versus the dollar. Dollar strengthening on further rate increases and the continued signals of Fed tightening was a major reversal from earlier in the year. Fears of inflation have taken hold of US bond investors but not with the same anxiousness in other global debt markets. Stock indices were mixed with US equities pointed down slightly and foreign stock indices moving higher. 

Precious and base metals moved lower. Gold sold lower on dollar strength. Energy prices were higher on further inventory adjustment and commodities were affected by the late spring. 

Bonds and the dollar generated strong breakouts which offered opportunities for short-term traders, but we have seen steep trends often reverse. Nevertheless, sector indices suggest good opportunities for trend-followers in May.

Past performance is not indicative of future success.

Managed futures mixed performance for April but better than a stock/bond mix

Managed futures showed flat performance for the month with the SocGen CTA index up only 5 bps for the month. The BTOP50 index was up 29 bps and the SG trend index was up 47 bps. With only limited reporting, the Barclays CTA index gained 14 bps. The CTA mutual fund index lost 46 bps for the month. Our early read is that there was strong dispersion in performance based on the markets traded and the speed of the models used. 

The big moves were the dollar and bond breakouts during the second half of the month. With more belief that the Fed will continue to tighten and no strong action by other central banks, bonds had a major sell-off and the dollar had a strong breakout to the upside. Given the strength of the moves over a short horizon,  these breakouts caused significant financial pain for those not tilted in the right direction and gain for those managers that have faster reaction times. Equities even though tilted lower proved to be a mixed sector for many traders. Energy (oil and refined product) showed strong positive trends in April. Base metal trading was mixed while gold and precious metals sold-off as the dollar rallied. Commodities were mixed, but year highs were hit in some grain markets. 

Managed futures provided good diversification versus bonds which have fallen this year on inflation concerns. A diversified CTA would have outperformed a passive 60/40 stock/bond mix for the month. 

Tuesday, May 1, 2018

Call it the revenge of the safe asset - Bond returns decline

Call it the revenge of the safe asset. Bonds, especially on the long-end, continue to see a sell-off on a surge in inflation and the continued view that the Fed will not change their rate hiking program. This decline has been coupled with generally weaker performance in equities which has led to higher correlation between equity and bonds. The correlation measurement, which is backward-looking, still is negative between stock and bonds but it has risen from previous lows. This increase reduces the "safety" effect associated with bond diversification which has been the "free lunch" for many investors. This will be a growing problem if it continues. Investors will have to make portfolio diversification changes.

The continued view that the Fed will raise rates is starting to impact international markets which have declined on a stronger dollar which has surged since the middle of the month. The combination of Fed tightening and other central banks continuing to follow easing policies has created a clear dollar yield advantage that is starting to affect capital flows. 

Equity markets were generally positive but showed mixed directions. First, economic growth was slower for the first quarter even though earnings were attractive. Second, long rates hitting the magical three percent mark has created some negative sentiment. That said, value proved to be a winner in April. Credit provided a cushion against some of the Treasury sell-off and commodities proved to be a winner based on higher energy prices. 

The headwinds against a diversified portfolio are still the combination of higher inflation and a Fed that will continue to push borrowing costs higher. However, these expectations should already be embedded in expectations. Generally, there is not enough evidence to reverse a risk-on sentiment view but any further diversification should come through strategies and not through building further exposure in the "safe" asset.

Monday, April 30, 2018

Improving global macro investing - Monitor and understand financial conditions both globally and locally

What is the most fundamental lesson learned for investors from the Financial Crisis of 2008?  It is simple and in the name. We don't call 2008 the Great Recession. We call it the Financial Crisis. Financial conditions matter more than what we have thought in the past. If money and credit is the oil that runs the engine of commerce, then financial conditions measure the efficiency of the wiring. 

Financial conditions impact all markets. When there is a breakdown in the financial environment, credit will not properly flow to those that need it. A break in financial conditions will change the willingness of financial institutions to lend and the confidence of firms and consumers to borrow. There are real effects from changes in financial conditions, but investors and consumer react to finance conditions by either being more optimistic or pessimistic on growth or returns on investment. This change in sentiment affects financial prices.

Hence, financial conditions should be monitored to track potential changes in economic growth and the value of assets. This emphasis on financial conditions is now a focus of macro research, and global macro investors should follow them closely. Financial condition indices (FCIs) use information from a wide set of financial variables to measure risk-taking and possible financial frictions. Wall Street firms, Federal Reserve Banks, other central banks, and the IMF have all developed FCIs. The indices provide insight on whether markets are in a risk-on or risk-off  environment. Risk-on/risk-off (RORO) regimes are another way of measuring global sentiment through fundamental factors.

Recent research, (see "Can countries manage their financial conditions amid globalization" IMF Working Paper, WP/18/15) has focused on the impact of global and local financial conditions on different economics. The authors look at 10 financial indicators including: corporate spreads, term spreads, interbank spreads, sovereign spreads, change in long-term rates, equity and housing price returns, equity volatility, credit growth, and financial market share. Their analysis looks at both global and local financial conditions across a broad settlement of countries.

Their evidence suggests that common global financial conditions have a meaningful effect on the financial conditions of local economies, between 20% to 40%.  The global financial conditions are closely tied to US financial conditions and global risk factors like the VIX index. Still, local financial conditions are different across countries so following each country's conditions is useful. 

If you want to avoid country specific macro risks, track global financial conditions as well as local conditions. If these conditions start to turn negative there is a clear signal that financial sentiment is changing. What still needs to be done, is measuring the link between the level and change in financial conditions with future market returns. An extreme move is a clear signal, but the sensitivity between financial conditions and performance still needs further documentation.