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The oil price shock is affecting the oil patch. Companies are going under with most of the defaults in 2015 associated with commodity and energy names. Oil workers are getting cut with above average lay-offs relative to other economic sectors. However, the rest of the country is enjoying low oil and gasoline prices. Price decline shocks are always a trade-off between localized negative effects and positive macro effects. What will surprise markets are the secondary effects, the spill-over to other sectors which were not expected.  We think housing markets in Texas and other oil regions may be affected. Just look at the price indices for Dallas and Houston versus the other major markets of New York, LA, and Chicago. Texas housing has actually increased its momentum since the Financial Crisis. The other three major cities have not matched pre-crisis highs.  We know that Texas is a much more diversified economy than during the oil shocks of the 90's or the 80's, but on margin, a f

While it has been argued that simple rules for forecasting do better than complex rules, many are skeptical of this conclusion. There is the view that to compete in competitive markets your edge should be complexity. However, the data just does not support that conclusion. It is better to follow the advice of William Ockham. My confidence in simplicity is not based on a belief but on data that supports this conclusion. A recent paper by Kersten Green and J. Scott Armstrong called "Simple versus Complex Forecasting: The Evidence" shows that when direct comparisons are made simple wins.   Simplicity in forecasting requires that (1) method, (2) representation of cumulative knowledge, (3) relationships in models, and (4) relationships among models, forecasts, and decisions are all sufficiently uncomplicated as to be easily understood by decision-makers. Our review of studies comparing simple and complex methods— including those in this special issue—found 97 comparisons in 32 pap

Looking at the projections of the Fed for 2016 and beyond can provide a starting point for private projections with the "big three" forecasts of growth, unemployment, and inflation. Should it not surprise us that the Fed believes all three are going to be exactly where they should be for the coming two to three years? Of course, they have to believe their generated forecasts or they would not have raised rates.  In spite of starting to raise rates and forecasting four rate increases for 2016 as measured by the SEP, the Fed thinks growth will be stronger and be above 2% for the year. Unemployment will continue to decline and stay below 5% for the the long-run. Inflation will surge in 2016 and hit the 2% target by 2018. Investors have to ask three questions.  Do you believe that growth will rebound in 2016 and stay at or above 2%? Do you believe unemployment will decline further and then flatten and stay below 5% for the next three years? Do you believe inflation will surge in

Remember the KISS method for modeling and decision-making? Keep It Simple, Stupid! The quick and easy read, Simple Rules - How to Thrive in a Complex World by  Donald Sull and Kathleen Eisenhardt, two leading management gurus, more fully develops this key concept. Their premise for good strategy and management is to celebrate simplicity through the use of rules that can be easily implemented and remembered. When there is a lot of uncertainty, making your decision more simple is better than trying to develop more complex processes to find a solution. Rules of thumb are useful when there is a high degree of uncertainty from a shortage of information and time.  When you think about the degree of uncertainty and complexity with investment decisions, it seems natural that a rules-based system should be considered and provide support to money managers. Simple rules work because they do three things well. First, the set of guidelines are limited to just a handful of decisions. There is not a

The key to active management in many markets may not be alpha generation, but beta avoidance when the market declines. Just avoid the pot-holes when the market declines and you will do a good job preserving long-term wealth. Preserving wealth during the occasional big down moves is more valuable than generating alpha every year. It is just that those times of large downside risks come infrequently, so you have to be prepared with a strategy for when those big negative events occur.  However, it is not easy to prepare and wait for the big event at the expense of trying to find those special alpha opportunities everyday. The focus on downside protection is simple. The magnitude of a down market event is significantly larger than the alpha that can be made from specific asset selection. Size matters. Avoiding a bad security selection when it may be less than 5% of the portfolio is not as important as getting out of beta exposure that could represent well over 2/3rds of the total market ex

What causes price momentum? You can define prices moving over a time period in different ways, but price momentum is the manifestation that that there is a change in the equilibrium price, or a change in supply and demand for a market. The reason for this change is the receiving of new information that will change the price. If there is no new information, there will not be a change in price. Hence, the process of how information enters the markets will define how price should  move.  If there is a discrete increase in information, there will be a discrete jump in prices. If there is a continuous increase or disclosure of information, there will be a continuous movement in price. This is consistent with rational expectations and market efficiency. If there is one surprise, there will be one jump in price. If there are a series of surprises in one direction, there will be a trend in price.  Recent research has discussed and analyzed this issue in the context of the "frog-in-the-pan

There has been a growing research focus on the problem with momentum trading. Momentum trading is subject to crashes, or to put is simply, it's good until it's not. The data is suggestive of two major problems with momentum. First, you may actually only receive higher returns because you are taking on the potential for crash risk. Second, there may be periods when momentum just does not work. The charts below are from Patrick O'Shaughnessy 's research on momentum. First, there are periods of poor performance. You cannot get away from it. It looks like these crashes come after a big market downturn, but there is limited information to classify these events. Second, if you look at high versus low momentum you will find that are extended periods when momentum will underperform. Currently, we are in one of those periods. If you avoided momentum since the Financial Crisis, you would have been better off. Is momentum one more strategy that has served its time and should now b

The Fed raised rates, no surprise.  The Fed acted, "Move along - nothing to see here".  This was the one of the most telegraphed Fed action in history, but what now? Market reaction is usually not associated with the headline or what was expected but what was occurring under the surface buried in the fine print. This FOMC meeting was all about the dots and 2016 forecasts. The dots of what the Fed is expecting in its Summary of Economic Projections (SEP), what the market is expecting in the Fed funds futures, what forecasters are thinking, and what may actually occur. Money will be focused on the rate path now that the first increase is in the books. The dot plot suggests that there will be four 25 bps rate increases in 2016.This will be over 8 FOMC meetings in year. The Fed funds futures may be a little more pessimistic on these hikes. Economists are more consistent with Fed expectations, but there is a strong minority which we can call the "one and done" school. Ce

Who you know and what you do - that is the story of how hedge funds are going to raise money. The PWC Global Hedge Fund Distribution Survey 2015  is a treasure trove of survey information on the upheaval in the marketing and distribution of hedge funds, but there are some things that are consistent in marketing. The key drivers for fund selection do not seem to change. Number one is performance, not risk-adjusted returns. Investors still have an attitude of "show me the money". Second most importance is experience, followed by strategy. Give me absolute returns from experienced professionals then we will talk about strategy and other issues. Sounds like the world has not changed.  For all of the talk about new distribution channels, the number one source for new clients is prior contact with the manager. Investors need to know the manager and the manager needs to know the investors. The contact is critical. The second most important source is the prime broker. While everyone

We are strong believers that the first rule of global macro money management is knowing where you are not where you will be. You cannot forecast correctly if you do not know your positioning in the business and credit cycle. This seems like a simple proposition but is actually much harder than expected. Financial markets are supposed to be expectational markets - discounting future events; nevertheless the discount process is grounded on current situations. If markets are cheap the discounted future value is different than if the market is rich. Current positioning scales the future and provides context. Let's take the case of the credit cycle. Defaults are on the rise. Spreads are increasing. Investor capital is moving out of the sector. CAPEX is declining in some key sectors. Rates are moving higher. On the other hand, buybacks are continuing, M&A is still robust, and cash positions are still high. The consensus is that we may be late in the cycle,  but this positioning is su

"Diversification across assets does not necessarily imply diversification across risk factors and it is risk factor diversification that determines return outcomes, especially during systemic risk events,” says Andrew Weisman, CIO of Janus Capital Management’s liquid alternatives funds. Weisman capsulizes the "new school" of diversification which focuses on risk factors and not asset classes. The old school just looked at correlations across returns and not at the drivers of those returns. When the drivers became similar like at turning point in the business cycles, assets become correlated. When inflation shocks occur, returns correlate. The new school says that you need to know the drivers or risk factors because these are what will cause correlation changes.  Of course, the problem with the new school is that we still may not have a good understanding of how to forecast these risk factors or even measure some of these risk factors. What is the right inflation measure

One of the tenets of capitalism is the close association between growth and economies of scale of firms. Because of economies of scale, firms push for growth in an attempt to lower costs and drive competitors from business. It is the brutal part of competition - grow or die. This competitive drive for growth is not faced by the skilled artisan who produces goods that cannot be easily manufactured or generated through scale.  There was once a time when hedge fund managers were viewed like master craftsmen who used their skill to produce unique return streams.  Quantitative finance has for the most part destroyed the hedge fund manager as master craftsman through the identification and measurement of alternative beta and alphas sources. Alpha can now be created through scale. Beta can be separated from alpha. The creation of true skill alpha from the manager artisan has been minimized or marginalized  Additionally, the institutionalization of the hedge fund industry has moved it from a c

There were four key stats or factoids that caught my attention this last week. 1. High yield spreads have exploded higher. We are now at the highest levels since the Financial Crisis. The only times the market has gotten to these types of levels were during or right after a recession. At this time, the reach for yield is over for high yield. 2. 101 defaults this year, most since 2009. The defaults have been centered in the energy and commodity sectors, but it is still disruptive to the overall global economy. The impact of the credit problems in energy seem to have had a contagion to other sectors. 3.  Commodities hit 13 year low based on CRB index. This is not a Financial Crisis problem. This is not a short-term inventory problem. This is a reversal of the super-cycle and it may not be finished. Technology has lowered costs, so production in many commodities has continued even with massive price declines. 4. China's foreign reserves fell again last month. Their reserves have decli

The month really began with the ECB announcement of lower rates and QE extension and will end with the FOMC meeting. Of course there will be almost two weeks left to the end of the year but with holidays coming, there will not be any new information that will drive the markets. Firms will start cleaning the books and preparing for 2016 where the major macro theme will be the Great Divergence in monetary policy between the Fed and ECB and to a lesser extent other central banks. This is a crowded trade but will still be the macro focus for most of the year.

There is a wide set of business models in the alternative investment industry. The WEF's Alternative Investments 2020 - The Future of Alternative Investment  provides a good framework for how hedge funds can be classified through their business model. Most began as start-up, but have now moved either into global alternative firms or specialists. This is similar to the traditional asset management world where the differentiation is based on either asset gathering or skill-focsed as a core approach to business. The fact that more firms are moving away from a skill focus suggests the direction of the alternative investment industry. Alpha may be important, but asset gathering may be the greater goal. This could be a reason for why hedge funds have not been performing as well as when they were small and solely focused on return generation.

Not until you look at complete set of regulation to do realize how much the financial industry has and will change over the last 5-7 years. The World Economic Forum paper  - The Future of Alternative Investments provides some good graphics on the amount of regulation. These will have a huge impact on all parts of finance. Alternative investments will not be immune to the new regulations in the US, EU, and Great Britain. Costs from regulation are going up while fees are going down. This causes the alternative industry to move to a scaling model. Firms have to grow to pay for this oversight.

The Great Divergence in monetary policy Perhaps the Great Divergence in monetary policy between the Fed and ECB is not a great as expected given the weaker than expected policy change by the ECB, yet 2016 will continue to be the story between the Fed raising rates and the ECB pushing interest rates further into negative territory. Right before the ECB announcements the interest rate differential between Germany and the US was at the widest level since the introduction of the Euro. Yields in the EU jumped up and the Euro had one of the biggest positive days since its inception on the announcement only to see ECB president Draghi suggest that there is "no limit" to what the ECB will do to help the economy. The high volume of activity coupled with the price moves tells us that that many are trading this differential closely. Some of the most liquid markets in the world may still face cascades when these crowded trades are surprised.  Assume that the Fed raises rates in December,

The economies of scale and money management Management costs and size  Economies of scale become even more important when there is a down year with less manager return dispersion. When there is a down year for many hedge fund styles and managers like what we are likely to see in 2015, the power inherent in economies of scale become even more acute. When performance is down, there will no incentive fees to lean on to help pay the bills. This issue is especially the case for smaller managers. Small firms cannot use the incentive fees to recoup their start-up costs and management fees are just too low. Down years also lead to more manager switching, so marginally sized managers who lose assets will be harmed more. If there is little dispersion in returns, investors will use other criteria for determining investment decisions. Size will matter more in these cases. What you gain with economies of scale in up years, you lose in down years. Fixed costs are harder to cover. The industry has se

Most investors have likely past over the stories on the IMF's inclusion of the Chinese Renminbi in the basket for SDR's. The change in SDR weights will take effect next year. This is boring stuff for even some specialists in international finance, but in reality, it is going to have a great impact around the globe. SDR's are a supplemental international reserve asset which is allocated to IMF members in quotas as an alternative reserve asset to dollars, gold or other currencies held by a central bank. It is used as the IMF's unit of account and as method of payment across central banks. To be considered as a member of the SDR basket sends a clear signal to the financial world that you are an important currency in the global marketplace. To be a member of the basket, an currency has to be "widely used" and "freely usable". As the largest exporter in the world, the Chinese currency is widely used and notable in trade discussions. The second criteria of

A good stating point for any discussion about alternative investments is defining terms and providing a classification system for strategies. Without definitions and classifications, no serious discussion on costs or benefits can be undertaken. Putnam Investments has done a good job of providing a useful framework. This framework further moves the discussion forward through providing an analysis of which strategies do well based on different economic environments. This look at conditional behavior  is a good research advancement. The Putnam breakdown is a deeper take on the CAIA classification system of substitutes and diversifiers. Here the main breakdown between "zero beta" styles and volatility dampeners which could be a proxy for substitutes. The inflation hedge and return enhancers are more outlier to the first two categories. It is notable that Putnam and CAIA place global macro in different buckets. This is why thinking about classifications is important.  Breaking dow

Hedge funds showed more dispersion in performance in November with managed futures and global macro generating good returns while the remaining hedge fund strategies generally losing money. Both equity and fixed income related strategies underperformed and multi-strategy managers had a poor month simple because they have a tilt toward equity trading. The market was punctuated by the surprise in the employment number at the beginning of the month with a spike in volatility. The flat performance in equity indices for the month as well as the falling trend in volatility masked the chop within the month that caused the trading loses. More diversified strategies like managed futures did better even though there were more shallow trends.  The year to date performance of hedge funds is now showing more dispersion across strategies with merger arbitrage, market neutral, and absolute return strategies doing best while special situations, distressed, event, and direction equities having a bad ye

The SocGen CTA index gained 2.7% for the month of November placing the returns for the managed futures index in positive territory for the first time since May. The CTA index is now above the Barclays Aggregate bond index and only slightly below the returns for the S&P 500 stock index.  The good returns were caused by getting the direction of the main market exposure correct because the size of the market moves were quite modest. Stocks around the global ended the months in a tight range. Bonds gained for the second half of the bond but generally yield curves flattened on rising short rates under the expectation that the Fed will raise rates in December. Metals, energies and agricultures were all generally down for the month with declines of over 4 percent in the energy complex. Currencies continued to follow trends based on the expectation that the dollar will still strengthen in response to Fed action. It was noticeable that the most liquid markets had some of the largest moves s

This table is from the latest research piece by Andy Lo and shows in a heat map the benefit of different hedge fund styles. The dedicated short bias has the lowest correlation relative to all of the other styles for the simple reason that most hedge fund states have a long bias. An investor is buying a different view. The next two styles that have the most diversification benefit are global macro and managed futures. These two should be the diversifiers of choice for any investor once the decision to hold alternative investments is made.  A two step process may be an effective approach. First, determine whether you want diversifiers or substitutes and then second, choose the best managers within the style space. No different than the work on strategic asset allocation, the allocation decision may matter more than the manager selection. 

The consolidation of FCM's in the futures industry will continue and some may ask the question why FCM are needed at all given a greater portion of the fees from trading goes to the exchange. One third of all FCM's holding customer funds have disappeared in the last decade. It is unlikely that we will see another 30 disappear, but it is not clear how profitable this business can be for firms. The top ten FCM's are all associated with banks and not stand alone entities. The chart from the FIA tell the story. If you are a small fund or small hedger or if you do not have the right credit, you will not have a place to trade. The system will not work for you, and CME's ads about the marketplace for hedging risk will be just a dream. Of course, costs will go up and there will be point where brokerage and clearing will be profitable, but it will be at the expense of the small trader. Perhaps I am exaggerating, but which one of the top ten clearing firms will want to service sm

The CAIA and AIMA groups developed a hedge fund framework for trustee which provides a good introduction on how to classify hedge funds for a portfolio. Cutting through all of the issues of alpha and beta focuses on two large groupings, substitutes and diversifiers. Now all hedge funds will provide some diversification versus a traditional equity and bond investment, but the degree of differences matters.  The substitutes are those hedge fund strategies that can fill-in as an alternative to a equity or bond investment with less risk. If an investor does not want as much directional risk, he can sell bonds and buy a fixed income arbitrage fund. If an investor wants less directional equity risk, he can buy a long/short equity fund. There will be exposure to stocks or bonds but at a lower beta and a higher likelihood of alpha. The diversifiers are hedge fund styles that will provide a greater degree of diversification because the correlation will be low and potentially negative during &qu