testing

There is a Gordian Knot with asset allocation as we move into 2016. The problem is simple but fundamental to all asset allocation this year. If interest rates are going higher, what happens if stocks do not go higher. Moving out of bonds and not stocks may not protect principal.  The premise on switching between these two assets classes is based on the negative relationship between stock and bonds that have existed for a fairly long time albeit not guaranteed. Investors are in a difficult situation of the negative correlation does not exist in 2016. The 2016 assumption is that the Fed will normalize rate and we will thus see higher rates across the yield curve. The higher rates are based on expected higher inflation and higher growth. If there is higher growth, there will be an expectation for higher earnings based on higher sales which will boost stock prices. Similarly, there will be higher inflation if there is a higher growth. Because earnings are adjusted with inflation, equities

Many firms are now engaging in surveys to provide insight on the direction of asset allocation choices of large investors.  Natixis Global Asset Management just released their 2016 survey of institutional investors  which provides interesting reading. It tells us that institutions want efficient diversification, different asset class and strategy choices that efficiently use capital.  The top objective for institutions is not about growing or preserving capital but achieving the highest risk adjusted returns. This plays nicely into the higher demand for alternative investments. The one thing that hedge funds do well is more efficiently use capital and this seems to be the desire of investors. Of course the big elephant in the room for any investor is the threat of higher interest rates from a Fed normalization. 2/3rds of institutional investors plan to shorten bond durations as a way to respond to this threat. Unfortunately, lower durations comes at the cost of lower yields.  Protectio

Mercer consulting announced their themes for 2016.  Their four themes are not surprising, but it is still important to review them and think about how they can be exploited in the global macro space. The overriding theme is that investors will be facing a low return environment, or more importantly, we are not in a positive long-only environment. In the short-run, holding beta exposure will not get you to your return dreams. The four themes are: 1. Reduced liquidity for liquid assets 2. A maturing credit cycle 3. A tilt form beta to alpha 4. Think long-term The reduced liquidity theme has been the talk of both investors and regulators. Investors are getting more risk averse given the potential for liquidity events. Police-makers either do not want to admit their is a problem or believe they are not the cause of any liquidity shortfall. Nevertheless, they have increased their focus on macro prudential policies which include monitoring liquidity. Our view is that a reduced liquidity envi

I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell…. So how much should we worry? This is where economics… gives the dreaded two-handed answer. If it becomes clear… that fundamentals are in fact not so bad, stock prices will recover…. [But] the stock market slump… can become self-fulfilling…. Hope for the first… worry about the second. - Olivier Blanchard  on the current markets  Call it animal spirits, confidence problems, sunspots, self-fulfilling prophecies, sentiment, herding, noise traders, risk-on/risk-off, or multiple near-rational equilibrium, the markets are not following the fundamental news. Economist have a hard time when market move and there is not a clear link to fundamentals. The story that links fundamentals with the price action is often a complex form of expectations and game theory. Economist do not have a good or consistent name for this behavior of prices unre

Commodities are not like other asset classes. They will be affected by different factors from stocks and bonds. This is one of their key attributes. Commodities will offer unique diversification, but their uniqueness is also what will harm investors who think that they can just hold long-only exposure in order to receive consistent gains. Commodities cannot all be bundled together, energy markets are different from metals or agriculture. The commodity cycle is different from the business cycle and the cycle for each commodity is usually significantly different. The cycle for in-the-ground commodities is different form those that are mined or below-the-ground. The commodity cycle will generally last longer than a business cycle. Right now we are in the down portion of the cycle even though the overall global business is still positive albeit losing momentum. Commodity markets as accessed through futures will be subject to hedging pressure and short-term storage issues which are very dif

There will be fads in asset management industry just like the fashion industry. Look back at the fashions in the 70's or 80's and you may just shake your head and ask, "What were you thinking wearing that?". The time has already come for investors to shake their heads about holding a commodity index and ask the same question. What were investors thinking? That said, the big dislocation between equities and commodities came after the Financial Crisis as evidenced by our graph between the S&P 500 and the Bloomberg commodity index. Commodities peaked in 2008 and tracked equities through the middle of 2011. Since mid-2011, equities and commodities have had a significant divergence. This was the post-QE2, beginning of the slowdown in China period. Commodities were a good trade when you were riding the wave of the up-cycle. The case for commodities ran through this long up cycle and seemed like a natural portfolio diversifier. Shortages and peak supply were the underlyi

We have been big believers of Nasim Taleb's concept of "antifragile" when thinking about portfolio building. You want a portfolio that will gain from uncertainty and not just be resilient. His book, Antifragile, was a path-breaking extension of his earlier work, yet it seems to have had limited impact on investment thinking. Those who have passed on these concepts are hurt. 2016 may turn into a year of disorder and transition. It certainly feels that way as we enter the third week of the year. If there is more uncertainty and market turbulence, investors should want a portfolio that will gain from disorder. Investors want a portfolio that will do well if government policies are mishandled, markets reactions are unclear, or models seem to give false signals.   The world seems very fragile. We are less than a month away from the last FOMC meeting and there is already talk that rate increases should be on hold. Policy in China is more opaque than a year ago. The credit cycl

Risk can be separated into two types - exogenous and endogenous. Exogenous risks are the ones that we most often discuss and model, but endogenous risks may be the most dangerous because they are not easy to describe or measure.  Exogenous risks are those associated with news - the fundamentals that drive markets. They can be the latest announcement from the Fed, or the new employment numbers. The risk from these announcements will be unanticipated, but the impact is often well recognized. These risks are the measurable or explained volatility in markets. These risks will be related to model structures. The behavior of traders and investors are well-defined and rational with respect to these risks. These risks help to formulate expectations because the models describing the economy are known. You could call the battle to measure and assess these risks as a game against nature.  Endogenous risks are the risks derived from the trading in markets. These risks are the unexplained volatilit

There has been a new focus on market liquidity in the last year. Will bid-ask spreads increase? Will there be a shortage of liquidity so prices will move away from fair value when you want to execute? Will there be liquidity crises through swift downdrafts in price? All of these liquidity issues are important for investors, but they may not be the most important liquidity issues. There are more macro liquidity risks which can be more onerous and far-ranging. There is a distinction between macro and micro liquidity risks. Macro liquidity risks are associated with an asset class or broad set of markets and minimize the ability of investors to get out at any price. This could be regulatory restrictions on any sale. Micro liquidity risks are associated with the inability to get an immediate transaction done.  Macro liquidity risk will come from regulatory changes or financial repression that limits the ability to trade. The restrictions on large shareholders ability to sell in China is a s

The capital flows out of China continue. It is like a financial diaspora of wealth moving to new parts of the globe in search of safety that was not expected just two years ago. The number are big and have an impact on the rest of the world. The real estate gains in some the leading cities around the world are driven by Chinese investors. Now, it makes sense to diversify out side a home country, but let's remember that China has been one of the fastest growing area in the world. The opportunities in China are still vast. There is more going on than diversification; however, the explanation is rather simple. All things equal, wealth hates uncertainty. It can hedge volatility, but hates uncertainty. In particular, wealth hates anything that changes the rules of the game because then you cannot make the appropriate long-term inter-generational planning that can sustain past successes. Everyone can endure some uncertainty, but when uncertainty affects your ability to liquefy assets, yo

I hope it will not shock experimental physicists too much if I say that we do not accept their observation unless they are confirmed by theory. - Arthur Eddington We should make this very simple. If there is no explanation or theory for the numbers in a systematic model, there should be no faith in their ability to be repeatable. Statistics without theory have no meaning.  Investors should be able to get comfortable with back-tested data provided the work is done carefully and if the results can be described through a theory. If you are a trend-follower, you should have an explanation for why markets trend. If there is an alpha strategy for hedge funds, you should be able to explain why the alpha is exists and whether it can be arbitraged away. You should be able to differentiate between skill, luck, structural advantage. We can go so far as to say that skill without a story should not be believed. Repeatable results are only those that can be explained with a theory.

The '40 Act mutual fund space has grown significantly for CTA's and this sector now has its own index. It is not the same as the SocGen CTA index that has been reporting returns for the last fifteen years. A comparison between the SG CTA index and the SG CTA mutual fund index shows there is value in moving looking outside the mutual fund area. There are more managers to choose from which adds diversification from more styles of managers, timing of trades, and markets traded. Starting a new index is never easy. You have to figure out the criteria for the constituent managers and actually back-fill to provide some history. The result of this construction is a new index which may not track the performance of similar existing indices. The existing CTA index has 20 managers while the new mutual fund index has 10 managers with a minimum size in the mutual fund AUM of just under $100 mm. There are only two names that overlap. Both are equally weighted. Our first chart shows the cumula

When discussing efficient markets, the one thing that we know is true is that prices will adjust quickly to new information. Markets may make mistakes but they will occur quickly. There an be under and over-reaction but there is still reaction to new information. This immediate reaction is one of the reasons that policy-makers are often so careful about what they say and do. A wrong move and the markets will send a signal immediately. That kind of feedback is not always what policy-makers want to hear and the reaction may have follow-through. The information accumulated will have an impact on longer-term prices. The markets are sending signals to China policy-makers and it is saying that there are issues with current policies. China signals and response - Circuit breakers - First in and then thrown out. Investor market reaction is further exiting from stocks on this uncertainty. Circuit breakers are supposed to give investors time to assess market conditions, but that does not mean in

The post-crisis zero interest rate period was all about the reach for yield . One of the purposes of the Fed's zero rate policy was to get people to spend their money and not save. For those that still wanted to save, the objective was to get investors to put their money to use through riskier investments. Get money out the mattress of safety and into new investments that will serve as a catalyst for growth.  Zero rates are now over, so the discount rate for any investment project should be higher and the present value should be lower. Projects that seemed worthy as a stretch for yield now do not seem to make as much sense. If the Fed policy states that rates are to be normalized, then the marginal project should be rejected and current investments may not seem as economical. There is less reach and the movement should in the opposite direction. Investors will stretch for safer investments .  Interest rates represent the time value of money and the price of risk. If the Fed keeps r

The rankings of hedge fund strategy index returns for 2015 show a lot of negative numbers. It was not a good year. Most strategies underperformed the Barclays Aggregate and 2/3rds did worse than the S&P 500.  Hedge fund did not hedge. Fixed income did not find the sweet spot and global macro did not find the major market trends. The only winners were merger arbitrage given the large deal flow, equity market neutral, and the absolute return index. Managed futures and global macro did better than most strategies, but these strategies were not able to find big pay-offs and missed the big fixed income, commodity, and foreign exchange opportunities. Of course, some individual managers did well, but the central tendencies are what drive expectations and allocation decisions for managers.

The year was filled with surprises and big divergences, but most of them were policy-made and highly unpredictable. This is a small table highlighting some of the ones that we think caught investors napping.

The main theme last month was whether the Fed was going to raise rates. It did the job. It also presented the SEP "dot plots" for the new year which suggested that four Fed increases would occur in 2016. The story is not switched to not when will the Fed start normalization but how will it occur. The "data dependent" Fed focus will mean a higher sensitivity to economic data and higher market volatility.  Larry Summers began the year with a strong editorial on secular stagnation. The slow growth in the US and the rest of the world should cause all investors to take a closer look at his arguments. A world of global secular stagnation is very real. If rates are going to move higher, then the reach for yield may be over. It is more likely investors will be stretching for safety. We are more likely to be in a RO/RO environment like the period between QE's. A world without QE is not the same as a world with it.  I hate to be a pessimist but fading consensus and being

Effort and results were not linked for managed futures managers in 2015.  For all of the trends, opportunities, and trading, the SOCGEN CTA index ended the year up 10 bps. Going to sleep for the year with money in a mattress would have gotten the same return. Nevertheless, equities as measured by the S&P 500 stock index (SPX) fell less than one percent while bonds as measured by the Barclay Aggregate Index (AGG) gained just less than 50 bps. It was a sideways year in spite of the historic change in Fed behavior,  significant oil shocks, and negative interest rates in the EU. A closer look at the monthly returns show an interesting story for how and when managed futures managers made profits and lost money. Of course, we are generalizing, but we believe a simple comparison with traditional assets can tell an effective story.  Looking at equities, there were two big positive return months, February and October. During these months, managed futures posted loses. The power of diversifi

Instead of predictions of what will happen, it may be a good idea to talk about where there will be surprises. A surprise is an event that is contrary to the consensus of the market. There are five that will be the key focus of the year. We are not saying that any will occur, but argue that these are events or market reactions that will surprise the consensus. The dollar declines - The consensus is that the Fed is tightening and raising rates while the rest of the world is easing. This is all true, but if the Fed does not follow its path of increases, a dollar reversal will be the trade in foreign exchange. Is this dollar decline likely? The Fed has generally predicted a faster increase in rates over the last few years only to go slower than expected. History tells us four Fed increases per the SEP dot forecasts is aggressive.  A rate decline - With negative rates in the EU and the Fed expected to raise rates four times in 2016, the market bias is toward higher rates. This view is rei

If you are a managed futures trend-follower, you need market dislocations, divergences, to make money. You follow a mean-fleeing strategy. Most managers futures managers can be classified in this manner. If there are no market moves, that is, markets are range-bound, trend-followers will not have any viable opportunities.  If we look at the moves for 2015 in the futures markets, it is clear there were limited long opportunities. The major potential trends were from the short-side in the energy and metals markets. Unfortunately, these markets are usually the most volatile and have smaller weightings in the portfolios of most managers futures managers. The high volatility of these markets also makes it more likely to be stopped-out of positions or harder to find trend identification.  Clearly, it is hard to extrapolate from year over year changes but even a high level examination tell us  that there were limited opportunities. For all trend-followers, there is a cost of trend identificat

The framework of convergence and divergence is useful to describe markets and hedge fund styles. With this framework, we can focus on the big events of 2015 as market divergences. There were by my count eight unexpected market moves that were mean-fleeing. All were surprises that caused major market dislocations. These events were the biggest opportunities and risks for the year.  There were three key global macro shocks that had an immediate impact on markets. All were surprises in government policies. The year started out with the Swiss National Bank ending its euro/chf peg. This single event led to the failure of a number of hedge funds and hurt many trend-followers in January. The China devaluation in August was another currency surprise that was one of the reasons for the August market sell-off. China risks were much greater than anticipated. The third policy shock was the limited ECB monetary action in December. The market was caught surprised by a less aggressive policy announce

Computer science is no more about computers than astronomy is about telescopes Edsger Dijkstra In spite of all of the advancements in quantitative tools and the use of computers and large databases, effective investment management is not about technique but rather about the process of meeting financial goals. Since some of the risks faced by investors are not quantifiable, a focus just on tools and numbers is insufficient to gain success.  The advancements of finance have been able to better formulate the investment problems, but does not always provide solutions. We have a better understanding of factors and can better decompose alpha and beta, but we are no better at predicting what will happen to factors such as growth and inflation over time. There is still significant room for  theory, testing, and analysis - the science of investment management.  

True genius resides in the capacity for evaluation of uncertain, hazardous, and conflicting information. -Winston Churchill I don't know whether Churchill was a good investor. He always had money problems and was forced to write to pay the bills earlier in his life, but he does seem to understand the essence of what it takes to be a good investment manager.  Perhaps those who find investment management difficult and have failed at different times better  understand the genius of investment management. The genius is learning not to be over-confident about the what can be understood from conflicting information. There is genius with saying you don't know or that you are confused and having the courage to step-away from taking risks. May everyone show genius with the uncertainty of 2016. 

Science is what we understand well enough to explain to a computer. Art is everything else we do. - Donald Knuth, computer scientist The same could be said for investing.  There is the portion of investing that can be rules-based and explained to a computer. It could be the Fama-French model of betas. It could be a set of rules for finding trends. It could be the risk management that measures portfolio volatility.  However, this is often not enough to generate high returns.  Advanced investment science now is the revolution in smart beta, but even if we can decompose the return of a fund through smart betas, there is still a lot of the variation that cannot be explained. This is caused by the art of investment management. It is the job of investment analysts through their due diligence to make sense of this art and find the unique intersection between it and the science of investing. 

Computers are boring. They only give answers. - Pablo Picasso Predictions for the new year are about the same. They only give answers for what may be the wrong questions. I think there are only three questions for the year. I keep it three to ensure it is very simple. One policy, one environmental, and one behavioral. The policy question is the follow-through question from 2015. In 2015, the issue was when would the Fed raise rates. The 2016 question is how will they further raise rates. The behavioral question is also simple. The last few years was determining how investors would reach for yield in a zero rate environment. The 2016 question is determining how investors will react to a rising rate environment. The reach for yield may actually be more like the RORO (risk-on/risk-off) environment of 2010-2011. The third question is focused on the macro-environmental. How will the emerging market slowdown spill-over to developed markets? China trade is bigger than the US. EM economies are