testing

It may seem that the world is gripped by terrorism, but there is a school of researchers who suggest that the world has gotten more peaceful and that violence is trending down. There certainly has been something of a "Long Peace" with no world conflicts in more than 70 years, yet it may be hard to draw conclusions on whether the trend is toward non-violence. Leave it to Nassim Taleb and his co-ahtor Pasquale Cirillo to provide some useful perspective on this issue with a math foundation. Employing the tools of extreme value mathematics with fat-tails distributions the authors provide some much needed analysis on this critical research topic. Their conclusion is that we just do not have enough data to draw any conclusions on the trends in violence around the world. It is fine to be hopeful, but there is little evidence to support a good news story. See their working paper, "What are the chance of a third world war?" and their paper " On the statistical properti

The market reaction to Fed Chairman Yellen's speech has been asset price positive although it is likely that few have read the text. The key market issue is determining what is the Fed's reaction function. This discussion has all too often devolved into a simple model of dove versus hawk. In reality, we have to think about three competing models of Fed behavior, time-dependent, data-dependent, and market-dependent. The emphasis of one model over another is a function of Fed communication and market perception.  During the zero bound period, the focus was on time-dpendent communication. The Fed communicated that action was in the future and was not focused on the immediate data .  The data-dependent Fed focuses on what is happening with growth and inflation. The Fed is moving in the direction of being more data-dependent.  Yellen discusses a third reaction function which is market dependent. Delays in policy have been a function of external forces like China, the stock market, a

Is there a difference between global macro and managed futures hedge fund styles? Many investors lump the two of these strategies together. Clearly, the investor's objective of holding global macro and managed futures are the same. Investors want to get a unique return stream that is uncorrelated with major asset classes. More importantly, investors want that low correlation to come at the right time - the "bad times" for equities. This is the crisis beta that has been written about for managed futures and to a lesser extent global macro. While the expected result for each is supposed to be the same, each strategy will generate returns in avery different fashion. Good global macro managers are able to generate high stand alone returns or alpha. Good managed futures managers are able to provide more diversification at extremes, but at the cost of lower stand alone returns. We have listed sixteen differences between a managed futures and global macro manager. Now, this brea

Global macro is a very broad hedge fund category which does not lend itself to easy descriptions. Nevertheless, we can take a simple stab and divide global macro into top-down and bottom-up approaches. This is a variation of how many stock-pickers behave but reset to a global macro environment. The distinction is important because the return and risk profiles should be different based on the approach taken. We don't want to make a value judgement about which is better other than to say that each will generate a different return pattern. The top-down approach approach tries to exploit buying (selling) cheap (rich) beta. The bottom-up approach is looking for alpha opportunities across a global set of markets. The top-down global macro manager will focus on major themes in markets and look to take directional bets on the market. Are European stocks cheap relative to the US? Is inflation rising? Will the Fed raise rates? These can be exploited in the futures markets as directional bets

A newly published research piece studied out of sample and post publication return predictability for a number of variables that have been shown to predict cross-sectional stock returns. They ran tests over 97 relevant variables. The researchers found that most variables show declines in expected returns out of sample. On average, portfolio returns decline by 26% which serves as an upper bound of data mining effects. More importantly, the authors find that returns decline 58% post publication of the research on any variable. Assuming that we conservatively take the 26% decline from data mining away, the researchers believe there is a  32% decline in returns from traders who have taken advantage of this research or market mispricing. See "Does Academic Research Destroy Stock Return Predictability?" Traders read the research that is conducted by academics and they exploit any pricing anomalies that are found in the research. After the research is widely disseminated, the excess

There is a long tradition of believing that exchange rates cannot be forecast with economic fundamentals. The power of fundamental models to beat a random walk always been poor albeit trend and carry models have proven to be successful. A new research paper from the BIS, "When the walk is not random: commodity prices and exchange rates" , suggests that currencies that are highly tied to commodity exports do not follow a random walk but are closely tied to the market prices of their exports.  There have been researchers who have tried to look at commodity prices and currencies but have not done the careful work of creating country-specific indices that reflect their exports and thus their terms of trade. When country specific indices are created there is a forecasting link at short-term horizons that extend out to two months. You can track these export weighted commodity price indices and be able to do better than a random walk.  More importantly, these forecasts do better tha

The growth of money flows to hedge funds continues. The recently released Deutsche Bank (DB) hedge fund survey states that assets under management will increase about 7% in 2016 and 39% of their survey respondents say that they will increase allocations.  However must investors expect to decrease the number of hedge funds they hold. There is a move to fewer managers which means there will be further fall-out with smaller hedge funds. Each manager will get a bigger allocation but there will be fewer winning mandates. If a hedge fund cannot gain scale, it is game over.  Even though there are greater asset flows, investors do not expect big returns. Only 14% of respondents target a return of 10% or higher. More money is moving into hedge funds, but investors are expecting less from these managers. Although they are expecting less, there still is a wide distribution of returns. The survey suggests that the spread between the top managers and the those that underperform is getting wider.  M

One of the confusions with monetary policy is determining the intentions of the central bank. With some many talking heads form the Fed, it is hard to determine what is the message that is being conveyed. In more formal terms, investors need to know the Fed's reaction function or how it will respond to different economic scenarios. If there is not a well-defined reaction function, there will be confusion. At one extreme would be a central bank that is completely rules-based. There will be no room to maneuver and the reaction function would be clear for everyone. There would not be any need for speeches. At the other extreme would be a Fed that does not communicate any intentions or communicates regularly but in a inconsistent manner. A variation on this theme would be a Fed that does to have creditability.  One of the current keys to central bank communication has been the idea of "forward guidance" or the use of communication to provide the market with its intentions in

The Harvard endowment is restructuring its asset allocation process with a new approach called Flexible Indeterminate Factor-based Asset Allocation (FIFAA). This new approach will try and address the issue that the endowment has underperformed many of its rivals since the Financial Crisis. The question is whether this is going to have a large impact on the thinking of other toward asset allocation like the Yale endowment model. The key idea that your core approach is "Flexible" and "Indeterminate" tells you a lot about how much Harvard wants to be constrained by any view or philosophy concerning asset allocation. The endowment describes it as a process. The allocation process has four steps: 1. Determining the underlying factors that drive performance; 2. Measuring the link between those factors and asset classes; 3. Finding the desired factor exposures; 4. Building a portfolio based on those factor exposures. The factor are said to be flexible but include world equ

There are a wide set of allocation approaches but there has been little work at trying to classify them. Nevertheless, a classification scheme will help the investor understand how are bets taken and bundled within a portfolio. It will provide an idea of the information requirements and a view on how the financial world works. Asset allocation can fall in a spectrum along a quantitative or qualitative range.  At one extreme is the use of modern portfolio theory or one of its derivatives. Given the amount of research done on the MPT approach, we can be precise with describing its limitations. Some of the inputs could be qualitative but the asset allocation mechanisms is based on optimization across return, risk, and correlation. At the other extreme could be an approach called best ideas which tries to bundle a set of best trades within a portfolio. The endowment model often described as an effective strategy is actually very qualitative and somewhat arbitrary. On the other hand, risk t

I did not have a good way of expressing how the Fed should convey information after the lift-off until I read the recent paper, "Language after Lift-off: Fed Communication Away from the Zero Lower Bound" by a group of Wall Street and academic economists with a lot of Fed experience. The current policy confusion about communication is caused by the Fed and the market focusing on "time-dependent" messaging when it should be "data-dependent". This paper is a long but worth the effort. Most can read it quickly, but it is filled with little nuggets of important information.  One of the key monetary policy issues is the form of forward guidance by central bankers. This issue has become all the more important in the zero lower bound period especially when Fed wanted to sent signals on the path for rising rates. There has been too much focus on "time-based" forward guidance. When will rates start to rise and when will be the next move by the Fed? Will i

I have been troubled by the Fed. In December, we had lift-off with an increase in rates. The Fed provided their forward guidance dot plots which suggested that there would likely be 4 increases in 2016. The market rates were thinking differently, but the Fed was conveying information through their language. They have also said that they are data-dependent. Given this information, the focus of investors has been to try and fit the forward expectations from the Fed in a data dependent world. The market has been trying to understand the Fed reaction function. It just has not been able to understand the Fed and this has been a problem. Now, we are in March, just three months later and the Fed states that there will likely only be two increases in 2016 based on plot information and comments by Chairman Yellen. We will wait and see. It is not clear what has happened over the last three months to labor, growth, and inflation that would shift Fed views so dramatically. Of course, we have seen

There is a long history of showing that tracking trends or sorting by momentum in currencies will lead to good return performance.  Trends are viewed as one of the three key drivers for explaining currency returns along with carry and fundamental value. Currency returns are tied closely with the short-term interest differential or carry, deviations from fair value as measured by some variation of purchasing power parity and past return performance. The view is that fundamental models have done poorly in these markets so using price-based systems is the best way to extract returns. A new study shows that currency returns are tied to trends in economic fundamentals. Put simply, the trend in macro variables will lead to price trends. This makes perfect sense in the trend-follower's world, but they choose to focus on price and not worry about the fundamentals. The choice of which economic variables to follow may be problematic. Instead, prices are viewed as primal to the process. What

The futures industry meets at this time each year to have their annual FIA Expo in beautiful Florida. It allows the executives of the exchanges, FCM's, and regulators to rub elbows and discuss the issues of the day. The FIA does a lot of good behind the scenes work for the industry, but an interesting question is the value of this event for the futures customers, the actual end users of these markets. The agenda gives little information on this value, so I thought I would list some of the issues or questions that may be important for end clients. Market consolidation of FCM's -  The number of FCM alternatives are shrinking with the big firms (banks) only taking more market share. Why is this good for the industry? Market liquidity and the potential for flash crashes -  A growing concern across all markets is liquidity or the lack of liquidity at key times. This concern is different than the risk management of large market moves. A liquidity crisis will affect the industry and

Themes, issues, and opportunities often do not change from week to week, but it is important to still identify what should be the key drivers in the mind of traders and portfolio managers. These themes are often not associated with the announcements for the week but represent the bias or filter through which new information will pass through.  While we have mentioned four, the RO/RO trading environment may be the most important. Volatility has fallen from the highs earlier in the year with the VIX below 20%, but that does not change the fact that an unexpected announcement or an odd policy announcement will cause a switch to risk aversion. The switches will often be short-term but violent which leads to both trading loses and opportunities. 

Is there moral hazard with CTA's? That is, do CTA's change their risk behavior to increase their chance of an incentive fee at the expense of investors? If you read the new paper, "Risk-taking behavior of Commodity Trading Advisors" by Li, Jiang and Molyboga, the answer is clearly yes. Investors will bear the consequences of a manager's risk choice, albeit the impact is based on market conditions.  There has been research on this topic with other hedge funds, so the authors focus on the behavior of CTA's. Since incentive fees are a call option on performance, there is an incentive to take on more risk when a fund's performance is out of the money or below the high water mark. This will increase the chance that you will hit the target for incentive fees. Of course, the investor will benefit from the higher performance, but he will have to take-on higher risk that would not occur if the fund was at a different point in the performance cycle. The authors loo

The question is often asked, "What do I need in my portfolio?". The answer is usually long-winded with deep discussions about asset classes, factors, securities, and risk. I think we can make it easier by putting the discussion in a BAG - focus on three things: beta, alpha, and gamma. If you can keep it simple, it is more likely you can get a better portfolio mix.  To BAG performance you need: BETA - exposure to the major asset classes. This exposure is where most risk will be in a portfolio. Beta exposure is not immutable. It can be dynamic and adjust to market conditions. Static beta may be the greatest risk to performance. The beta exposure can be gained cheaply through indices and ETF's. Investors should not pay-up for beta because there is no skill in obtaining it.  Beta exposure can be gained through traditional investment managers. ALPHA - This is the return that is unrelated to beta, non-market risk. It could strategy or manager-specific or it could be related to

The Family Office Association issued a white paper called "Improving the "Endowment Model" Recipe". This is a provocative piece because it takes aim at what has been key thinking on long-term portfolio management through the Yale endowment model. It focuses on what is still the key driver of portfolio performance - asset allocation. Their premise that there is a difference between using a recipe which employs different proportions of ingredients and the use of superior ingredients. Their argument is that if you want to have a better stew the recipe matters more than the ingredients.  The endowment model focus more on the ingredients when the real focus should be on dynamic asset allocation. Their simple description of the endowment model is threefold: Equity-like investments for nearly all returns Illiquid investments as a means of picking up extra premium  Added return through selection of skilled managers. The result for those who have followed an endowment model

New Zealand dollar action is a canary (kiwi) in a coal mine. The central bank lowered rates by 25 bps to 2.25 percent which led to an immediate sharp currency decline. The currency has bumped up against a ceiling over the last few months and is now back in the middle of its range since the fall. Last spring and summer the NZD was declining based on potential Fed action.  As a small open economy that is tied to commodities and Asian trade, the NZD cannot afford to have an appreciating exchange rate. Interest rate action will have an immediate effect on exchange rates. The currency had appreciated about 4% since the central bank's December policy meeting projection.  Lowering rates is just a further sign that open economies have to take action versus the negative rate countries or face declining exports, rising currencies, and slower growth. The negative rate countries like Japan are exporting their deflation problems to the rest of the world. New Zealand just acted in a manner that

When trade goes up, there is more demand for shipping. Of course, if there is an over-supply, the rate can still fall even on more trade. Nevertheless, a simple look at shipping rate charts tell you this is a market that is not anywhere near the old equilibrium. This just reinforces the commodity story that the super-cycle is over and trade is not growing at rates any near what shipbuilders may have expected. Shipping rates seem to have flat-lined since the pre-Financial Crisis environment. However, the variation at these low rates is significant. Clearly, rates have fallen with oil prices. 100% gains and more than 50% declines over a six month or less period are not unusual for all ship sizes. It is not clear that rates will immediately rise with oil prices since some tankers have been used as expensive floating storage.  Shipping rates are sending a signal and it is not trade friendly.

The Economist noted the challenging environment for hedge funds last month. New launches are down and liquidations, albeit down are similar to the launch levels. The net number of hedge funds outstanding is not growing quickly. Small funds are having a hard time surviving or starting. Seward and Kissel released their 2015 New Hedge Fund Survey  with some interesting insights that reinforce current trends.  The focus of most hedge fund launches is still equities. For all of the talk of alternatives, many managers and investors still want to pick stocks. Fees are coming down slightly with new firms offering size and founder discounts. What is more interesting is the continued demand for lock-ups. There seems to be agreement that it takes time to grow so managers are asking for sticky money and investors are willing to accept these terms.  New launches seem to require more "seed" money to help start funds. While size of start-ups was not a focus on for survey, it seems that grow

The global macro indices generally posted gains for February but have not done as well as managed futures. However, the discretionary thematic and commodity traders have gotten it wrong this year. Of course, this is a representative index and not how all managers have done.  The graph is suggestive of the difference in risk-taking between different strategies. Plotting the return and risk of all the HFRI macro indices shows the good performance of systematic strategies. The Barclay BTOP50 and SocGen CTA indices have done even better than the systematic index by over 150 bps. The next best strategy, active trading, generated similar risk-adjusted returns and information ratio but had lower volatility. The adjusted returns are increased or decreased relative to the volatility of the systematic macro index volatility. If the volatility is 30% less than the systematic volatility, then returns are adjusted up 30%. Generally, we find that the directional trading of managed futures will be mo

One month makes a big difference. We have gone from a hugely negative equity environment, oil crash fears, a credit downturn, and Fed policy mistakes to strong equites, an oil rally, and less credit risk. The economic environment has not changed radically, but when risk appetite changes the asset markets around the world change.  Can this last? This will be the number one question for March. We think there are still major headwinds to stop a sustained rally, but data change and markets change. Nevertheless, there needs to be confirming economic information to sustain the current rally. 

Hedge fund skills are dependent on the economic environment. There are more hedge fund managers who show skill during the expansion state of the economy over recession periods. If you want to hold the truly exceptional managers, you will look for those that do well in both expansion and recession periods. The paper, “Measuring Hedge Fund Performance: A Markov Regime-Switching with False Discoveries Approach” by  Gulten Mero provides a different take on measuring hedge fund manager skill. The work uses some advanced econometrics to look at skill behavior in different states. The author looks at only one hedge fund style, equity long/short, but it does provide a good framework for thinking about skill in different environments.  There are more alpha producers during the economic expansion. The skill producers decline by about 20% in a recession. Unskilled or no skill managers increase to over 50% during a recession.  Recession will be associated with market declines and usually the marke

The market has shown new strength on slightly better economic data, increasing oil prices, and continued increased monetary liquidity, but care should still be taken with taking on more equity risk.  First, the threat of a recession albeit low is much higher than what we have seen in years. I have taken the St Louis Fed recession probability model estimates and changed the values to logs. This will place more roughness in the low probability numbers. It is nice way to look at the marginal changes in probabilities. The readings are certainly not close to Jim Rogers "100%" recession comment this week, but the threat is real and certainly more than what we have seen since the last recession.  Second, I look at the financial stress indices produced by different Fed banks. Below we show the Cleveland Fed numbers. That number shows a heightened level of stress although it looks like we have reached a local maximum. Financial stress is subjective and not part of the Fed's policy

The demand for hedge funds continues. The recently released 2016 Credit Suisse hedge fund investor survey shows that over 80% of investors plan to maintain or increase their allocations to hedge funds this year. The survey also ranked the most popular hedge fund strategies as measured by their net demand. Equity market neutral filled the top two spots and equity long/short grabbed two of the top five positions. The only strategy that was outside of equity trading was global macro discretionary. I find this very interesting because equity market neutral is really an attempt to gain the risk free rate of return plus alpha. We know the risk-free rate is still hovering close to zero, so you need to chase alpha. More money will be looking for the same set of opportunities. Markets may not be efficient, but we do know they are competitive and that easy market entry into an inefficiency will drive excess returns lower. The only reason to invest in market neutral is that you believe that there