testing

I visited the FXWeek North American conference across the street from my office. It is interesting that the issue of FX as an asset class is still being discussed as a topic. This issue just will not go away. While I think of it as an asset class, there are still many who are skeptical; nevertheless, we can change the focus from asset class to factors and then foreign exchange becomes more unique and useful. If the idea is that you would like to buy unique investment factors, currencies are good place to gain return and diversification.  In fact, some of the well-known factors that are applicable in equities or fixed income also apply to currencies but with a different return profile uncorrelated with other asset classes. What are the factors that can be the focus of foreign exchange? The usual suspects apply to foreign exchange - carry, momentum, value, and volatility. Exploiting carry in FX is different than in the fixed income markets. It may be related to global risk but it has a d

There have been more news stories this month about the poor performance of hedge funds in the first quarter of 2016 and the fact that there are rumblings that investors will pull money from hedge funds. Hedge funds have to get their act together on performance, fees, and the value proposition.  The first half of the month has seen some bright spots as measured by the HFR indices.  Directional hedge funds and those that generally  have more beta exposure did better. The market directional index posted the best performance doing even better than a stock index. The only style that showed a drag on performance was the equity market neutral which was down 114 bps. Almost all of the hedge fund styles beat the long bond.  Now, it is not always a good idea to compare hedge fund returns over a short horizon against equity and bond benchmarks, but unfortunately, many decisions are based on relative performance. Except in very strong up markets, the expectation from many investors is that the cum

The BREXIT issue may be the trade of the year. What does that mean and why give it this view?  1. This is a big event - Not only will this have huge impact on Great Britain and its place in the European and world economy, there will have a spill-over effect to the rest of the EU. This is the type of event that will shift rare event expectations and increase tail risks. 2. There is a specific date when uncertainty will be resolved. There is not an issue of when it will occur. We know the vote date. 3. The probability of the vote can be tracked and measured. Handicappers now say there is a 24% chance of an exit. The poll numbers look like it is very close. The risks of a bad outcome after June are still not clear, but the vote can be watched and given precision. 4. The market has already spoken that this is a big deal and talk is generating more interest. The IMF just stated that there will be severe global damage if the Brits leave.  5. Financial institutions will have to square their r

One of the most perplexing and important issues for any hedge fund investor is manager due diligence. Investors have gotten very good at operational due diligence in the post-Madoff era, but the same cannot always be said about skill assessment or investment process due diligence.  There is no doubt the quality of skill assessment has improved over the last few years. The ascent of factor-based analysis has done a good job of better describing the risks taken by managers. Skill assessment has also done a better job of separating alpha from beta for many hedge fund styles. Still, more work is needed in this area. There is still too much reliance on performance screens versus an assessment of a manager's ability that forward-looking. We think a simple two approach can be helpful. While many investors implicitly do this analysis, it is not structured within the due diligence analysis.  The two step approach is to to look at performance and the story that is told around performance. We

Two of the most important factors for investors are value and momentum. These are factors that can both easily be exploited and accessed in the market. Value indices are relatively easy to create using a simple set of rules. Momentum is also easy to create through rules or through specific fund styles. Nevertheless, the stories used to explain the excess returns in value and momentum are very different. A simple matrix based on five criteria can be used to explain the difference between these two factors. The approach of the  value factor is to look for cheapness or richness relative to other securities in a portfolio. For momentum, it is looking for assets where there have been high gains versus declines.  For a risk-based story for the excess returns associated with value, there is the view that investors are compensated for risk from firms that may be out of favor. In the case of momentum, there is the story that excess returns are associated with economic trends, the business cycle

Fixed income investing can be broken down into factor-based decisions. The risks of fixed income can be described through three main factors, the Treasury rate, growth, and volatility. The Treasury rate explains the variation with the bell-weather 10-year, the growth factor looks at a combination of the global equity and high yield excess returns, and a volatility factors as measured by the change in the VIX index. This is a simple approach but gets at the heart of the factor approach. Holding a credit-based portfolio is very different than a the Barclay's Aggregate index. With credit or emerging market fixed income index, you are holding a growth focus while the Agg is just rate focused. Volatility exposure is not important except for credit and emerging markets.  This work is outlined in  "Factor Approach to Fixed Income Allocation" in the Journal of Investing,  spring 2016. The factors do not sum to one. When tested as a three factor approach which are forced to sum t

There is a growing trend that investors should focus more on multi-asset class investing or the asset allocation decision over security selection. This is an important thinking for most investors. Don't worry about the elusive alpha. Focus on diversification and your betas. This is where the bulk of your returns will come from and where investors face the most risk. If you get the asset allocation wrong, investors will need a lot of alpha to make up for the difference. One can view risk parity as one innovative approach to this allocation issue and factor-based investing as another solution to the problem. Risky parity says diversify across multiple asset classes but make the allocation through contribution to risk. Factor-based allocation looks at the underlying driver of the asset class. The general scheme is to move away from security selection and focus on sector selection. This can be done either on an active or passive basis.  Certainly there is a mismatch of resources in ass

What drives the FX markets? This is a critical but complex issue for any investor who needs to look at this asset class. The usually approach is to develop a model with a some key fundamental factors like rates, inflation, or money and then see what the reduced form empirical relationships show significant relationships. However, this problem can be looked at with a more primal lens through the use of principal components. Using this approach, it is possible to determine how many common factors may drive currencies. Researchers have found that there are two principal components that can drive these markets. See "Common risk factors in currency markets"  by Lustig, Rousssanov and Verdelhan . The main first principal component can explain about 70% of the variation is related to risks versus the dollar. These are the usual risks investors often thing about with respect to currencies. What is more interesting the second principal component that seems to do a very good job of exp

When you repeat a mistake, it is not a mistake: it is a decision. - Paulo Coelho So what is an investment mistake? If the odds are 60/40 in your favor and you lose, is that a mistake or are you just unlucky? In this case, a bad outcome is just bad luck. If you calculate the odds to be 60/40 against you and you have a gain is that a lack of skill or just being lucky. These are important issues to consider if you want to measure or show skill.  A mistake is not being rational or being inconsistent with an articulated decision process. If there is a process and the decision-maker deviates from the process, it is a mistake regardless of your luck. If you don't have a well articulated process, you will not be able to say that you made a mistake. A more fluid process allows for ambiguity and thus makes it hard to admit a mistake even during bad performance periods. Given there is a process, the real issue is whether the decision-making model is wrong. If you are rationally following the

Investment decision-making is a combination of assessment of information and action. Analysis and trading. If you are right, there is profit but if you commit an error, there is a loss. A good analyst who cannot act with a specific recommendation is not worth much. A trader who is not a good analyst is just a busy investment professional without purpose. From a macro perspective, how traders act and the type of errors they are willing to make will have an impact on price behavior. When a trader receives some new "news", he has a set of choices which will either lead to profit or an error. Yet, all errors are not the same. Traders can make type I or type II errors which will have an impact on the type of trading conducted and affect the market in aggregate. Traders have to assess the probability of the type of error to be committed no different than any statistical test.  Walking through a trader's decision tree will help explain the problem. New information may enter the 

It is always worth monitoring the long view with trends. Beyond the last quarter or year, there are return patterns that show longer-term changes in style performance. Take a look at managed futures. There was a long period for which it was out of style, but that has changed markedly. (Saying a strategy is out of style is the nice way of saying it has performed poorly.  In style, means it is doing well and investors are chasing performance.)  We fitted a long-term linear trend through the performance curve of the SocGen managed futures index. The times of strong or poor performance from trend are obvious by looking at periods above or below the trend line. A fitted polynomial through the data can find periods when the slope of returns was rising or falling and provide a smoother view of performance. There are clearly long periods of strong and poor performance. There is an uptrend in performance through the Financial Crisis, but the slope turned down during the  post-crisis or QE perio

Systematic models are very useful and important for disciplined investing, but the percentage of the variation explained by most models in asset markets is relatively low especially over short horizons. The question for most managers, even quants, is determining how to deal with this percentage that is unexplained. There is no simple solution but applying a structural headwinds/tailwinds checklist may provide a good first pass for addressing the problem. A structural headwinds or tailwinds checklist groups or categorizes issues that may provide a tilt to returns. These tilts on expected returns may lead investors to make a tilt or base adjustment to asset class allocations. Instead of starting with a base allocation of zero, there could be a negative or positive base allocation. There could be more categories to this checklist, but these eight may get any discussion started. Some of these issues can be quantified, but we believe they often cannot explain short-term variation except if

Hedge fund performance across all styles generally showed positive performance as measured by the HFR indices. It should be noted that there has been significant divergences between index numbers this month in some styles, but the general story of good performance holds. Nonetheless, the year to date return numbers are still negative even with both stock and bond indices up for the year. The hedge fund bright spots were the market directional, distressed restructuring, fixed income credit, and convertible arbitrage style indices. Market neutral and systematic CTA's were the biggest losers for the month. It is notable that even with the S&P 500 being positive for the year the equity hedge, equity market neutral, and fundamental growth categories are still showing the worst performance for the year across hedge fund styles. Market neutral has been especially hurt in 2016 as a combination of sharp market moves with changing correlations have left these traders with drawdowns that

There was a disconnect between the performance in market sectors and the performance of managed futures funds based on our simple review of market sectors. We run each market through a simple trend model each month to determine the direction of the majority of markets in the sector and then make a sector profitability assessment.  April was a strong month for commodities although the increase in volatility made entry into these trends difficult.  Grain markets saw a significant increase in volatility that made active trading in options very successful. For trend-followers, the environment was challenging but did offer strong opportunities. There were also good trends in cocoa, cotton, and sugar.  The oil complex showed strong gains in spite of fears about the oil rally be overdone. Base metals were also volatile but generally moved higher. Precious metals, especially silver and platinum, generated good trends.  The currency markets moved in tandem with commodities albeit at lower volat

The SocGen managed futures index declined by over 2 percent for the month of April. This decline was in the face limited movement in equities and fixed income markets for the month and a strong move for commodities. Currently, the managed futures index, year to date, is higher than equities but has fallen behind bonds and commodities. The monthly returns for an asset class can miss the gyrations that may occur during the month, but equity as well as fixed income markets were relatively calm for April relative to what was seen earlier  in the year. The mix of continued unconventional monetary policies even with no further action by the Bank of Japan and increased fears of slower global growth were enough to keep stocks and bonds somewhat rangebound.  What is surprising is the negative performance in the face of strong upward trends in commodities. There are no rules of thumb, but trend-followers generally will do better in up markets than down markets. Up trends are usually smoother. Th

There needs to be a certain fatalism with the current long-term secular trend in real rates. Real rates  are expected to stay low after its continued march down over the last thirty years. This is the reality that has to be grasped by all investors. An asset allocation decision to hold bonds is not going to provide attractive yields. Alternatively, the big bond bear that has scared investors is unlikely to occur.  Global real rates are expected to stay low, around 1 percent. EM real rates will be higher, albeit lower than in the past. There will be variations based on risk and country specific issues, but the mean levels will stay low by any measure of medium-term horizon. Long-term real rates have fallen about 450 bps over the last 30 years. Around 400 bps can be explained by the some long-term secular trends. See "Secular Drivers of the Global Real Interest Rate", Bank of England Staff Working Paper No. 571. A long history shows the 1960-1980's were unusually high for r

I have been seeing more managers use machine learning tools to help with the investment process. This is an important advancement and will be very useful in helping generate better return generating engines. However, there are may investors who do not known what machine learning is or what it should be able to do. Simply put, machine learning is having an algorithm learn without explicit programming, a process of improvement with experience from new data. It is the training of a model for data that can be generalized for decisions against some performance measure.  I have listed some key ideas of what machine learning is and is not for an investor who is just being exposed to the concept. Machine learning is not artificial intelligence. Many think that machine learning is a sub-discipline within AI; however, there has been a large divergence between machine learning which is grounded in data and statistics and AI which is focused on logical systems. AI, for many, never realized its pot

Tracking a differ of ETF's adds perception at the market tendencies for the final month. Just focusing on equity, fastened income, commodity, and actual property affords a nice image of the market landscape. Investors had been in risk-on mode for the month even although the market benchmark S&P 500 or Barclays Aggregate indices didn't transfer much. The actual motion was within the credit score and commodity sectors. Moving from big cap to smaller cap or worth confirmed terrific boom in relative returns. Returns outdoor the US had been also terrific gainers albeit a nice element of the extra achieve was within the foreign money move. While the lengthy bond underperformed, there had been terrific features within the excessive yield and corporate bond sectors. These features from contracting credit score spreads happened in spite of extra downgrades within the power sector. Sentiment in credit became brighter with the stable features in commodities. Real property didn't s

The due diligence of hedge money is typically first rate, however the due diligence on supervisor talent is nonetheless primarily concentrated on simply three factors, previous performance, pedigree, and references. Given the tight performance throughout managers, the vast differ of supervisor experiences, and the constrained news from references, investors are nonetheless in search of higher tools of measuring the expertise of portfolio managers. The query is deciding upon the way to get internal the pinnacle of managers and discover out in the event that they have what it takes - skill.  Skill versus luck isn't simple to degree whilst you've got constrained data. In activities activities we are able to comply with much of statistics with giant samples over years. Even in poker, we are able to degree talent over a giant quantity of palms with a controlled environment.  Trading in a unsure environment with incredibly variable guidelines makes for extra tough testing. There has

The month doesn't actually soar till the employment numbers are announced. The April activity features have been decrease than anticipated and displaying a down trend. For a information established careful Fed, there isn't any proof to enhance the case for a fee increase. In fact, the numbers for a few mean that unconventional financial coverage isn't working. We do now not trust in that severe view; however, at this level within the trade cycle, financial coverage might now not be sufficient to maintain growth. Unfortunately, there isn't any assist at the fiscal side, so investors ought to steadiness warning towards a global the place central banks proceed to generate low cost money. We might all the time maintain within the again of our minds the adage, "Don't struggle the Fed", but weak boom requires consideration of extra conservative portfolio structures.   

Thanks to Ben Hunt's newest monetary letter, I pulled out my vintage copies of work by Ed Tufte, the visible information extraordinaire. He might have performed extra for nice visualization and information research than anybody over the final 40 years. The Anscombe Quartet says all of it in the event you do not seem to be on the data. I took the Tufte at some point course on the visualization of information over 20 years ago and it has had a profound impact on focusing my powers of observation and my capacity to suppose of blank representations of data. Over the years, I actually have adopted a set of guidelines while watching at information that has served me well. My information rule checklist: 1. Graph the information - If you can't see it, you can't recognize it. Pictures are critical. 2. Cut the information - Look over unique time intervals to see if there are changes. Data move. 3. Get the stats - Understand the distribution of the information in simple terms after se

Inflation expectations are upper throughout simply a few measures. The 5yr/5yr ahead inflation charges have proven the largest will increase in three years. The break-even inflation fee has increased 50% this year. The University of Michigan inflation expectations are growing and were continually above 2.5%, and the switch in CPI yr over yr has been the best in years over the final six months. Granted the inflation expectations were coming off lows, however the upward development has been clear. Nevertheless, longer-term charges haven't absolutely incorporated those changes. Investors will face three questions over the subsequent three months. One, how will those modifications in expectations be embedded in longer-term rates? Two, how will the data-dependent Fed react to those numbers in the event that they elevate additional or simply stabilize? Three, what is the implicit trade-off among elevate and inflation that markets participants are utilizing and that really exists? Of the

Has the science of finance evolved resulting from the the presence of hedge funds? Has our wisdom of finance greater resulting from hedge funds? These are thrilling questions to imagine no longer as it will possibly inform us anything about hedge funds, but as it will possibly inform us anything in regards to the advancement of science and the trend of wisdom in finance. Knowledge improves by way of its commonplace dissemination. Private wisdom largely would no longer boost science. So the query is regardless of even if hedge finances assist with the dissemination of monetary knowledge. Of course, there are hedge fund managers who've engaged and printed research, however the wider query is regardless of even if they impact the advancement of finance knowledge. This is much less clear; however, we suppose hedge finances do play 4 other roles to assist boost knowledge. Hedge finances as popularizers Given the enormous quantity of cash managed by hedge funds, they develop into popular

"My golly! I can't hold that managed futures fund, it is always in a darn drawdown." I have heard far worse language in reference to a fund in a drawdown.  The logic of the investor is simple. Managed futures funds are bad and risky investments because they are always in drawdowns. I don't like drawdowns. It never fees goods. A drawdown eats into any high water mark and suggests a loss of principal on a mark to market basis. Interestingly, the focus on drawdowns is a result of the regulatory requirement to report drawdowns. CTA's have to report the largest drawdowns. Mutual funds and normal asset managers do not have to report drawdowns. There is no problem if you don't have to report the problem.  Look at some simple balanced fund structures that should not be considered risky, the classic 60/40 stock/bond mix and a three asset stock/international stock/bond aggregate combination. Each of these funds spent close to 85% of the days in a three and half year per