testing

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 econom...

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...

"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...

News headlines will impact market returns and volatility. Headlines often represents uncertainty and can increase the fear or probability of rare disasters.  More news headlines that generate investor uncertainty will lead to higher price volatility.  Headlines will change return expectations and cause investors to switch their views on the chance of markets being in a good or bad state. This will lead to greater deviations in prices. An increase in volatility will mean that return premium have to increase to compensate investors for the added risk from uncertainty. The short-term impact between risk and return can be complex, but longer-term links between news implied volatility and return is actually well-defined.  This link is especially the case when the news is focused on low probability potential disasters. There has been strong research work that when the probability of a rare disaster or left-hand tail event increases, returns will have to...

Volatility matters. Portfolio efficiency focuses on the return to risk trade-off. There has been a focus on low volatility strategies, but just as important is the idea that when volatility is high or increasing, investors should be walking away from risk. Adapting or adjusting to volatility is a dynamic concept. In simple terms, investors are often not compensated for shocks or increases in volatility. The low volatility argument is that investors are not compensated when volatility is high. Investors do not receive enough return compensation for either level of changes in volatility to keep their Sharpe ratios stable. Given this viewpoint, along comes a very interesting paper,  Volatility Managed Portfolios, by Alan Moreira ad Tyler Muir. The authors show that dynamic adjustment of portfolio exposures with respect to volatility will add to the portfolio's overall Sharpe ratio. If volatility is high, cut the risk exposure to that asset or factor.  Thi...

Asset price volatility follows a pattern of spiking only to then gradually decay. This is the essence of much of the GARCH modeling revolution. The patterns for volatility behavior is well-defined. The key issue is what causes the spikes in volatility. A simple answer is market uncertainty, but it is hard to determine what is uncertain versus what could just be a surprise. Surprises are unanticipated but may not be the same as uncertainty. Surprises will cause spikes in return, but they may not always lead to persistence in volatility.  Many volatility spikes are related to changes in liquidity as defined by money in the credit channel. A decline in money through increases in rates will cause reduction is risk-taking and change the discount factor used to price assets. This will lead to higher volatility which will decline as the market adapts to the change in liquidity conditions. Increases in liquidit...

Just like ‘eating right’ requires you to look through food labels to understand the nutrient content, ‘investing right’ means looking through asset class labels for the underlying factor risks. It's the nutrients in the food that matter. And similarly, the factors matter, not the asset labels. - Andrew Ang, Columbia University  The Ang quote has been making the rounds of financial blogs and news for some time. I like the analogy. Asset classes are like different foods. The real value of the food is in the nutrients. We eat the food to ultimately get at the nutrients.  Unfortunately, we often do not eat the nutrient directly. The foods and nutrients are balanced in the meals we eat. We like some foods. We have aversion to others. There are good meals prepared by skilled chefs and there are bad meals where we do not get any value. The difference is often with how the food is prepared. Asset management could be considered the cooking or the preparation o...

After attending a conference that highlighted some of the latest research on smart-beta and factor-based investing, I can say that this new focus is taking the industry by storm. There was no discussion about allocation to asset classes except in the context of benchmarks and the "old" approach. There is no questions that factor-based approach is a more nuanced view on risk allocation, but there is going to have to be more education on how this research can be implemented and what are the right factors.  One of the clear advantages of factor-based investing is that it can better target the unique (orthogonal) risks in the portfolio. Unfortunately, there is growing number of factors that are being discussed as potential risks. The market has moved well beyond a Fama-French three factor model approach, but how many risk factors are out there and how many are truly needed is very much up for debate. there is no set standard don what is a good factor and I believe the factor used...

Nassim Taleb is a forward thinker who is always pushing scientists to think more deeply about of the statistical distributions of data. His latest effort has been trying to have more scientists accept the precautionary principle in their thinking about risks. Thinking of this principle places the focus on the risk of ruin. Investors are constantly facing risk as measured by the volatility associated with their assets positions and there is no shortage of good work on risk management. The really problem is whether the risks we face are actually measurable and whether not realizing this uncertainty may cause our ruin. Forget about the VaR in a portfolio. What matters is whether the risks of some unlikely or extreme event will cause permanent harm to the portfolio. VaR is a good indication of some measurable risks, but it is just a tool for what is  important in a thin-tailed or Gaussian world. The idea of the precautionary principle - that if an action is suspected of causing severe ...

Many money managers want to make the investment process complex as if complexity will have investors think there they should pay a premium for the services of the manager. In reality, simplicity is extremely valuable for any process faced with high uncertainty.  Simplicity starts with a philosophy that drives the discussion and decision-making. The Natixis Durable Portfolio Construction approach does a nice job of providing that good investment foundation. Of course, execution is the ultimate driver, but we think there is something to learn from the five tenents of their durable portfolio construction philosophy.No one will argue with their five tenets; nevertheless, explicitly stating them forces decisions to pass through their filter. First, put risk ahead of other considerations. Ultimately, money management is about principle protection because the cost of coming out of any drawdown is high. Putting risk first does not mean that returns should be scarified. Rather, the focus sh...

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...

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 han...

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 ...

I have seen some discussion in the financial press and from clients about portfolio insurance in the last month. This does not make a trend, but it does seem like a flash from the past. I lived the craze of portfolio insurance during 1987 and the end results during that crash were not pretty. Nevertheless, there may be a place for revisiting this strategy if it is placed in the proper context of asset allocation. The rationale for portfolio insurance strategies is simple - there is a need for positive convexity to help when markets can move to extremes. You can go back almost 30 years to get a good feel of the foundation for this key asset allocation issue. See Perold and Sharpe - "Dynamic Strategies for Asset Allocation".   Think of portfolio insurance from a high level - an investor is trying to replicate an option through holding exposure in a risky asset and bonds. Hence, when the market goes up, you want to put on more risk exposure and when the market goes down you want...

FINANCIAL SECTOR THINKS IT'S ABOUT READY TO RUIN WORLD AGAIN -The Onion Look at some of the current market price signals and it looks like we are headed for some difficult times: Deutsche Bank and financial sector CDS spreads have exploded higher to levels similar to Financial Crisis;  COCO contingency bonds have significantly fallen in price based on the belief that banks will not be able to refinance; Equity sell-off moving to bear market and is global in nature; Rates signal economic slowdown around globe albeit not with inverted yield curves;  Gold has moved significantly higher against central bank negative rate policies;  These market signals seem at odds or at least an exaggeration versus the macroeconomic data. While the global macro data suggests slow growth and continued weak inflation, it is not signaling recessions in the developed world. We can look at probability models which show increased risk of recession, but the numbers are still at relatively low level...

Most surveys suggest that endowments and pensions have been increasing their alternative exposure. The reason may be clear when you look at 2015 performance. There is a huge gap between a target return of 7.5% and the actual returns from endowments. Of course, the ten -year average is closer to the target, but 2015 was not a good year and this was before the sell-off in August.  Low rates coupled with Fed normalization mean that the fixed income portion of a portfolio is unlikely to have total returns close to the 7.5% level. The first month of the year has not sent a strong signal on equity performance. Credit markets have been in upheaval and commodities have continued to slide lower. So where is the 7.5% going to come from? The only alternative is to gain returns through high alpha generation. This is not really realistic but it seems to be the place where investors are willing to place their bets. It is a semi-defensive strategy of protecting against a sharp decline through div...

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, equit...

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 yiel...