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The line between recent “exotic preferences” and “behavioral finance” is so blurred that it describes academic politics better than anything substantive.                                 – John Cochrane University of Chicago 

John Cochrane, as well as others in finance, has focused on the academic issue of defining preferences for investors at an abstract level, but the issue becomes a reality when trying to extract preferences from investors to help build a portfolios.

The Wall Street talk is that all markets are over-valued, yet any valuation has to be placed in context. For fixed income, this is not easy given you have to make a judgment on both the real rate of return and expected inflation. Additionally, there is a need to measure the term premium associated with bonds. The premium measures the compensation necessary for investors to hold longer duration bonds versus a series of successive short bonds given the volatility and uncertainty associated with real rates and inflation. The term premium is not directly observable and is difficult to measure but has intuitive appeal.

You have heard of Yellen (Fed), Draghi (ECB), Kuroda (BoJ), and Carney (BOE), but most cannot name any China central banker, yet the moves of this bank may be more important than the four when thinking about the future of world currency hegemony. Zhou Xiaochuan has been in the news just before the Chinese Congress with a strong appeal for financial reform. This is reform for further ascent of China as a major financial player. He has followed this path across his central banking career, but he is set to retire in January.

An investor can ask, “Find me the most intelligent hedge fund manager. Someone else may say, “I want the smartest manager in the hedge fund space”. Saying that you want an intelligent manager may not be the same as saying you want a smart manager. There is a difference between intelligence and smarts, so says, Heather Butler in the recent Scientific American article, “Why do smart do dumb things, Intelligence is not the same as critical thinking and the difference matters”.

September was a month of transition for many styles, sectors, and class returns. In the style sector, small cap, growth, and value benchmarks generated strong performance under higher expectations for the reflation trade. There was a rotation from safer fixed income to higher risk premium styles. We are a long way from tax reform or a cut, but the fiscal issue is back on the table and in the minds of investors who want to get ahead of any changes.

The trend story for September was an end to the summer bond rally, a pick-up in equity trends, and a new interest in buying dollars. Without major strong trend opportunities in commodities, the reversal in bonds and currencies hurt many managed futures traders.

Regardless of the speculative warnings or the beware signs in fundamentals equity markets continue to move higher. Who says there isn’t inflation? It is just a matter of definition between real goods and financial goods.

There is no question that research shows that asset allocation matters. It matters more than stock selection and it matter more than manager selection. But, it is sometimes hard to visualize what is the impact of different asset allocation choices. The following table from Fidelity’s Market Snacks is enlightening. The table of average annual return is completely expected. If you increase risk through more aggressive asset allocations, return goes up. The movement from conservative to aggressive over the long-run is linear; nothing new here.

The Deloitte CFO quarterly survey should give any investor pause for concern. The numbers for this quarter show that 83 percent of those surveyed believe the equity market is overvalued. The number is at all time highs but has been around 80% all year, in spite of the market continuing to go up. Perhaps the CFO’s forecasts are wrong; however, I have more concern from the economic sentiment and expectations.

The key challenge for many global macro and managed futures managers (or any hedge fund combination) is showing their relevance during the post Financial Crisis period when the simple combination of stocks and bonds seem to have been enough to generate a very effective Sharpe ratio.
Hedge fund managers need to show their value-added in an environment where the negative correlation between stocks and bond has allowed the two-asset class blend to do an effective job of diversification.

A panic only occurs if you are a late follower toward the exit. The panic occurs when you realize that the cost of exiting is higher than expected and liquidation is not moving as fast as expected. A trader can go through a mini-panic on a regular basis if an exit strategy is not planned correctly and there is a liquidity shortfall, Exit strategies are all about not panicking at those critical times, yet there are trade-offs between reducing panic and maximizing return. The control of exits as well as entries is a core issue with model building and drives incremental returns.

The lifeblood of hedge funds as businesses is their performance pricing proposition through incentive fees, but the simple business model of 2% management fee and 20% incentive fees is fast becoming extinct. Pricing is coming down as well as becoming more complex with more pricing alternatives as the businesses become more competitive and investors become more sensitive to alpha production.

The talking heads in the media spend significant time making political predictions. Even many Wall Street economists fall into the trap of giving political forecasting advice instead of digesting the economic data. The outcomes and impact of elections; pundits usually don’t know. The time of geopolitical risks and wars; pundits don’t know. The cultural changes that will impact markets; pundits don’t know. Unfortunately, the media does like the experts who are doubtful and equivocate. Pundits, however, are not often stupid. They provide significant amounts of information, background, and data. It is just that their ability to make good forecasts is poor. The advice from the forecasting expert Phillip Tetlock, the author of Superforecasters and Expert Political Judgment: How Good is It? How Can We Know? is very simple, “Don’t listen to them”. Their overconfidence will cause investor decisions to go awry. They place too high a probability on their views.