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Interest concerning alternative risk premiums has surged over the last few years. With this increased interest there has been questions with how to best access these premiums under real market conditions and not just measure them through existing asset classes. Investors want to know how to operationalize the theory and research.

In spite of the strong growth of systematic trading, the problem of “algorithm aversion” is real and must be addressed. In many cases and in many disciplines, models do better than humans, but humans feel anxious with models and do not want to place decision-making in the hands of a machine. Even if a model does better at forecasting, individuals may still prefer the discretionary or non-alto approach if there is the perception that the model is imperfect. It seems as though individuals will like to have the optionality to choose an approach (model or discretion) as opposed to being locked into one choice. See our posts: “Algorithm aversion” and managed futures and Algorithm aversion or just a desire for low cost optionality

To be a good investor, there needs to be a strong sense of history. To understand financial panic and crashes, the past crises have to be studied. To understand why opportunities sometimes persist or disappear, there needs to be an appreciation of past behavior and market structure. Nevertheless, history is not linear. The same investment mistakes are made as past lesson are often never learned. There is not really an arc of progress that can be bent or even followed. Progress in finance and in particular valuation can lurch forward or it can fall back based on the latest behavior of the crowd.

Thomas Kuhn, the science historian, developed big ideas like the paradigm shift in science, but his ideas can also work on the “smaller” ideas of finance research. The Kuhn cycle, which has been applied to the evolution of science, is a durable model for how real world research is conducted. It is an effective way to look at one critical part of the systematic research process. Quantitative research for many firms is broken into two parts:
1. A search for new models and strategies that are either uncorrelated with existing models or a new variation on an existing strategy theme, or
2. Maintenance of existing models through improvement and enhancements of existing parameters and frameworks.

The comment from Kip McDaniel provides a roadmap for what any hedge fund needs to address when marketing to a pension or any client. It is not about you, the manager, but the investor.
1. How does this investment fit within the asset allocation framework of the pension? Why does it matter?
2. How should this investment be delivered to the client? How does it fit within the overall portfolio construction and use capital efficiently?
3. What is your edge versus other managers and how can you generate confidence that this edge can be achieved?
4. What will be done by your fund to protect the money allocated to you? How will your investment help protect the overall portfolio?

The questions are relatively simple, but the answers require a lot of thought if the manager wants to truly be a top service provider.

Many have used the metaphor “fog of war” to describe the uncertainty faced in risky situations. It is attributed to Carl von Clausewitz from his work On War. It has had a profound effect on military thinking. Unfortunately, many have used the phrase without reading the book. The phrase “nebel des krieges” was never written by Clausewitz. You cannot blame many for this mistake given it is a dense work written in 19th century German and translated into English in the 1870’s.

Market structure matters regardless of the industry. The interaction of economic agents will impact market behavior and drive pricing. Competition reduces markets frictions and transaction costs. If there is less competition, the cost of execution will be higher, and there will be less liquidity. This applies even to highly regulated markets like futures trading. A simple graph shows the decline in the number of FCM’s operating in the futures markets. The number has been cut in half since 2011.

Almost all HFR hedge fund strategy indices were positive for the month of July. In many cases, the strategies beat small cap and value indices for the month. Our take on this good performance is that the increased dispersion in returns, lower average correlation across equity pairs, is a key reason for the gains. Greater dispersion means there are greater opportunities for stock pickers to differentiate themselves.

For trend-followers in July, currencies were the big winners. Strong trends with relatively low volatility made for many winning trades. These trends as well as moves in precious metals are likely to continue in August. Currently, this is the place for greatest upside opportunities. The currency moves did see some short-term reversals around central bank and key economic announcements which may have hurt traders with tight stops, but the general direction in 2017 continues.

The Yale International Center for Finance conducts monthly surveys of individual and institutional investor’s confidence in the stock market. While there are other surveys available, the Yale Center provides a long term view of what investors may think about the markets.

The equity markets again continued to march higher with strong gains in international and emerging markets. However, it should be noted that non-dollar equities were given a nice tailwind from the decline in the dollar, (take off 2-3+ percent). After the currency adjustments, there is less reason for large celebrations. What should be a concern is that the biggest moves were in large cap stocks with more modest returns for small cap and value indices. This should be expected on a dollar decline given the international nature of large-cap earnings, but lower breath is not a positive sign for follow-through with the trend.

The drumbeat of over-valuation continued in July, but investors do not seem to be listening to any negative stories as stocks around the world continued to move higher. The view that economic growth will pick-up in the second half of the year coupled with rosier earning forecasts have pushed equities higher. Any worry about valuation will be for tomorrow. Today, the focus is on buying risky assets around the world.

Here is a simple question that should have an easy answer. Name a universal set of asset classes that can be employed to categorize the investments for a large university endowment. The answer to this question may astound you. There is no agreement on the number of asset classes an endowment should have in order to make asset allocation decisions. That’s right, the largest university endowments cannot agree on this basic number for how to categorize investments. See the paper, “The evolution of asset classes: Lessons from university endowments”, Journal of Investment Consulting Vol 17, no 2, 2016.