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Investors have had an aversion to using models, but that may be changing rapidly. More money is being managed by systematic managers or focused on some form of smart beta or a set of rules to investing. Nevertheless, there has been documented fear from letting go and having a model make decisions.

There is a well know cognitive bias called the Dunning-Kruger effect whereby individuals who perceive themselves as experts will have the illusion of superiority concerning their cognitive abilities. They believe their own talk. They are experts, right?

When I hear about diversification across funds or strategies, I, like most investors, will immediately focus on the correlation matrix versus other alternatives and asset classes. However, investors should be thinking beyond the simple historical numbers and focus on forward expectations for correlations. There should be views of how diversification may change through time or behave under different scenarios. To form diversification or correlation forecasts, investors should have a classification scheme for diversification. All diversification is not alike and a classification scheme may help with determining how correlation may move.

Investors are looking closely at the fees being charged, but the hidden fee of liquidity may be the most significant cost that is often not talked about. Large firms that are charging less may have higher costs associated with liquidity than small firms. As the size of the firm grows, the cost of entering and exiting may be higher. Additionally, some markets that may offer opportunities are avoided because the cost of trading when liquidity is lower is higher.

Automated execution is taking over futures markets. Actually, the battle is over. Voice (non-electronic) and manual execution are reserved for illiquid products, old school firms, smaller traders, those who may be undertaking spreads, complex legged or option strategies, roll strategies, and some block trade. However, the use of electronic trading can vary by market and sector. Technically, we are referring to manual (MAN) versus automated (ATS) trade execution where automated is generated and/or routed without human intervention. Non-electronic would be a separate category. By far, automated to automated trades dominate most markets even in many commodities. The high frequency automated traders are the new market scalpers. Financials have a higher percentage of automated trading over commodity markets.

The idea that hedge funds are getting 2/20 for management fees is becoming a myth. Dynamic pricing is being used more aggressively by hedge funds with a wide range of management and incentive fee options. For example, in the managed futures space, there seems to be a willingness to offer beta products as low-cost alternatives as well as traditional alpha plus beta products. The low cost products are being marketed as trend-following beta at low cost while higher priced products are being offered as alpha generators relative to trend-following beta. Of course, there is not a clear definition for what is trend-following beta so there is something more going on with this pricing. (The beta may be associated with a peer index, so the beta firms offer a low cost product to match a bundle of competitors.) This approach is being used by a number of larger firms.

We have learned from behavior finance that one of the key thing that investors do not want to suffer from is regret. From prospect theory, there is a desire to sell winners and hang onto losers in order to avoid regret not suffer from loss aversion. Loss aversion tied everywhere to the decisions we make. Picking the wrong manager. Picking the wrong strategy. Picking the wrong time to enter or exit a trade. Investors do want to make a decision only to find out that ex post it was a poor one.

It is hard to determine whether one manager is better than another when looking at performance numbers. The sample sizes are often too small to distinguish return differences, so investors often looking for other signals that can be used to suggests one manager is better. One that is often used is growth of AUM. Call it the “wisdom of crowds” signal. If an investor cannot distinguish the return performance between two managers, he will place weight on the dollar opinion of others. If the herd is investing in manager X, perhaps they know something that others don’t. The investor will free ride on the due diligence of others and invest with the manager who is growing faster.

Consistency is critical for any investment style or factor, and it seems that trend-following seems to show it better than most other alternative strategies. It is now almost amusing that when efficient markets ran supreme as the paradigm of choice for market behavior no one was able to find these results, but now that there […]

Most stocks do not do well over their lifetime. If you randomly pick a stock or set of stocks there is a high likelihood you will not do better than T-bills and you will likely not survive for a long time. This should be well-known, but a new research paper really present some stark conclusions. This is a paper that is insightful and sobering for most investors. See “Do stocks Outperform Treasury Bills” by Hendrik Bessembinder.

The equity focused HFR hedge fund indices produced positive returns for the month of June while those indices focused on broad-based macro trades declined. Equity focused hedge fund managers will often do better when there is more dispersion across industry sectors and when there is stronger performance in broader-based indices like the Russell 2000. The market saw strong gains in both growth and value indices and less emphasis on large cap names. The fall in tech stocks which have been at elevated levels may also have been a contributor to some hedge fund gains.

Trend traders were hit with a number of significant reversals in major asset classes near the end of the month. Bonds were rocked with a possible ECB “taper tantrum” albeit it is early to say that this will be like what was seen in the US. No two market tantrums will ever be the same. Equities are in a trend decline in Europe and the US has started to trend lower although the month still generated positive gains for many investors. There is an equity rotation away from large cap indices, but it is hard to take advantage of in futures. The dollar also trended lower near the end of the month only to see some gains in the last two trading sessions. Many commodities moved higher on weaker supply reports and oil products has bounced off the declines from the past few weeks. Last week was the major reversal period.