Investors can form exaggerated expectations on what can be the potential return performance from factors. Some have described a “zoo” of factors. There are now hundreds of factors that have been analyzed and reported in the academic literature. Nevertheless, many have been hard to replicate, show performance return declines after being researched, and have failed when tested out of sample under realistic market conditions. These poor results may be from data mining, not accounting for transaction costs, data mining, poor design, and potential crowding. There are successful factors that have stood the test of time, yet even their performance has been time varying and may be less successful factor after accounting for all costs. Don’t be disappointed if actual returns are less than what is reported in academic studies.
If you have an asset that has some market risk but a large portion that is unexplained, the risks you face are different. You still can either leave the market risk exposed or hedged, but the majority of the risk cannot be explained. Hence, it cannot be truly hedged. You can conduct further analysis to measure the risks from other factors but you may still be left with a high percentage unexplained. You may have thought of everything with respect to your risks, but there is a lot leftover.
Cognitive priming is a real effect that has often not been discussed with investment decisions and behavioral finance. Suggestions can be used to steer the behavior of investors. Priming is the use of stimulus to create a memory effect or create a temporary increase in accessibility of thoughts and ideas. It is the non-conscious use of memory. It could be used to increase both positive and negative thoughts, ideas, and behavior. Businesses have constantly used priming in advertising to help steer or suggest positive memories. Psychologists have tested priming for years and find that the power of suggestion or linkage is real and extensive. At the extreme, think of Christopher Nolan’s movie Inception on the idea of implanting ideas in memory.
If there is an adverse market move and you want to change portfolio allocations and sell some securities, will you get a fair price? Any downside situations that investors will face will face a liquidity shortage. This is different than thinking about illiquid investments, where the knowledge concerning illiquidity is known. The IMF Global Financial […]
He (Bill Belichick) is a five-tool leader, adept at strategy, tactics, preparation, execution, and what you might call situational intuition, the rare ability to know which among the first four is required and when.
Few will disagree that competition through a diverse set of independent traders is good for futures markets trading. Still, this issue should be broadened to the subtle impact of general competition across firms in the economy, not just the futures markets themselves. A growing set of recent research suggests that the US is becoming less […]
Reviewing the first quarter financial performance, the dominant macro theme was the change in Fed policy actions. The same could be said about the EU—no rate increase and no solid trend for normalization. The new macro focus is on the choice of Fed governors. More important than any policy comments or change in Fed governors […]
Is the Fed independent? Should it be independent? Has independence been an important topic in the past? More specifically, should new Fed governors be biased to economic growth, consistent with current fiscal policies over expected inflation, focus on price stability? The current discussion associated with new Fed governors is nothing new. The Fed has always fought for as much independent as possible, yet the Fed is a creature of Congress.
Paul Nutt, a leading decision-making researcher – Only 15% of the case studies saw decision-makers actively seek out new options than what was available at the outset. Only 29% of organizational decisions contemplated more than one alternative. (From Farsighted by Steve Johnson) There is more to decision-making than “whether or not”. Too often, decision-making is bereft of choices. Everything […]
Selected alternative risk premia showed strong performance during the first quarter. There is significant tracking error with the HFR risk premium indices versus individual bank risk premia swaps, but they can provide some suggestive rankings. This strong performance should not be surprising given the large reversal of with equity beta and the strong moves in global bond markets. A couple of major themes emerged for the first quarter centered around positive equity beta risk and falling volatility.
Hedge fund performance was dominated by the exposure to market risk as those fundamental equity funds that held more market risk dominated style performance. However, the average returns mask the large dispersion across styles. We still use indices for analysis because it does provide some information on what the average investor may expect. For example, while CTAs were down, on average, for the first quarter, anecdotal evidence from managers sending me reports show some up in the double digits for the first quarter. Winners made big money in the last quarter.
The CTA space has struggled mightily over the past 10 years. We believe a CTA manager with a proprietary trading skill set, proven over time throughout various market regimes, is the necessary future of the industry. Trading proprietary firm capital under an SMA structure can have multiple benefits. This way, firms do not have the overhead and headache of bringing on a new trading team. Both parties are free to focus on what they do best; trading and managing risk.
An analysis of the first quarter tells us a lot abut factor investing in the short-run. Foremost, the worst factors last year are the best for this year. Factor risks change with the market environment as shown through the global factor indices from S&P Dow Jones. Factor rotation occurs, but not clear that it is predictable. Factors effects also can be swamped by the impact of large macro events.