This was a negative month for managed futures funds as measured by peer indices for a simple reason, range bound behavior in equities and a reversal in bonds. Equity indices have started to trend higher, but longer-term trend followers were not able to effectively exploit these moves in the second half of the month. Global bonds have trended higher for most of the month but smaller position sizes based on higher volatility limited gains. Oil prices offered strong gains, but the size of positions may not have large enough to make an overall impact on fund returns. Commodity trades are generally a small portion of the total risk exposure for large funds.
The cost of being wrong with political uncertainty is significant and the impact will be felt across many markets. The yellow jacket “uprising” has already shifted French economic policy and will also affect the direction of government. We may not be extremists but the fundamental pact between the governed and government is broken which is not good for any investments.
Last month nothing worked with all asset classes generating negative returns. October saw a shift in market sentiment toward risk-off behavior. Investors started to take loses and adjust to more defensive portfolios. Momentum was clearly negative early in November, but monthly returns are sending different signals with both US and global equities higher. Nevertheless, it is too early to make any statement that risk-taking is back on. Equity markets have come off lows but are not showing any trends. Credit ETFs declined sharply relative to Treasuries and long duration bonds gained on new fears of economic slowdown. Commodities declined on a sharp fall in energy prices.
If you have an asset that has an illiquidity premium, an optimizer will love it as a choice. An illiquidity premium is a dangerous area for investing. First, are you getting paid enough for illiquid? Second, is there a good way to measure illiquidity? Third, do you really know your liquidity needs?
A big problem with macro fundamental investing is getting timely data on the economy and then translating that information to effective investment signals. Government issued data generally are out of date and old information for forward looking forecasts. Hence, there is greater value on macro data that is current and prospective.
The classic 60/40 stock bond asset mix has proven to be a good core asset allocation. When in doubt, employing the simple 60/40 (SPY/AGG) asset mix as a base case has been an allocation that has performed well versus other diversification strategies. This allocation bias may be coming to an end.
It not a matter of like or dislike the fundamentals of equities in the current environment. When sentiment changes and volatility increases, reassessment of current exposures is warranted. However, concern about the macro environment should be increasing. Maintaining lower market risk exposure by more than half of core allocation from 60% to 30% or half equity beta exposure is appropriate. (The darker red signifies a stronger trend.)
“Categorization is not a matter to be taken lightly. There is nothing more basic than categorization to our thought, perception, action, and speech. Every time we see something as a kind of thing… we are categorizing.”
– Linguist George Lakoff
From The Geometry of Wealth by Brian Portnoy
Most investment work is about forming categories. We divide securities into asset classes. We make subcategories within an asset classes. We make industry classifications. We divide risks into different types of premia. There are value classifications. There are categories and classifications based on macro factors like inflation. Investors like to group. All scientists like to make groups and form clusters of similar things to find commonality.
Current views on asset allocation in fixed income and credit are generally negative. The focus should be on holding shorter duration and cash investments.
It does not take much for an investor to have a losing credit trade on long duration bonds. The average duration on a long-term 10-year corporate is around 8 and current OAS spreads for triple-B corporates are 160 over Treasuries up from 120 earlier in the year. Half this move will take investors back to levels seen in 2016 and wipeout all of the spread compensation for a year. This is not an extreme bet if we have any further erosion of equity prices or change in credit risk expectations, (See Corporate debt growth has exploded – The added macro shock sensitivity creates real risks.) Shorter duration corporates will be at less risk given their lower duration but the stocking up of credit for yield reaching can be painful if credit risks increase.
Diversification is usually thought of as a longer-term concept. Don’t worry if it seems like you are not receiving diversification in a given month or quarter. Think about diversification across a longer horizon. Diversification also does not guarantee better returns for a portfolio. Negative diversification does mean that your losers will be offset with winners.
Hedge funds styles, strategies, and firms evolve over time. The behavior of a hedge fund today is not the same as yesterday. These behavior changes are not because a manager has changed his style but because the environment, the tools, the regulations, and the ideas surrounding finance are different.
Alpha generation will fall when it is measured correctly through an appropriate benchmark. Alpha shrinkage over the last ten years is a measurement problem. Returns for hedge funds are a combination of the underlying risk premia styles employed and the skill of the manager.