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History, Linear Thinking, and Addressing Market Noise
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.
Kuhn and Systematic Research – Solving One Crisis at a Time
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.
Global Macro – Managed Futures as an Alternative to Corporate Bonds
Corporate bond risk is rising. Of course, with improvement in the overall economy and continued bond flows many will not believe it, but the statistical data suggest that spread moves are no longer symmetrical. There is more potential for spread widening versus continued tightening.
What do CIO’s Care About? Only Four Things
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.
Navigating Risk: Lessons from the US Navy for Money Managers
The US Navy has an structured approach to risk management which is slightly different than the Marine Corps and US Army. See our posts on US Marine Corps and US Army risk management. The US Navy actually has a trifold brochure for Time Critical Risk Management. Would you ever expect to see this from a money manager? Certainly, the ABCD process is a loop for determining any trade or portfolio action.
On the “Fog of War” – No One gets this Quote Right, but the Concept Stands
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.
FCM Concentration – Is This Good for Futures? We Don’t Know
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.
US Army Risk Management – A Process for Dealing with Uncertainty
We have already focused on the US Marine Corps’ approach to risk management. Still, the Marine Corps is not alone in the military in formalizing approaches to decision-making under uncertainty. The US Army addresses the issue with a variation on the problem in its risk management manual. Again, the focus is on process and discipline, […]
Risk Parity and Volatility Targeting as a Danger – Let’s Get Real with Some Numbers
There is growing talk that volatility targeting and risk parity are the dangerous new “portfolio insurance” strategy of the decade. In the post-’87 crash period, the view was that portfolio insurance sowed the seeds of market destruction by creating a market decline feedback loop. As an option replication strategy, portfolio insurance automatically increases risk exposure […]
Risk Management the US Marine Corp Way – It Is a Process
If you have to ask most people what is one of the riskiest professions, it is likely being a soldier. The downside is huge, death. The uncertainty of any battle situation is extremely high. No amount of planning can truly address the uncertainty and dynamic situations associated with battlefield situations. This uncertainty and risk is why training and risk management are so critical for armed forces.
Global Macro on One Page – The Complexity of Central Banking
How often are we going to hear about the overvaluation in equity markets? It already seems too much, yet talk is cheap because markets continue to trend higher. The focus should be on what events will cause this trend to reverse; nevertheless, a trend in place will stay in place until there is a reason to change. Unfortunately, a change in a trend usually comes from a surprise.
With Asset Return Dispersion Increasing – Hedge Funds Generate Gains
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.
July was a Currency Trend Month – Likely to Continue
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.