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A provocative chart from the research piece The Volatility Paradox: Tranquil Markets May Harbor Hidden Risks by the Office of Financial Research Markets Monitor shows the poor forecasting of volatility when there is a regime change. Of course, tranquil markets harbor hidden risks. Low volatility is pricing in a lack of imagination of what the future may hold. The markets usually say that tomorrow’s change will be represented by the deviations of yesterday. We have learned from reading Minsky that low volatility will lead to risk-seeking behavior as investors reach for yield, employ leverage, and become complacent. Hence, a shift in regime will lead to more dramatic change in volatility.

Momentum works, whether structured as a times series or a cross-sectional strategy, across many asset classes. Carry strategies or risk premiums also work across a wide set of asset classes. More importantly, we know when these strategies do not work, or we at least know what are times to avoid. Also, when trend-following (time series momentum) does best, carry will likely under-perform and when carry is doing well, trend strategies are likely to under-perform. These are statistical relationships, but there are good narratives for why these two strategies are complements.

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.

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.

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.