Is Gundlach Right, Have Bonds Bottomed?

A few weeks ago bond king and fellow Angeleno Jeff Gundlach mentioned that he thought bonds were near a bottom.  From Reuters:

“The momentum of higher interest rates is slowing,” Gundlach said. “Now is the time to be thinking about taking advantage of the price discounts that exist in some of the risk areas of the bond market,” he added.

Now I don’t know why his econometric analysis had led him to this conclusion, but history is certainly on his side, and we agree with him.  We used to do a lot of posts on asset classes, drawdowns, and really bad months.  Here are two charts on bond drawdowns from a post in 2010:

In general it shows that 10 year bonds usually don’t decline much more than 8%, and if they hit mid teens that is a great buying opportunity.  

Longer duration 30 year bonds obviously have higher drawdowns, and 15% is rare, with 25% being even more so.

A post we did in 2011 titled “When things go on sale, people run out of the store” examined what happens when you buy bonds in these drawdowns.  10 year bonds are down around 7% and 30 year around 12%.  That is usually time for a nice intermediate term trade.  Please visit the 2011 post for many more tables and charts.

Note:  This long term drawdown system usually couples well with short term really bad months.  We examined what happens after really bad months in asset classes (usually around -8% for equity like and -4% for bonds) and no surprise, that is usually a good time for a short term trade.

Hedge Fund Alpha is Negative; Down Around 1700 BPs in 11 Years

Adam Parker of Morgan Stanley is out with a new report on the S&P 500. He notes that hedge fund alpha has tanked since early 200s and today is still negative, with a drop of about 1700 basis points. At the same time correlation is up making many hedge funds appear to be nothing more than closet index funds.

Adam S. Parker, Ph.D., Chief US Equity Strategist, Morgan Stanley, is out with a great new report titled ‘US Equity Strategy’. In the 99 page report Parker has nearly a hundred interesting charts. Morgan Stanley sees the S&P 500 (.INX) in 2014 at 1600 in the base case scenario . However, the most interesting data is on hedge fund alpha and hedge fund correlation with the S&P 500 (.INX).

HFRI and S&P 500 Correlation

In terms of correlation, the S&P 500 correlation with the HFRI Equity Hedge Index is moving up. Basically, investors are paying 2/20 to buy a closet index fund. As Parker puts it (in a much more eloquent fashion) ‘Hedge Funds in Aggregate Are Essentially Long the S&P 500′. See the chart below.

Although there is no explanation given, the rise in correlation is likely due to the macro dominated news atmosphere. Many investors have complained that stocks are not moving based on fundamentals, but rather based on what Ben Bernanke said (or didn’t say). With the stock market riding the QE gravy train most stocks are moving in tandem with the S&P 500 and broader market. This makes it an especially tough environment for value investors who have lamented in the past few years that investors have been ignoring fundamentals.

The other piece of data has to do with hedge fund alpha. The chart below speaks for itself and is another sad tale. Hedge fund alpha is now negative, meaning (for the large percentage who find alpha to be a useful metric) that hedge funds are underperforming.

When you put the two facts together you see how truly sad the situation is. Not only are many hedge funds just closet index funds with enormous fees, but investors are paying for both the underperformance (and risk adjusted underperformance).

Hedge Fund Alpha Abysmal

The final nail in the coffin, hedge fund alpha ( see chart at the top). Alpha was very high in the 1990s and up to about 2002 (it appears to have hit about 16 percent). Since then alpha has gone downhill and is now in the negative territory for quite some time (it appears to be negative one currently). While Parker notes that it is difficult for hedge funds to outperform in big up years alpha was high in the late 1990s. Furthermore, even though long biased hedge funds are having a better year than short biased funds, the numbers are still abysmal.

I would guess that alpha has fallen 1. Because there are so many more hedge funds with guys living in their parents basements charging 2/20 who might not be great money managers 2. Increasing correlation due to the large role central banks are playing in today’s market. Whatever the reason, it is hard to argue that investors would have been far better off putting their money in a hedge fund the past few years, as opposed to an S&P 500 index.

Arnott: Emerging Markets Look Attractive

By Olly Ludwig | July 19, 2013

While many investors have been fleeing positions in emerging markets, they should probably be doing exactly the opposite, according to Rob Arnott, founder of the pioneering fundamental indexing firm Research Affiliates. In fact, Arnott told IndexUniverse.com Managing Editor Olly Ludwig that the opportunities for investors in developing markets probably haven’t been this good since the nadir of the stock market collapse in 2009. Arnott’s Newport Beach, Calif.-based firm is behind the indexes in six upcoming Schwab ETFs as well as nearly three dozen PowerShares ETFs that together now have $5 billion in assets. He also spoke to something we’ve been noticing here at IndexUniverse; namely, that investors seem very clearly to be warming up to fundamental indexing methodologies that go beyond cap weighting. IndexUniverse.com: I'm detecting that fundamental indexing is getting some traction among advisors and investors. Arnott: It is getting traction. When we first rolled the idea out eight years ago, the reaction ranged from active interest to skepticism to derision to outrage—the whole spectrum. And the outrage was mostly centered on our calling it an index. IU.com: The outrage might have emanated from Valley Forge, Pa., no? Arnott: It was across the board. The whole indexing community was outraged that the word “index” could be attached to something that was not cap weighted. But that’s just semantics. And what's happened since then is very, very interesting. Value investing, since 2007, has been a disaster all over the world. It’s underperformed in the U.S.; it’s underperformed in international markets; it’s underperformed in small-caps; it’s underperformed, even in the last five years, in emerging markets, which is an area where value never underperformed. And so, how has Fundamental Indexing done since 2007? It has added respectable value, not huge, but respectable. So the early critics said, firstly it’s a backtest—have you ever seen a bad backtest? And secondly, it’s a value strategy in drag. It’s going to work when value works, and it won't work when value doesn’t. OK, it’s worked when value hasn’t. Now, to be sure, when value has been hit hard, we’ve underperformed. But every time value has a modest snapback, we have a big snapback. IU.com: When you talk about underperformance in this context, it’s relative to cap weighting, right? Arnott: Correct. And so the markets are basically validating the idea and saying: “The worst thing you could say about it is that it’s the best value strategy to come along in a long time.” IU.com: How do you describe it to a layperson so they can get their head around it? Arnott: Do you want a portfolio that resembles the look and composition of the broad macro economy? Or one that is weighted to most heavily rely on safe havens, trendy growth stocks, momentum stocks—a portfolio that’s popularity-weighted. You tell me which you’d prefer. And so, Fundamental Indexing, viewed in that context, does look something like an index, an index that studiously seeks to match the composition of the macroeconomy, not one that seeks to match the look and composition of the stock market. Arnott (cont'd.): What we found is that the idea has worked very, very nicely. In the last 12 months, the FTSE RAFI All World 3000 was at a 20.7 percent return. The FTSE All World Series, the cap-weighted index, is 330 basis points behind. The MSCI All World is 350 basis points behind. And when we look over at the Russell Indexes, the gap is almost identical. The Russell Fundamental Global is 20.6 against the others. So the idea is working. In the U.S., it's even more dramatic. The U.S. FTSE RAFI 1000, in the last year, is up 27 percent and Russell Fundamental is up 25.5, while S&P is up 20.6 and the Russell 3000 is up 21.4. IU.com: So is it really coming down to these performance metrics that are now in the bag and no longer backtested? Is that what's causing the derision to recede? Or are there other issues? Arnott: I think there's a lot of other issues. What’s causing the flow of funds into the strategies is recent performance—this is a performance-chasing business. We’ve got to be in the only business on the planet where, when products are trading at a steep discount, client appetite evaporates. So, the flow of funds into Fundamental Indexing is largely driven by the fact that it has worked. The evaporation of the derision is largely due to the fact that people are starting to really understand the basic principles and are starting to recognize that if you link the weight to the price, you will—pretty systematically—overweight the overvalued and underweight the undervalued. And if you break that link, the errors in price can cancel instead of systematically pulling your performance down. People are starting to buy that. Even in the academic world, people are starting to embrace that idea. IU.com: Now, when you mentioned them a moment ago, there was a very slight distinction between the returns of the FTSE RAFI series and the Russell Fundamental series. What are the differences? Clearly not huge, given the similar returns, but there must be some, right? Arnott: Basically, the FTSE RAFI Index will have a more profound value tilt. The Russell Fundamental Index modifies the index in a fashion that mitigates the value tilt. If you look back 40 years, FTSE RAFI wins by about 10 basis points, too small to matter. And Russell Fundamental has slightly smaller tracking error. But they're basically just two different flavors of the same broad product. IU.com: You now have, obviously, the existing lineup of products with Invesco PowerShares. That’s the FTSE RAFI series, right? Arnott: Correct. IU.com: And the lineup with Schwab is the Russell series? Arnott: Yes.. IU.com: Does it create any kind of difficulty for you that you have competing products that are out there with slightly different branding? Arnott: To the casual observer, it looks like it might confuse the marketplace a little bit. But you have S&P 500 and Russell 1000 indexes that are very, very similar. One will win in one year, the other will win in another year. Everyone knows that. Everyone accepts that. Arnott (cont'd.): When Fundamental Indexing was new, people thought there should be only one flavor. It’s a little bit like choosing between cabernet and merlot. You’ve got two similar products. And depending on what you pair the wine with, one might be better with one food, and the other might be better with another food. But the goal is not to put out a whole array of me-too products. At Russell, they were skeptics back in ’05, ’06, ’07. In ’08, ’09, 2010, they came around. And they liked the idea. They asked us, “Can we work with you on this?” Because they didn’t want to come out with a product that might make some serious blunder in its design. They knew that we knew as much about the topic as anyone on the planet. So they wanted to work with us. IU.com: And the synergy there is that you benefit from their marketing muscle and they benefit from this laboratory called Research Affiliates? Arnott: Absolutely. IU.com: How many assets are benchmarked globally to your indexes now? Arnott: It’s about $92 billion, as of June 30. It started last year at $54 billion. So it’s grown from $54 billion to $92 billion in 18 months. It’s fun seeing that the idea works well enough that people eagerly embrace it. It’s been good business for us. I mean, we’re not exactly hedge fund managers. So it’s not as if our product, even though it performs better than hedge funds, is priced at 2-plus-20! But I like to joke that a handful of basis points on a large enough asset base can be a pretty good business. IU.com: Let’s talk a bit about Charles Schwab. It’s on the verge of rolling out six fundamental products that use your indexes, but with the Russell brand name. Can you share some thoughts about what kinds of things you're thinking about as this launch approaches? Arnott: People can do Russell Fundamental or FTSE RAFI. If they're already deeply wedded to the Schwab platform, they have an easy place to go there. It broadens the toolkit. IU.com: What about the vast distribution power of that Schwab platform? Arnott: I don’t know what I'm allowed to say. I think I can comfortably say they're a distribution powerhouse. And it’s been a complete pleasure working with them on the mutual funds side. And I think it’s going to be great fun working with them on the ETF side as well. I view them as complementary products. To the extent that if one of us achieves success, there will be still a real success for the other. This is one of the interesting things with FTSE and Russell. Russell’s distribution successes have actually served to accelerate FTSE’s growth in this area and vice versa. It's wonderful to see that take hold. Anyone in a marketing MBA program would predict that to happen. You go from one competitor to two, both will grow faster. IU.com: Interesting. Any other thoughts you might want to share that I've not even come close to touching upon? Arnott: Well one thing that I think is fascinating is we’re in a business where customer demand evaporates as soon as there's a bargain. What's going on with emerging markets, you’ve got emerging markets trading at a Shiller PE ratio of 13 when U.S. stocks are at 24. Back in 2007, emerging crested at 37 Shiller PE at a time when U.S. was at 26. So it's been a complete about-face, from an 11 points higher price to 11 points lower price. And now people are scared of putting money into emerging markets. To me, this is a wonderful-—this is the closest thing to low-hanging fruit I've seen in the global stock market since February 2009. IU.com: Right. It’s all about expected returns. And they sure outsize there in the emerging markets, is what you're saying, right? Arnott: Exactly. And most investors simply extrapolate from the past. Emerging markets have been pretty disappointing for three years. And they’ve been downright awful for six months, and downright scary for two months. So people look at that and say, “I didn’t sign up for this. I'm outta here.” The correct response should be, “These are interesting prices—unless I want to postulate that a China slowdown turns into a China meltdown, and conflict in Syria and Egypt turns into a Middle East conflagration; are those things possible?” Of course they are. That’s why we’ve got bargains. Are they likely? Maybe not. Are they likely to have an effect that spans the whole emerging economy of the world? Absolutely not. But it’s affecting pricing all over the world. Now, add to that the fact that growth has beat value in emerging markets by upwards of 1,000 basis points this year to date, and a Fundamental Index is looking really cheap. Fundamental Indexing for emerging markets is currently priced at a 9 Shiller PE ratio. IU.com: And are the numbers apples to apples when you look at the Shiller PEs? Or do they have a different scale altogether? Arnott: Well, a Fundamental Index clearly has a value tilt. So the presumptive growth rate is going to be slower. But the valuation multiple is one-third off of a market that’s already nearly half off relative to the U.S. To me, that’s a really easy investment choice. It’s not a comfortable one, but you don’t get rewarded for comfort.

MOBY BEN, OR, THE WASHINGTON SUPER-WHALE: HEDGE FUNDIES, THE FEDERAL RESERVE, AND BERNANKE-HATRED

In February 2012, a number of hedge fund traders noted one particular index--CDX IG 9--that seemed to be underpriced. It seemed to be cheaper to buy credit default protection on the 125 companies that made the index by buying the index than by buying protection on the 125 companies one by one. This was an obvious short-term moneymaking opportunity: Buy the index, sell its component short, in short order either the index will rise or the components will fall in value, and then you will be able to quickly close out your position with a large profit.

But February passed, and March passed, and April rolled in, and the gap between the price of CDX IG 9 and what the hedge fund traders thought it should be grew. And their bosses asked them questions, like: "Shouldn't this trade have converged by now?" "Have you missed something?" "How much longer do you want to tie up our risk-bearing capacity here?" "Isn't it time to liquidate--albeit at a loss?"

So the hedge fund traders began asking who their counterparty was. It seemed that they all had the same counterparty. And so they began calling their counterparty "the London Whale". They kept buying. And the London Whale kept selling. And so they had no opportunity to even begin to liquidate their positions and their mark-to-market losses grew, and the risk they had exposed their firms to grew.

So they got annoyed.

And they went public, hoping that they could induce the bosses of the London Whale to force him to unwind his possession, in which case they would profit immensely not just when the value of CDX IG 9 returned to its fundamental but by price pressure as the London Whale had to find people to transact with. And so we had 'London Whale' Rattles Debt Market, and similar stories

The London Whale was Bruno Iksil. He had been losing, and rolling double or nothing, and losing again for months. His boss, Ina Drew, took a look at his positions. They found they had a choice: they could hold the portfolio and thus go all-in, or they could fold. They could hold CDX IG 9 until maturity--make a fortune if a fewer-than-expected number of its 125 companies went bankrupt, and lose J.P. Morgan Chase entirely to bankruptcy if more did. Or they could take their $6 billion loss and go home. They could either take their losses, or sing "Luck, Be a Lady Tonight!" and bet J.P. Morgan Chase on a single crapshoot. After all, what could they do if the bet went wrong and they had to eat losses at maturity? J.P. Morgan Chase couldn't print money. So Drew stood Iksil down, and the hedge fund traders had their happy ending.

In late 2008, the Treasury bond went haywire. The interest rate on the Ten Year Nominal Treasury bond fell to 2.1% in the panic--clearly overpriced. In the late 1990s with the debt-to-annual-GDP ratio on the decline the Treasury bond had traded between 5% and 7%. In the 2000s with a weak economy the Treasury bond had traded between 4% and 5%. With the Federal debt exploding even faster than it had around 1990, it seemed to hedge fund traders very clear that the long-term fundamental value of the Ten-Year Treasury bond probably carried an interest rate of 7%, or more--and was at the very least more than 5%. So smart hedge fund traders shorted Treasuries, and waited for the Treasury Bond to return to its fundamental value.

And they ran into the widowmaker.

So they scrambled around, wondering: "Why did the interest rate on the Ten-Year Treasury peak at 4%? And why has it gone down since then? And why won't it go back to its 5%-7% fundamental." And they looked around. And they found Ben Bernanke:

The Washington Super-Whale.

He had printed-up reserve deposits, and used them to buy Treasury Bonds, and in so doing, they thought, had pushed the price of Treasuries up well beyond their fundamentals. Yet rather than easing off, taking his lumps, and letting the market "clear" he kept buying and buying and buying and buying, leaving the hedge fund traders with larger and larger and larger short positions in Treasuries that had to be carried at a loss. And every year that they carry those positions is a -2% times the size of the long leg negative entry in their cash flow.

Bruno Iksil, they thought, had been pulled up short by his boss Ina Drew's unwillingness to bet the firm and risk bankruptcy. Ben Bernanke, they thought, ought to have been pulled up short by his regard for financial stability--by his promise to keep inflation at its target, for the counterpart to J.P. Morgan Chase's bankruptcy and liquidation would be the national bankruptcy that is another episode of inflation like the 1970s. But Ben Bernanke wasn't pulled up short by the risk of inflation. He had no supervising CEO. And he dominated the Federal Open Market Committee.

But what Bernanke was doing, they thought, was as unprofessional as it would have been for Ina Drew to tell Bruno Iksil: "You turn out to have made a large directional bet that we can sell unhedged protection and profit? Let's see if you are right: let it ride!"

And so they went public with the Washington Super-Whale, as they had gone public with the London Whale. Perhaps somewhere out there was an equivalent of Jamie Dimon who could tell Bernanke that it was time to unwind the Federal Reserve's balance sheet now? Jeremy Stein, perhaps?

From my perspective, of course, the hedge fundies' analogy between the London Whale and the Washington Super-Whale is all wrong--the hedge fundies are thinking partial-equilibrium when they should be thinking general equilibrium. CDX IG 9 has a well-defined fundamental value: the payouts should each of the 125 companies go bankrupt times the chance that they will. What Bruno Iksil does does not affect that fundamental value. He can bet, and drive the price, but he cannot change the fundamental.

But the Washington Super-Whale is different.

In a healthy economy, the Ten-Year Treasury Bond does have a well-defined fundamental. When the economy is healthy enough that pricing power reverts to workers and keeping inflation from rising is job #1 for the Federal Reserve, the level of the Federal Funds rate now and in the future is pinned down by the requirement to hit the inflation target. And the fundamental of the Ten-Year Treasury Bond is then the expected value over the bond's lifetime of the future Federal Funds rate plus the appropriate ex ante duration risk premium.

But when the economy is depressed, like now? When market appetite for short-term cash at a zero interest rate is unlimited, like now? When workers have no pricing power, and so wage inflation is subdued, like now? The Federal Reserve is not J.P. Morgan Chase. It is not a highly-leveraged financial institution that must worry about holding too much duration risk. As Glenn Rudebusch once said:

Our business model here at the Fed is simple: (i) print reserve deposits that cost us 0 (OK. 0.25%/yer), (2) invest them in interest-paying bonds that we then hold to maturity, (3) PROFIT!!

And the more quantitative easing the Fed undertakes and the larger is its balance sheet the larger is the amount of money the Federal Reserve makes on its portfolio, without running any risks--as long as the economy remains depressed.

The Federal Reserve, you see, is unlike J.P. Morgan Chase: the Federal Reserve does print money.

But, the hedge fundies say: "What if the economy recovers and starts to boom? What if inflation shoots up? The Fed could loose $500 billion on its portfolio as it moves to control inflation! Why doesn't that fear that?"

The Fed does not fear that. That is what it is aiming for. The Fed is charged by law with "promot[ing] effectively the goals of maximum employment, stable prices, and moderate long term interest rates". A full-employment economy is not something to be feared but something to be welcomed. And a $500 billion mark-to-market loss on its current portfolio? The Fed has given $500 billion to the Treasury, as a present, over the past decade. It is not a profit-making private bank. It is a central bank charged with "promot[ing] effectively the goals of maximum employment, stable prices, and moderate long term interest rates".

"But," the hedgies say, "George Soros! The Bank of England held the pound sterling away from fundamentals in 1992, and George Soros bet against them and they could not maintain the parity and George Soros took them for $2 billion! Why aren't we doing the same?" Ah. But George Soros took $2 billion from the Bank of England because its political masters told it to stand down: "We will not," they said, "defend the ERM pound parity at the price of bringing on a deep recession and mass unemployment." Who do the hedgies imagine are the Fed's political masters who will tell it to shift and adopt policies that will bring on even massier unemployment? Rand Paul?

There is a reason that the trade of shorting the bonds of a sovereign issuer of a global reserve currency in a depressed economy is called "the widowmaker".

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute...

“Don't Invest in Hedge Funds” is probably the refrain you have been hearing and reading over and over again recently. The so-called “smart money” has been under attack as it has failed to beat the market and deliver juicy returns. Some hedge fund managers were harshly criticized because of their attacks on the FED and the monetary policies it has executed in recent years. While the reasons for their hatred towards Bernanke could originate from their trading positions (as Brad DeLong explained in this post) we should bear in mind that one size does not fit all. Blaming the hedge fund category as a whole is not only wrong, but silly. First of all, accurately quantifying the returns of hedge funds is very hard, if not impossible. For the simple reason that, the large majority of them do not disclose their performances to the public. Matthew O’Brien, in his latest piece for the Atlantic, used a performance chart looking over only ten years and the HFRX index as if this is an index of hedge funds (like the S&P 500 for stocks for example). But that’s wrong. The HFRX shows the return of an index that attempts to track broad hedge-fund performances through the most diffused hedge fund strategies. Several indices which track hedge funds strategies have been constructed to try to replicate their performances. But this is not an easy task! With a lot of limitations. Robert Frey (Professor at Stony Brook University) and myself, find the EDHEC index much more representative than the HFRX. The EDHEC index takes into account the high fees (1% fixed fee of all assets, 10% of all profits), which have been heavily criticized. This finds Matthew and myself in agreement. If we take a look at the cumulative return over the 2000-2013 time window we can see that:

Chart 1 - Courtesy of Robert Frey

And if we enlarge a little bit the time horizon, here is how the hedge fund performances look like:

Chart 2 - KPMG, AIMA, Centre for Hedge Funds Research

It seems like hedge funds have performed pretty well over a longer period of time. The two charts emphasize the big losses hedge funds incurred during the financial crisis. From Chart 1, we can also see that hedge funds have recently struggled a little bit to generate "abnormal" returns against the S&P 500. One could say “but it does not tell me anything about the risk taken by the industry, performances are not risk-adjusted” and this is of course a reasonable objection. However, it is almost impossible to measure the risk-adjusted returns of hedge funds because any measure of risk-adjusted returns is hocus pocus. Hedge funds have quantitative and qualitative risks that make them unique to evaluate and analyze. Someone else could say “An equally split (50%-50%) stock/bond hedge fund would have done better than the 60%-40% stock/bond portfolio”. Reasonable too. Objections can be many! But let's focus for a moment on the recent performances. Hedge funds lost a lot of money during the crisis and let's admit that they haven't been able to beat the market recently. Are those good excuses not to invest in hedge funds? In my opinion no, and here is why. 

We are missing three very important points here:

1. Hedge Funds provide diversification. Investment strategies of hedge funds vary vastly. To list a few: directional strategies, market-neutral strategies, equity long/short strategies, event driven funds, macro strategies, fixed income arbitrage, short bias etc. A lot of hedge funds try to achieve positive returns using strategies that move in the opposite direction of the major market indices. They therefore suit perfectly for diversification purposes. Risk, the premier journal for risk managers, found that 10 to 15 hedge funds are needed for optimum portfolio diversification: 

2. Hedge funds can improve an investor's overall return. It’s pretty common to think of hedge funds as risky bets. But hedge funds can be used for several purposes. There are in fact, low-volatility hedge funds that can enhance returns at limited costs. Or alternatively, returns can be boosted by using hedge funds that particularly focus on high-return strategies by trading volatile products. Generally speaking, investors look at hedge funds as dynamic and flexible investment vehicles able to be traded under several market circumstances. And when implemented in a portfolio with proper due diligence and awareness of the risks involved, benefits may be several. 

KPMG, AIMA, Centre for Hedge Funds Research

3. Continued interest in hedge funds has never diminished, regardless of the recent negative performances and the adverse articles on the media. The asset under management stands at around $2.375 trillion. Compared to the $100,000 first investment in the first hedge fund under Alfred Winslow Jones in 1949, that should equate to a 30.39% annualized growth rate in AUM. If hedge funds have had such a high growth rate, it would indicate much better performance over time (see Chart 2), especially given the fact that they haven't been able to, historically speaking, advertise. Prequin data shows that 60% of institutional investors, primary source of capital for hedge funds stated in 2013 that they are looking to increase their hedge fund allocation. And this should not be surprising, given the current macroeconomic environment and how hysterically investors have looked for yield in the last year or so. Investors, in fact, are getting prepared for both growth and volatility and use hedge funds as a way to access "dynamic and interconnected markets and to mitigate the risk inherent in these exposures".Like in point 2, the flexibility of these instruments is something that investors demand.

One big problem for the industry as whole, now that some hedge funds will be able to advertise themselves, may be the pollution coming from people who are largely incompetent, crooks, or whoever does not use the most up-to-date financial tools. An investor should be able to pick the good hedge funds. Investing in hedge funds because something is called "hedge fund" should be strongly avoided. And this is easier said than done.  An investor carries together with the trade its own risk attitude as well as its own grade of financial sophistication, with a trade-off between the two. 

Risk Parity: What’s Next?

Risk parity strategies are not supposed to shoot the lights out, and most agree that the strategy is a good starting point for building your portfolio.

What more then, should a modern risk parity product do for its clients? How can they adapt the original purpose of a risk parity fund--arguably launched in 1996 by Bridgewater--into one that is fit for purpose in today's volatile markets?
We're not alone in wondering this: the risk parity managers have been wondering it too.
Bridgewater is a good place to start: Almost immediately after the aforementioned Reuters article decrying the returns from All Weather had appeared, Bob Prince, CIO of Bridgewater, spoke to reassure investors of his strategy.
He also told them that he had already introduced interest rate hedges, to calm any further fears of rate rises hammering their portfolios.
But Prince insists this wasn't a knee-jerk reaction to recent rate rises. Instead, he claims the plan had been on the cards for months.
In a rare interview, Prince tells aiCIO that alarm bells were raised when All Weather started performing rather too well.
"If you look at our All Weather strategy it had much higher returns than we'd expected on a long-term basis," he says.
"It didn't reflect anything we did, as we manage the portfolio passively, but it reflects the compression of risk premiums and the decline in real yields.
"This raised our attention, and we asked 'now that the prices are up and the yields are down, we expect the returns will be lower, so what does that mean for us?'."
Is amending a portfolio an active decision? Or just a prudent passive move?
Bridgewater embarked on a research drive, analysing liquidity creation from central banks and how it affects economies and markets.
The production of liquidity initially drove down the yield of cash and short-term bonds, along with other near cash assets, and because of the risk aversion at the time, the money didn't really find its way out of the risk curve into higher risk assets.
Then in 2013, as risk aversion has gradually faded, money moved out of the curve into other assets, meaning credit spreads are down, real estate is doing better, the stock markets up and so forth.
Prince and Bridgewater decided to use what they'd learned to improve the structuring of All Weather strategy.
"As the discount rate changes, including the risk premiums and real yields, that drives prices up and reduces expected returns, and so our process led us to the obvious observation that the real yield are in all assets, not just in bonds," he says.
"And because real yields are part of the discount rate by which all assets are valued, we realised it had given us more real yield exposure than we really needed.
"To rebalance All Weather and improve the balance we hedged some of the real yield exposure. By doing that we've got the same Sharpe ratio but [we can also] produce a return that's as close to a straight line as possible over a long period of time."
Prince estimates that by taking some of that excess exposure to real yields out of the portfolio, he's improved the tracking of that straight line by around 20%.
Isn't this a rather active decision for a famously passive strategy to take though? Prince has previously gone on record saying the best risk parity strategy is a totally passive one.
Today, he argues that taking the decision to hedge against interest rate exposure isn't an active decision, but simply a strategic one. He describes it as "not really an earth-shattering change, more of an incremental improvement".
Prince is extremely keen to ensure his clients (and presumably the wider market) understand the difference "because it's so rare for us to do any sort of transactions in All Weather".
"We didn't want people to misunderstand what we were doing. It's a modest improvement. We didn't want people to misconstrue this as a tactical bet, as it's largely about finding better ways to structure a passive portfolio," he argues.
Could he prove that this wasn't a reactionary measure to the fallout from Bernanke's speech then? As is policy for Bridgewater, Prince can't reveal exactly when the trades were made, but he assures aiCIO: "We did it gradually over the past few months…certainly the research we'd been doing dates well beyond the [Fed announcement in May]."
Can he convince the doubters? Well, not all of them.
"I find the decision to introduce hedges really funny because fixed income is your hedge for equity, and now you've got a hedge on a hedge," says Arun Muralidhar, co-CIO of AlphaEngine Global Investment Solutions.
"If it's truly a hedge, what the hell are you hedging? That to me shows it's a dead man strategy--you've got all these guys signing up saying 'I want that strategy to be the core of my portfolio', but then you're left having to do stupid things like putting hedges on hedges.
"The reason Prince has added more hedges is because the passive strategy is flawed. In crazy dynamics like we have today, loading up on all three assets and leveraging it is setting yourself up for trouble."
Story continues… 


Tweaks, rebalancing and tactical overlays
Bridgewater's not the only manager introducing new ways of thinking about risk parity though.
Lombard Odier's head of multi-asset Aurele Storno told aiCIO his strategy features a "cushion mechanism" using dynamic drawdown management, which essentially acts as an insurance against bad periods.
"We know there are periods where nothing works. Any time we reach a high point with the fund, we capitalise on it and reduce our exposure to the market. And when the market goes down again, we reduce our leverage," he says.
AQR's portfolio manager Michael Mendelson places today's risk parity managers into two camps: those who are continually trying to adjust their position sizes and leverage based on the risk environment, and those who don't.
His employer is an example of the former. "As the risk level in the market has risen in the last couple of months, for the managers who fall into that first camp, they will have reduced their exposures in their fund," he says.
"The risk rises surprisingly haven't moved that dramatically, so it's reasonable to assume that there have been some moderate changes in positioning, but no big ones, and not necessarily across every asset class."
Don't tell him that his continual tweaking with the allocation and exposures is active, though. He'll completely disagree.
"You shouldn't think of it as tactical--we do it in order to be steady. Tactical to us means taking a view on things," he insists.
"We always want to be steady in risk, so when we make these adjustments it's to stay on our strategic target. You need to be able to make dollar position adjustments because market risk levels change.
"We also run risk parity plus funds with tactical overweights and underweights, and in those strategies we also then take [positions] to express model-based views on expected returns."
Redefining risk
Invesco's CIO, Scott Wolle, took a slightly different tack during his recent bout of research into how his strategy was performing--he decided to completely change the way he evaluated bond risk.
A common approach is to estimate the risk through looking at historical price volatility, but for Wolle, that looked counterintuitive when you consider the last 30 years has been an almost uninterrupted bull market, making bonds look safe as proverbial houses.
"What we chose to do was to use duration and convexity (a measure of the sensitivity of the duration of a bond to changes in interest rates--Editors) and the immediate impact was to reduce the allocation to bonds in our portfolio," Wolle explains.
"A year and a half ago it took 20-25 percentage points off of our bond allocation. And what we and others do is have a much higher commodity component to counter periods of inflationary growth, rather than use inflationary bonds."
That strategy hasn't been perfect either: Wolle freely admits in the past month it's been the commodities as much as anything else that have caused problems for the strategy.
Invesco also has a tactical component to its portfolio, where it compares asset performances against cash and decides whether they are attractive or not.
"Going into the correction we favoured equities, were relatively neutral on bonds and a bit underweight on commodities," he says.
"For us, the bonds are less a source of long-term return, although their value is a consideration, but the role we want gilts to play is as a safety asset, so when people argue that corporate bonds would be better than gilts, or that equities are more attractive than bonds, that maybe absolutely right, and we might look at it on a tactical basis, but what happens if you're wrong with that view? What happens if you go into a recession? Having the hedge against the unexpected happening is such a crucial element."
Also rethinking how to assess risk is Northwater Capital. Vice President Neil Simons says rather than just considering volatility risk, risk parity strategies should also consider tail risk and drawdown risk.
Tail risk represents the existence of infrequent but potentially large losses occurring over a short time frame within a particular asset class, while drawdown risk represents the potential across all asset classes for losses over an extended time. This situation is magnified when all of the assets within a portfolio drop simultaneously.
"We have an added layer of risk control that attempts to minimize these extended losses across the asset classes," Simons says.
By spotting that fewer asset classes were returning positive numbers by April, Simons used the drawdown control built into the strategy to help minimise the loss.
"It is essentially impossible for risk-parity portfolios to make money when all asset classes fall, however in constructing a risk-parity portfolio, an expanded view of risk can help to minimize losses when an environment such as the most recent environment occurs," he claims.
Will these subtle changes help reduce the pain investors feel when all assets plummet together in future? Only time will tell. But is it reassuring to see risk parity managers are no longer willing to rest on the laurels of their past five years' performance. Let us know if you're convinced.

Pondering Simplicity In Asset Allocation

"The biggest pitfall [for all investors who decide on an asset mix and invest accordingly] is behavioral, when people don't want to rebalance," Brad McMillan, chief investment officer at Commonwealth Financial Network, tells The Wall Street Journal. What's the solution? The Journal article makes a case for simplicity in asset allocation, perhaps as few as three funds targeting US stocks, foreign stocks, and US bonds.

A minimalist approach has some appeal, but it's hardly risk free. By narrowing the asset allocation down to a handful of broadly diversified funds, the effective bet is that the portfolios will capture most if not all of the necessary risk premia for satisfying your investment objectives. In the grand scheme of what passes for investment advice, favoring this trio of asset classes is a reasonable strategy, particularly if the underlying funds are low-cost index products and the time horizon is at least 10 years.

That said, no investment strategy can be accepted at face value as a silver bullet solution without considering the risks. What are the potential stumbling blocks with limiting the asset allocation to three funds vs. a more granular approach that holds, say, 10 or 15 products? I can think of several, and they're worth considering, if only as an academic exercise.

For starters, let's recognize that whether you hold three or 20 funds, the behavioral challenges of rebalancing are still lurking. That's no trivial issue. Technically speaking, harvesting the rebalancing premium (lower risk, higher return, or both) isn't an especially challenging task. Simple rules can do a lot. If your initial asset allocation has shifted by a considerable degree, for instance, the case for rebalancing is compelling. But the biggest opportunities tend to align with periods when market volatility is relatively high and so it's easy to suffer the deer-in-the-headlight syndrome and sit on your hands.

Given the behavioral headwinds, it's no surprise that relatively few investors (individuals or institutions) manage rebalancing in something close to optimal conditions. The reason is obvious: the contrarian mindset doesn't come naturally to most folks when in matters of financial markets.

You could, of course, eliminate the behavioral/rebalancing issue entirely by holding a multi-asset class portfolio that's managed by someone else. That introduces a different set of issues, which boil down to the well-known complications of picking active managers, albeit in this case an active manager who's skilled at designing and managing asset allocation. Assuming you can find someone of this caliber, and the portfolio matches your investment objectives and risk tolerance, well, mission complete. You're done. But keep in mind that you're exchanging one risk factor (behavioral) for another (choosing active managers).

Otherwise, there's the delicate art of deciding choosing asset classes and managing the mix through time. The Wall Street Journal story suggests that you'll have an easier time if you limit your choices to three asset classes. Maybe, but that's effectively a bet that sidestepping the remaining pieces of the global asset class pie won't hurt the end results. Considering that the major asset classes can be divided into 14 categories, if not more, it's debatable how much risk you're shedding (or holding) with a concentrated approach.

Minds will differ on this decision, but it's best not to blindly accept the idea that less is more without a thorough review of the evidence and some modeling of what's likely to occur. That's hardly the norm. Most folks tend to ignore several pieces of the global asset puzzle out of habit or ignorance.

Even so, you can do quite well if you hold a relatively diversified set of assets and you rebalance intelligently. Over time, the latter is going to be the main driver of portfolio results, for good or ill. Assuming you don't go off the deep end with the initial asset allocation, the lion's share of how your investment strategy fares will be determined by how and when you rebalance. And, yes, that's still true for a three-asset class portfolio.

In other words, don't kid yourself into thinking that if you hold just three funds you'll have an easier time of designing and managing a rebalancing strategy. Market volatility will continue to present you with challenging choices that demand steely discipline to sell when everybody else is buying, and vice versa.

Sure, the task is technically easier with three funds vs. 14. But a relatively concentrated strategy per se is still an active bet relative to the benchmark, or a portfolio that approximates the full opportunity set of risky assets.

Active bets in asset allocation are, to some degree, inevitable, of course. If you had an infinite time horizon, the optimal portfolio would probably be one that holds everything (or as close to everything as reasonably possible) and weights the assets by market value. In the real world, no one has such a time horizon, save for a handful of, say, pension with very long term liabilities. As a result, the crucial issue is one of figuring out how to customize Mr. Market's asset allocation to serve our specific needs.

As such, we face a series of decisions for building portfolios and managing them through time. Choosing asset classes is one of those decisions, and it's an important one. But it's best to see it as part of a continuum of risk-management choices vs. a single get-out-of-jail-free decision. It's tempting to look for simple solutions that absolve us of the messy work that's often required for successful investing. But like everything else in economics and finance, portfolio management is more complicated than it appears.

ROSENBERG CALLS IT: Deleveraging Is Dead

We've been a bit taken aback by economist David Rosenberg's new found optimism.

"When the facts change, I change my mind. What do you do, sir?" he said quoting economist John Maynard Keynes.

The long-time bearish economist adopted a decidedly rosy tone in the wake of last Friday's strong jobs report.

"We have the third act in full swing, which is the healing of the labour market," he said yesterday.

In today's Breakfast With Dave note, Rosenberg declares the death of the painful deleveraging cycle.

DELEVERAGING ... R.I.P.

Well, one headwind is now behind us. The consumer deleveraging cycle. This by no means suggests we are entering into a whole new credit cycle. But at the margin, the inability to access loans that plagued the consumer for so long has dissipated rather substantially of late. And just as the labour market embarks on an improving trend and just as the fiscal squeeze enters into its final stage. The building blocks for the consumer to grab the torch are being put together with each and every passing data point of late. Don't fight it. Embrace it.

He delves into yesterday's bullish consumer credit balance report from the Federal Reserve.

The latest data point was the consumer credit data from the Fed for May — rising $19.6 billion (the consensus was +12.5 billion) or at an 8.3% annual rate, in the fastest pace of borrowing since May 2012. The gains were broad based with revolving credit up at a 9.3% annual rate, the strongest advance since May last year, and nonrevolving credit was also up at a 7.9% annual rate, but we know that in recent years, this was more of a federally-assisted student loan story than a tale about the consumer sector again willing to tap the credit lines for spending purposes. In fact, stripping out the federal government, credit lines for spending purposes. In fact, stripping out the federal government, credit surged at an 8.9% annual rate and the YOY trend ticked up to +2.5%.

At the banks, consumer credit is up 2.8% from year-ago levels. Consumer credit extended by savings institutions is up 6%. Credit unions have lent out funds to the consumer sector at a 10.2% pace over the past year (thanks to George Bailey!). And asset pools backed by consumer credit are also up 2.6%. Are these ripping credit numbers? Absolutely not. The new era is still one of prudence and frugality compared with the insanity and excesses of the last cycle. But deflationary deleveraging this ain't.

Gluskin Sheff

Staying balanced through the crisis to present day

I believe that, as investors, we all deserve some applause. The past six years have been trying and volatile. In this very challenging environment, it hasn’t been easy to stick to your asset allocation or portfolio decisions. Vanguard has tried to be a voice of reason during this time, cautioning investors against chasing returns. Those who stuck to their plan were rewarded.

Sources: S&P 500 Index, MSCI All Country World ex USA Index, and Barclays U.S. Aggregate Bond Index (rebalanced monthly). Equities split 70% U.S., 30% non-U.S. Data provided by Barclays and Thomson Reuters Datastream, as of April 30, 2013.

Let’s review: As our chart illustrates, a well-diversified portfolio would have plummeted roughly 37% or worse as financial markets went into a tailspin from late 2007 through early 2009. In 2009, some very smart, prominent individuals in the investment community were convinced that because of low economic growth, we were going to have a new investment normal with an extremely poor outlook for U.S. stocks. These individuals suggested that the only way to regenerate stock market returns might be to, for instance, overweight emerging markets.

In the subsequent years, investors faced myriad concerns, ranging from hyperinflation to a wide rash of municipal bond defaults in California, to the fiscal crisis overseas and here on our own shores, as well as some fears prevailing even today that we may be in the middle of a bond bubble. Everything in the headlines was an added pressure to abandon a balanced, diversified portfolio.

Luckily, there were voices that explained why expected higher earnings in emerging markets and economic growth would not necessarily translate into higher stock returns and why California would  not be the next Greece. Still, standing firm despite the headlines proved a daily challenge that tested the nerves of many investors.

I know headline risk will always exist, but the good news is that investors who stayed with their original strategies were well rewarded for their patience and perseverance. If you were one of them, give yourself a pat on the back because the diversified portfolio we mentioned earlier, not only recovered, but also actually gained 23% on the original amount from the start of the period through the end of April.