What Did Skew Do for You?

Sharpe or Skew?

Managed Futures offers this promise- uncorrelated returns with the potential for crisis protection. How an allocator chooses to allocate to this asset class is important. Do they judge managers by best risk-adjusted performance? Or do they judge managers by how they improve the risk-adjusted performance of the total portfolio? Do they view the asset as an absolute return element, prioritizing Sharpe Ratio, or as a portfolio element prioritizing diversification? Assuming the latter, prioritizing the addition of positive skew is critical to crisis diversification, offsetting the historically negative skew of the equity market and creating a better total portfolio.

Typical Managed Futures managers employ a risk controlled approach called vol targeting (we have written previously on this topic here and here). In essence, vol targeting involves increasing exposure when volatility is low and reducing it when volatility is high. Historically this has improved manager Sharpe ratio at the expense of skew. Our MLM Index EV and MLM Global Index EV are constructed a bit differently. While following similar trend following algorithms, positions are sized on exposure, not vol. The net effect is our indices are long changes in volatility, providing higher skew when needed most; in highly volatile markets. This makes intuitive sense; trend following tends to crash up while equity markets tend to crash down. The last thing you want to do is put the brakes on your diversifier while it is crashing up.

You Shouldn’t Bring a Knife to a Gunfight!

Stocks and credits are negatively skewed and historically have had large drawdowns. Neither asset class is volatility adjusted. If you are optimizing for the whole, and are rebalancing, you ideally need diversifying assets that have a negative or low correlation and positive skew.

Source: Mount Lucas and Evestment

Below we compare the MLM Index EV and MLM Global Index EV to the SG Trend Index (index of manager returns) and the CS Liquid Managed Futures Index (vol-adjusted price based index) and show skew and correlation statistics. Note the crisis returns are materially higher, our indices have the highest skew and kurtosis – which pairs most advantageously with stocks and credit that are negatively skewed with high kurtosis.

Source: Mount Lucas and Evestment

Correlations below as well.

Source: Mount Lucas and Evestment

Practical Examples

Cast your mind back to late 2008 into 2009 when things were really going wrong. Stocks were plummeting, credit markets were freezing. At the same time, the USD was going up, crude oil was dropping precipitously, and the US Treasury market was rallying. See the impact at the position level of a representative model that vol adjusts vs our trend following approach, using the Nasdaq as the example.

Source: Mount Lucas

Volatility adjusting positions reduces the diversification benefit at the worst time. The Nasdaq began to fall, the trend following component of the models moved short. The volatility adjustment process reduces the short as realized volatility picks up on the down move around the Lehman collapse. In this representative example, the short is reduced by some 60%.

In the next chart we compare the volatility adjusted model to the unadjusted model, you can see the unadjusted volatility approach has higher returns when you need them most. When using this approach, it is critically important that that portfolio elements are rebalanced. Even though returns in this example end up in about the same spot, at the portfolio level the sequence matters. The extra gains are monetized, the Managed Futures allocation is sold down, and more stock is bought at lower levels.

Source: Mount Lucas

Volatility adjusting can also be detrimental, given that equity prices and vol are negatively correlated. In early 2018, volatility collapsed until it didn’t. As volatility adjusting models increased position sizes in response to falling realized volatility, they are making the case that risk is falling, which is dangerous in our view. When the market fell and fell quickly, they took larger losses as they were at max positions. In a portfolio context this reduces the portfolio diversification benefit to the investor, particularly when this is applied to equity index markets.

A Better Portfolio

When modeling a portfolio with stocks and credits, the different approach is clear. In the example below, we start with a portfolio that holds 50% each stocks and credit. Then we add some vol-adjusted managed futures and some leverage to create a portfolio with 40% stocks, 40% credit, and 60% in CS Liquid Managed Futures. For the last two portfolios, we swap in the MLM Global Index EV and the MLM Index EV at the same 60% allocation for managed futures.

Source: Mount Lucas and Evestment
Source: Mount Lucas and Evestment

Note the skew changes at the portfolio level – typical portfolios are negatively skewed, and adding an uncorrelated positively skewed strategy takes the overall portfolio to zero skew. Drawdowns are much reduced, portfolio Sharpe ratio increases, overall portfolio volatility goes down.

Conclusion

The Covid crisis (Jan 2020 to Mar 2020) provides a complete example in a compact period. Typical trend managers were very long equity December through February, as volatility was still quite low. When markets broke, volatility increased and the exposure of the trend shorts was proportionately reduced. The same was true in other markets like energy. The MLM Index approach, using constant exposure and thus increased skew, provided better returns over this difficult period. If its diversification you want, ignore the siren song of Sharpe, and go for the skew.

What’s Killing Value Managers – 1999

One of the biggest challenges in investing is timing a rotation from a style that is currently in favor into a style that is currently out of favor. This was the challenge in 1999 and is so again today. In April 1999, the NY Times had an article titled “Mutual Fund Report; What’s Killing the Value Managers?”; history doesn’t repeat itself but it surely does seem to rhyme.

Back to 2020. Concentration in the equity markets has been a topic of conversation in the past year. Five years ago, Apple, Amazon, Facebook, Google, and Microsoft were 9.5% of the S&P 500. At the end of the second quarter, these five companies accounted for 21.7% of the S&P 500. These same five companies account for 45.7% of the Nasdaq 100 and Amazon itself is 44.4% of the total market of all the companies in the S&P 500 Consumer Discretionary sector. The current average forward P/E of these five companies is over 40, doubling from mid-March. As a result, the forward P/E of the Russell 1000 Growth Index at the end of the second quarter was 32.7. Since 1995, the only other time the forward P/E of the Russell 1000 Growth Index was this at this level was in late 1999 and in 2000, the heart of the dot-com bubble where it reached a peak forward P/E of 43.5 in July 2000. Over the entire 1995 to present period, the average forward P/E is 20.3. While equity valuations in general have increased as a result of low nominal rates, the increase has been more pronounced in the growth factor as the spread of the forward P/E of the Russell 1000 Growth Index is 11 P/E points more than the forward P/E of the Russell 1000 Value index.

killingvaluemanagers_cht1

Data Source: Bloomberg

killingvaluemanagers_cht2

Data Source: Bloomberg

With Trend Following – Beta Is Not Just Fine, It Is Preferable

One opportunity this stay-at-home quarantine has afforded us, sad as it may sound to some, is increased time to work through the pile of academic papers on quantitative finance. It is amazing how much great stuff is out there. When you come across one that happens to be right in your wheel house and makes the case in a MUCH smarter sounding way than we ever can, all to the better. Such as it was with this recent piece – When it pays to follow the crowd: Strategy conformity and CTA performance by Nicolas Bollen, Mark Hutchinson and John O’Brien from Vanderbilt University and University College Cork.

The authors find that contrary to other areas of fund management in hedge funds and mutual funds, where being different is a positive trait (research on active share in the equity space is informative – see here), when it comes to CTAs/Managed Futures being a purist is the right approach. The authors analyzed the data using two different methods. First they sort funds into style groupings and calculate a Strategy Distinctiveness Index – funds that have low correlations to the style. They then look at the performance of portfolios of funds based on the SDI score. Second, they empirically check by rebuilding a simple model for standard trend following and regress funds against that model. Closer to pure trend the better.

From the conclusion:

“Prior research has shown that strategy distinctiveness is a key determinant of cross sectional differences in hedge fund and mutual fund performance. It is intuitive that funds with more unique strategies should outperform, as the returns to more well-known strategies are competed away. However, futures markets are characterized by a high level of momentum, leading to the prevalence of trend following strategies. Consequently, trading against the crowd while pursuing an independent strategy may incur a high risk of failure.

We measure the distinctiveness of a CTA’s investment strategy following Sun et al. (2012). We estimate the correlation of a CTA’s return with that of its peers and classify funds with low correlation as high SDI funds. Our key result is that, in complete contrast to prior literature on SDI and hedge funds, SDI is negatively associated with future CTA performance. Funds that are more unique tend to underperform, after controlling for risks and styles, irrespective of holding period. Moreover, our evidence indicates SDI is an informative measure for predicting CTA performance only during times when momentum trading in futures markets yields positive returns. In summary, the best performing CTAs trade largely on momentum, and offer investors exposure to this strategy. Investors can realize a benefit over the full sample, but suffer losses when momentum strategies fail.”

A short interlude for some history on the authors of this blog. Mount Lucas has its roots at Commodities Corp, one of the birthplaces of the hedge fund industry some forty years ago. We spun out as we began to take on public pension plan clients, who subsequently required a benchmark for our performance. Remember, this was the 1980s, before there existed more indices than stocks and an index for absolutely everything. There were few benchmarks, and certainly no proper price based benchmarks for alternative investments. So we built one; the MLM Index. It is not exactly the same as the model used in the paper we are discussing, but its close enough to be representative. Long term trend following in a diversified set of representative markets. Although we have added some markets over the years, and altered the implementation a little, it has stood the test of time and is still running today. It is a great way to access the beta of CTAs and Managed Futures.

To our mind, if an investor’s goal is to obtain a representative, pure trend following return stream (and in our view it should be a component of all portfolios – see here) and being closer to the pack is a positive, then a low cost Index approach is a fine, if not preferable, solution.

Value and Rebalancing

The temptation is strong. The strategy you have used for years has underperformed. Why take the risk? Move back to the benchmark. Like a remake of a classic film, we have seen most of this before. In early 2009, pressure was on value stock managers to change their stripes. We recall a conversation from April 2009 with a foundation client invested in our Large Cap Value strategy. We had recently rolled to a new portfolio, and one of the selections was Wyndham Hotels. They were quite agitated – after the financial crisis it was unlikely that people would be going back to hotels for years. How could we? I took the quant’s way out of the question – “the model made me do it.” Wyndham was the best performing stock in the S&P 500 over the next 12 months.

The current reckoning certainly rhymes with the financial crisis. We must confess that even our conviction was challenged this time, and I promise you, ours runs deeper than most. Last week it was time to roll our value portfolio forward. Put the names back into the hat, take a fresh look, buy what is cheapest based on the models and caveats we employ. To add to the insult, it was also time to rebalance our multi-asset portfolios. What this meant was we had to buy a portfolio of decimated value names, in some cases buy more of them. Alaska Air? Kohl’s? Valero? MGM? Who is going to fly, go to a department store, get gas or gamble? Sure, these stocks have never really been cheaper, but come on. This is wake up in the middle of the night with these ticker symbols swirling in your head stuff. And you want us to buy more!

Take a deep breath. Think for a minute. What works? Buy when others are selling, sell when others are buying. Buy zero coupon bonds in the early 1980’s. Sell tech and buy value in 2000 (value was “broken” then, too). Sell crude at $150 (that’s when people stop buying gas). Value stocks look like that right now. They have discounted the end of air travel, retail, gasoline, and gambling. Never again will there be cash flow or dividends. We aren’t blind, we get that the near term is difficult for these names. But does that justify low single digit PEs? Or should it be mid-single digit PEs? Or can you look forward a few years and imagine a world different than today. For at least part of your portfolio, don’t you need to own the cheapest assets in the world? Rebalancing works best when you have volatile assets with low correlation and positive return – pump that volatility. What you shouldn’t do is sort by near term returns top to bottom and pile into the biggest winners. That’s not a portfolio.

Value stocks at this juncture are incredibly cheap. We aren’t the first people to say this, but it bears repeating nonetheless. The chart below shows the ratio of S&P Growth PE ratios to S&P Value PE ratios. There are bargains galore on offer, right now. Great businesses that are temporarily troubled and are being penalized to extreme degrees. Take advantage of it.

RatioSPGrowthValuePE

Data Source: Bloomberg, Mount Lucas LP

Managed Futures and the Virus: Update

We posted a blog on March 2nd discussing the initial reaction of managed futures to the market break as a result of COVID-19, including diversification and position sizing issues around volatility targeting at equity market highs. Today, we wanted to give an update on managed futures performance as the crisis has dragged out. We often tell our clients; building diversification into a portfolio and preparing for crisis events takes a multi-pronged approach. If you want instant protection to an equity market sell-off, long duration bonds provide the best bang for your buck. As a crisis extends bond protection is less reliable; this where managed futures (aka systematic trend following) steps in, accepting directional crash flows.

From the chart below (updated from previous blog), we see after a slow start managed futures has performed well, and more importantly, positive! Managed futures is a tough allocation to hold in good times, when volatility is low, when equity markets make new highs year after year. This is why you own it.

ManFutAndTheVirus2

Data Source: Bloomberg LP, Mount Lucas

This chart compares a sampling of largely blue-chip managed futures mutual funds (Fund 1 is a multi-alternative fund that uses managed futures, but clearly has an equity bias) with the MLM Index EV (15V) (which does not vol adjust).

Managed Futures and the Virus

Managed futures is supposed to be a “profitable hedge” – long term positive returns with zero or negative correlation to the equity market. The recent coronavirus crisis highlights one of our core beliefs, namely that the construction of most managed futures portfolios diminishes that critical characteristic in two important ways. First, they include equity futures in the portfolio mix, and second, positions are adjusted for volatility. The combination of these two things is particularly deadly. There is nothing wrong with trend following equity futures. But anyone who watches the markets knows that equity vol is lowest at the TOP! That means that managers will have their largest equity positions at the TOP! Furthermore, when the market breaks, the eventual short position they take will be much, much smaller than the long they had at the top. In non-equity markets, the same can be true. In the recent virus break, crude was previously making new highs, then broke very sharply. Vol adjusted short positions will be tiny. Chart below compares a sampling of large blue-chip futures mutual funds with the MLM Index EV (15V) (which does not vol adjust).

Data source: Bloomberg LP, Mount Lucas

It’s a question of conflicting goals. If you want to maximize Sharpe ratio as a standalone investment, then vol adjust. If the rest of your portfolio is full of stocks and credits already, and you want a “profitable hedge” to maximize total portfolio Sharpe ratio, don’t. (See this blog post for more technical detail).

Correlation Is Not Causation

Drummed into applied math students everywhere. It even has its own website, with this gem on how margarine consumption is correlated with divorce rates in Maine.

correlation

Should be true enough in markets as well. But in reality, at least in pockets, it isn’t always true. Stocks have always in part been driven by relative valuations. Stat-arb was a big thing some twenty years ago when computing power was starting to be applied to stocks. Pairs trading based on common risk factors makes some sense, Ford and GM operate in the same business after all, it makes sense they should be broadly be impacted by the same broad industry and economy trends. When computing power jumped later, factor investing came to dominate. Grouping stocks based on different attributes has some merit. At their heart, the old quants had valuation firmly in the mix of parameters. Many of the newer factors and machine learning quants have thrown out what ultimately matters. Price – or rather ‘value’. Low vol investing doesn’t care whether a stock is priced for perfection or not. Quality takes no account of what that pricing implies going forward, just that its metrics are stable. Momentum will push junk yields far below default rates and not even notice. As long as the quants see the property they like, regardless of valuation, away they go. They operate as if they are just observers, quietly taking a look from afar and being able to interact without impact. The Hawthorne effect is the phenomena where the behavior of subjects is altered due to the awareness of being observed. The quants in places are not observing any longer, and their impact is self-fulfilling, for a time anyways. There is plenty to be gained from applying stats and metrics to markets, but it is surely important to not take it too far.

You can see this today (September 9, 2019). ‘Value’ stocks are up a lot, not particularly based on the merits of the underlying businesses, but because other types of stocks are down. When stocks are held for their correlation properties, strange things happen. Like the butterfly that flaps its wings and causes a distant thunderstorm. It’s easier to make a case that at least today, retail stock Gap is up big because Boris Johnson chose to shut down parliament. Not often thought of as a butterfly, but bear with the logic here. Boris shut parliament…which catalyzed votes to stave off ‘no deal’ Brexit…which caused Gilts to fall…which drove global bonds to fall…which pushes growth stocks, utility stocks and REITS down…which makes value stocks jump. Seem strange? It should. But the stock market acts this way more and more. Factor investing and ETF baskets that segment stocks into groups are big drivers of prices, particularly when smaller names get larger weights in factors. We need to get back to a more fundamentally driven world.

Looking Beneath The Hood Of Factor Investing

Factor investing, particularly within the scope of risk premia strategies, has been a popular topic. Vanguard has convinced the investing community that beta can be achieved by buying passive indices and the cost of owning beta should be very low. Investors use risk premia strategies as a source of generating alpha.   But …. are people looking carefully enough when evaluating these strategies? Much gets hidden in broad risk and return statistics. We thought we would take a deeper dive into how factors behave over market cycles. Continue reading

Can News Flow Create Value?

Searching Google for “Retail Apocalypse” returns 8.8 million results (in .45 seconds!). For the better part of a decade the sector has been beaten up in the press. The headlines are not unfounded. Former staples of American consumerism such as Toys-R-Us, Radio Shack, and Payless ShoeSource are no longer, while many others struggle to find stable ground. The negative hype surrounding the Retail Apocalypse has created a fog around the whole sector and retail stocks have not been a popular pick amongst active money managers in recent memory.

Behind the retail apocalypse headlines are companies who have adapted to new market conditions, have strong balance sheets, and forward-thinking management. Looking into the fog, we see a shunned sector, overly beaten down valuations, and good potential to seek out value. Our Mount Lucas Focused Large Cap Value currently holds 4 retail names amongst its 36 total holdings. Some may view this as a high concentration of an unpopular sector for a focused strategy which holds no more than 40 stocks. However, our quantitative stock picking algorithms have no such opinions, they are programmed to seek value.

Below are the 4 retail names currently being held in the strategy, each picked for the portfolio on Sept. 22, 2017. Presented are price charts with selection date indicated and resulting price move, as well as headlines from the time preceding selection. Even positive news is tinged with negatively worded headlines. We believe this illustrates the headline fear and peer pressures that all human stock pickers face, as well as the benefit of a non-biased quantitative approach to value investing.

Mount Lucas Focused Large Cap Value Strategy Information

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Stress Testing CTA Portfolios – Impact of Volatility Adjusting Positions

In light of recent market performance, and the corresponding effect on changes in volatility on CTA returns we thought it important to give our views on the topic. Late last year, we were asked by a prospective client to see how one of our trend following models performed over several different stress environments. We highlight one particular stress that was given- a 20% stock market drop over 3 months, with 40% of move in month 1, 35% in month 2, and the last 25% of the move in month 3. A relatively straightforward exercise, but to really understand the nuances of different CTAs relative to our approach, you must look past just the change in level, but consider the potential price paths and volatility over that stress period. The difference boils down to whether one is viewing CTAs as a standalone investment, or as a piece of a larger portfolio, and the role of volatility targeting in position sizing.
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