PAAMCO Research

An Endless Waiting Room: How should pension investors manage a world of low yields, tight spreads and high valuations?

06/11/2018

As markets remain close to record levels, pension investors have a hard choice in front of them: should they 1) hedge liabilities and lock in low returns, 2) aim for their return target and take their chances regarding the liabilities or 3) do a bit of both?

While they are increasingly expensive, markets are cooperating in one big way: the cost of insurance has collapsed in interest rates (and stayed low). By implementing a nonlinear hedge with interest rate options, investors can be hedged in scenarios where protection is vital and be less impacted by losses in scenarios where a hedge is a hindrance – always an attractive position, but all the more so at these low price levels.

Furthermore, at current spreads, investors should seriously consider diversifying away from credit risk in their portfolios. Right now a portfolio that is focused solely on the various flavors of the credit risk factor is receiving historically low levels of return. Credit has had a fair wind for several years now and there is little headroom remaining. Diversifying away from this makes sense.

Therefore, our recommendations include:

1.  Using low levels of implied volatility to help the portfolio as a whole
The current level of implied volatility in long-dated swaptions, which has not been seen in over 10 years (and is 25% less expensive than at the start of 2017), makes these instruments a cost-effective choice to protect the portfolio.

2.  Diversifying away from credit risk
Tight spreads and low yields for high grade credit continue to be a headwind for investors, forcing a dilemma of accepting poor returns in exchange for hedging liabilities. A singular focus on credit for Liability Driven Investing (LDI) implementation makes achieving return targets and overcoming index slippage a very tall order.

3.  Moving from passive to active; macro to micro
Until recently, many investors have focused on making the right macro decisions and selecting passive strategies to implement their views. This is an approach that has certainly borne fruit in the recent one-way markets. The current historically high valuations of so many asset classes mean that making the right macro decision is increasingly difficult (as shorting in a pension fund can be challenging). Pension investors should resist the temptation to lash themselves to the mast of low yields and tight spreads. Rather, they should try to operate in a much more micro fashion and accentuate a more active role.

Macroeconomic trends are hard to call regardless of the amount of due diligence done. For microeconomic trades, however, the amount of due diligence meaningfully improves the odds of success. Rather than looking for asset class value, investors should re-focus on sub-asset class and individual trade value. In other words, invest actively rather than passively.

The start of the year saw some rediscovery of the truism that investing is hard and that markets go two ways. Whichever scenario we end up in, there is value in flexibility, opportunism and diversification. Being positioned for this sort of transition is never free but, remarkably, it is cheaper now than it has ever been.

Uncertain Times

Pension investors have a series of hard and possibly irreconcilable choices in front of them: should they hedge liabilities and lock in low returns or should they invest for high returns and not hedge liabilities, or should they do a bit of both?

Uncertainty remains high and investing in this environment may feel like being in an endless waiting room with no resolution. Looking at three potential future scenarios: normalization, a Japan-like scenario in the U.S., and the return of volatility (the bad sort), helps frame the issues. There are also non-symmetric choices for hedging rates such as using currently historically cheap swaptions that, when utilized, offer significant flexibility to investors in managing their overall portfolios. The other component worthy of consideration is that investors should pay heed to the tightness of credit spreads. Investors would be wise to remain engaged in credit risk replacement as a matter of urgency regardless of views on rates.

What are People Saying?

Recent talk (and actions) from the Fed and other central banks regarding an increase in inflation and rate rises has substantially influenced views among commentators and pundits. The strong global economy, and the slow withdrawal of monetary stimulus have bolstered hawkish rate views. Despite these factors, long bond rates still remain firmly within the range of the past five years.

Over the past few years, investors have seen almost every risk market move from significantly undervalued (2009) to priced for perfection (2017/2018). Today’s choice seems to be between a rock and a hard place: take your pick of one overpriced asset class over the other. This investment conundrum is further compounded by the requirement of pension investors to address their liability hedge ratio. What can be done? Well, there is one thing that continues to get cheaper even as everything else gets expensive: rate insurance. The cost of rate insurance has declined by nearly 30% over the past 12 months and — even after the shock to volatility at the start of February — remains at very low levels. This is demonstrated by the following chart which shows the relative change in implied volatility for VIX and for long-dated swaptions since the start of the year:

Swaption Implied Volatility (Level at 1/1/18 = 1)

Source: Bloomberg
As of May 31, 2018

 

What’s Been Going On?

We all know the headlines and the trends but stepping back and reconciling where we are today versus expectations of even a few years ago is quite enlightening. The past five years or so have caught the investing world in a one-way trip: according to pundits, long rates have been on the verge of “normalizing” for the entire period but have instead stayed within a range; meanwhile equities have been on a trip skyward (until the recent high in early 2018) and credit has steadily ground tighter. If, in 2012, you said that in 2018 the S&P 500 would have nearly doubled from 1400, unemployment would be at 4%, and the Fed would be shrinking its balance sheet with the end of Quantitative Easing (QE), but despite all of this, the 30-year rate would be close to 3%, there would have been some funny looks and probably laughter. Further, your counterpart, who was laughing at you, would have maintained their positions in preparation for a take-off in both rates and inflation (neither of which happened). Finally, if you told them that the cost of insuring against such a take-off of rates would be about 30% cheaper than it was then, they would have thought you were crazy. And yet here we are.

Cost of Swaption Insurance is the lowest since 2007

 

Source: JP Morgan Markets
As of May 31, 2018
Note: The 11-year date range was chosen in order to include the period leading to the 2008 financial crisis.

Meanwhile, the term premium in the rate curve has gone away: the difference between the 2 year and the 30-year yield is less than 1% as the short end has crept higher. This is despite the Fed’s signaling to the market both a continuing increase in the short-term rate level as well as the slow shrinking of current holdings of other duration bonds. There is a continuous bid for the long end of the curve, as suggested by the 2.41 bid to cover ratio of the recent 30-year auction in April. This was in line with January’s ratio of 2.74 which was the highest such ratio since 2014.¹ Fixed income investors are in an endless waiting room, stuck there for an indefinite period for judgement and eventual consignment to an appropriate fate. While there, they are caught between requirements to be long duration and unsustainable return targets.

Collapse in Term Premium

Source: JPMorgan Markets
As of May 31, 2018
Note: The 11-year date range was chosen in order to include the period leading to the 2008 financial crisis.

So Where Do We Go From Here?

Taking an agnostic view of the motivations behind a flat yield curve, what does it tell us about the future? First off, the markets are saying that there is more capital than opportunity. In the long term the markets think that the appropriate risk-free rate of return for investing for 30 years is somewhere around 3%. Second, there is a lot of talk of the future and how this situation in rates may or may not change. Assuming we don’t revert to the waiting room of the past few years of low volatility markets, let’s look at three possible scenarios that could play out in the short-medium term that merit consideration by investors.

Scenario 1: Normalization – at last!

• Economic growth is strong
• The bond market sells off, driven by central bank removing QE
• Everything is stable and steady

In this scenario, the term premium should increase, partially driven by the central banks of the world unwinding their QE balance sheets. Investors sell out of bonds and reinvest in better opportunities. This reduces the demand for long-duration bonds, raises yields and funds productivity-enhancing investments, increasing the “pie” for all.

But might this actually happen? This could be a sort of hell for the holders of long-duration assets as a new rate regime consistent with what was previously considered normal reasserts itself. However, given that there is a large set of pension investors following a glide path that requires them to sell their risk assets and buy the required long-duration bonds, a rising equity market has the side impact of also providing a steady bid for duration. This occurs despite rising yields at the short end. In other words, pension investors are forced to buy into a bond market depressing yields below where they would otherwise be, maintaining the current flat yield curve.

In this scenario, the economy lives up to the hype implied by equities. Normally we would expect that the curve should start to steepen as bond investors are attracted to other asset classes, but LDI glide paths don’t account for this. They will either cause yields to stay stubbornly static or force investors into a losing trade. This would replicate the situation in the UK gilt market, where a limited issuance of long-dated gilts has been eagerly snapped up by a set of constrained investors.

Scenario 2: Japan-like Scenario in the U.S.

• Stagnant Growth
• Deflation
• All investments perform poorly

In this scenario, the economy does not grow and inflation is not the problem — deflation is. Yields keep going down and the curve is basically flat, meaning no term premium at all. Holding long duration assets produces capital gains but the yield is derisory. Equities perform poorly over the long term as growth is in line with what has been predicted by the low and flat yield curve. This will hurt investors who choose to remain unhedged to rates as well as those who focus on a passive approach to risk assets.

Scenario 3: Something Happens – Volatility!

• Exogenous shock
• Positive or negative development draws capital from bonds
• Yields increase

In this scenario, an exogenous shock forces markets to adapt to a new economic equilibrium causing real change to the long-term calculus embedded in current markets. Such a change can be positive or negative. A positive change brings a set of transformative technologies and investments that pull capital from safe assets to reinvest in productivity-enhancing assets. Such a shortage of capital for bonds will drive yields up. The withdrawal of QE is also meant to have a similar effect.

On the negative side, an event that causes a large destruction of economic capital, such as a natural or manmade disaster, attracts large amounts of financial capital away from other uses in order to rebuild and regenerate. In other words, volatility! We had a little bit of a taste of what volatility is at the start of February; market participants that had grown complacent riding market trends suddenly experienced real uncertainty and actual losses. In the event of real uncertainty around future prospects, bond investors will get hit by both rising rates and widening spreads.

Pension Investors’ Dilemma

The weight of glide paths on the long-duration bond market is critical; pension plans betting that rising long rates will bail them out of poor funded-status by keeping the hedge ratio low may be very disappointed. Similarly, fully hedged plans hoping that a rise in risky assets will bail them out of the gap between current yields and the expected return on assets may also be disappointed. There is no simple solution to this other than the hard work of investing beneath the macro level and staying open to opportunities, diversifying away from tight credit spreads and finding cheapness where possible, both for hedging and for return-seeking parts of the portfolio.

 

 

1    Source Department of Treasury, Bureau of the Fiscal Service 30 Year Auctions of Jan 11, 2018 and April 12, 2018.
www.treasurydirect.gov

 

 

 

Ronan Cosgrave, CFA, CQF is a Managing Director and is Portfolio Manager for PAAMCO’s LDI and Long Duration solutions. He serves also as the main point of contact for certain institutional investor relationships. Prior to joining PAAMCO, Ronan worked as a Process Engineer at IBM’s Storage Technology Division sites in Silicon Valley, Germany and Ireland. He also did chemical engineering design and commissioning for ProsCon, an Irish engineering and process control consultancy. Ronan received his MBA from Columbia Business School, and B. Eng. in Chemical and Process Engineering (Honors) from Cork Institute of Technology. </span>

 

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Miren Portföy Yönetimi A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.

This document contains the current, good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements.

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Volatility Has Returned (and is here to stay)

04/27/2018

Overview

What a difference a quarter makes! After a prolonged period of suppressed volatility, equity market volatility spiked meaningfully in early February. A number of short volatility strategies (including several popular ETFs) exposed their downside risk during the volatility spike, forcing many of these strategies to reduce risk or unwind. As a result, many retail and institutional investors alike experienced large losses.

Since those events, the level of volatility in markets has remained elevated. It is a challenge to pinpoint the specific cause of the equity market trade-off in late January and the subsequent volatility spike. At the end of 2017, many forecasters, including us, noted several risks to be wary of going into 2018: the impending end of a long period of global accommodative monetary stimulus, signs of acceleration in inflation, deficit spending, and lofty credit and equity valuations. Identifying the primary culprit in Q1 is not simple; more important is recognizing that we have entered a higher volatility regime that has investors finally waking up to the reality of tighter financial conditions, increased geopolitical uncertainty, expanding deficits and a U.S. economy in the late stages of expansion.

Portfolio Implications

We expect the following three primary investment themes to characterize the balance of the year:

1. Hedged relative value and trading-oriented strategies will likely outperform directional strategies.

a. The prospects for a continued equity bull run seem to have diminished for a number of reasons. PE multiples are re-rating lower. The FAANG (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) stocks’ overwhelming success is spurring an increased regulatory focus. “Trade war” rhetoric is capturing headlines well in advance of any concrete negotiations, obscuring the economic impact on specific industries. These phenomena are contributing to an increased risk premium for equities, more than offsetting the positive impact tax cuts are expected to have on future earnings. All of the above is creating a “sawtooth” pattern for equity prices as investors react to positive or negative headlines. This has resulted in a lot of directionless market volatility.

b. Higher short-term interest rates and a reduction in global monetary stimulus will likely create a headwind for credit markets. Over the past few months, credit spreads have widened, but in the absence of increased default fears. If the economy slows, higher interest rates and revenue compression will start to squeeze weaker credits. The volume of BBB debt is particularly significant, which could mean a downgrade to HY territory for a notable amount of formerly investment grade paper. A pickup in downgrades in conjunction with rising defaults would add pressure to credit markets and cause HY spreads to widen.

c. The pace and path of removal of monetary accommodation will vary from country to country, but as long as the general economy doesn’t show signs of rolling over, a move toward more restrictive monetary policy appears clear. This shift will create a less accommodative environment for credit trading. The world is still flush with cash and the debt markets remain open, buvt we are wary that the psychology of bond investors can switch from buy mode to hold or sell mode in an instant. This may create a choppy backdrop for credit trading with risk biased to wider spreads.

 

2. Macro-focused strategies that can position for trends in the USD and yield curves will benefit, while long-biased strategies face headwinds.

a. We expect the U.S. fiscal deficit to evolve into a bigger problem than is currently anticipated. The Trump administration has shown no spending restraint while also passing one of the largest budgets in U.S. history; at the same time, recently approved tax reform will reduce government revenue.

b. The continued spending spree in the U.S. becomes even more concerning as we approach the end of the economic cycle. The U.S. should instead be using the long period of economic growth to pay down debt and shore up the country’s balance sheet.

c. Short-dated bonds that were issued at near-zero interest rates are getting rolled over at rates in excess of 2%. Short-term rates will likely continue to rise, further adding to the deficit.

d. We expect these profligate policies to cause an increase in the term risk premium and a bearish dollar policy.

 

3. The market volatility witnessed in Q1 will likely become the norm and not the exception.

a. Coordinated, accommodative central bank policies around the world have suppressed risk for years. With this backdrop of central bank support, investors have moved into riskier assets in search of higher returns.

b. We have been warned that this party will come to an end in Q3 of this year. As central banks slow QE-related purchases, assets will once again re-price to a fair risk-adjusted value (rather than the inflated value caused by QE). We are in the very early innings of this asset re-pricing. As monetary policy becomes increasingly restrictive, the repositioning of this risk will weigh on markets.

c. The inconsistency of the pricing of volatility within and across asset classes will provide a viable and profitable investment opportunity for volatility trading strategies. Increased volatility should also provide a favorable environment for various risk premia strategies, as a higher volatility regime typically bolsters returns earned from harvesting risk premia.

 

Overall, we expect 2018 to be a more challenging investing year than 2017 or 2016. With a less stable macroeconomic backdrop and historically rich asset valuations, the key to earning reliable returns this year is focusing on hedged relative value and trading-oriented strategies. The newly volatile market environment will create a rich opportunity set for investment managers that extract return by understanding relative value or technical dislocations. On the other hand, investment managers that rely on a stable environment to earn consistent carry or ride a positive equity trend will likely be more challenged this year.

 
 

Basil Williams is a Managing Director and Head of Portfolio Management at PAAMCO. He is responsible for the firm’s completeAlpha approach to hedge fund investing and is the Chief Investment Officer of Horizons, the firm’s fixed-income investment solution. Basil is also a member of the firm’s Investment Oversight and Management Committees. During his career, he has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, he spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980 and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.

PAAMCO senior analyst Vanessa Welsh made significant contributions to this paper.

Why Alt Beta?

02/01/2018

Overview

Passive management has transformed the asset management industry. The first index fund was started in 1972. Since then, the U.S. index mutual fund industry has grown to more than $3 trillion. This represents about 20% of the total assets under management for the U.S. mutual fund industry.¹ This growth was driven by skepticism toward the value of active management as well as a relentless search for lower fees.

The next wave of innovation was “smart beta” funds, which modify passive strategies with factor tilts, such as favoring cheaper stocks to generate better returns than traditional market capitalization-based indices. This industry just passed $1 trillion in assets.²

Now “alt beta” funds are primed to be the next step. Alt beta aims to replicate some of the factor returns of hedge funds using automated trading rules implemented at low costs. The market is estimated at around $200 billion and is growing rapidly.³

This research note provides an overview of alt beta investments. It first illustrates how alt beta products can replicate returns for some categories of hedge funds, using foreign currency trading as an example. It then discusses the rationale for the existence of risk premia on alt beta products. Finally, it shows how alt beta products can be harnessed to add value to investor portfolios, through proper selection and structuring of the alt beta portfolio.

What is Alt Beta?

Alt beta strategies manufacture returns from systematic trading strategies that are expected to capture positive compensations for risk, or “risk premia”:

  • •  With low sensitivity to traditional asset classes (i.e., low beta, duration, spread duration)
  • •  Across various asset classes, such as equities, rates, currencies, and commodities
  • •  Across various styles, such as value, carry, trend, and volatility
  • •  At relatively low costs

Thus, alt beta strategies can be used to construct pure “zero correlation” portfolios.

Alt beta relies on a wide variety of risk premia. The rationale for this is analogous to the “equity premium.” Equity markets are very volatile. Over the long run, however, equities do tend to go up by an average of, say, 4–8% per annum. Most investors believe in the existence of a positive long-term equity premium—even though they may not agree on the exact number—because this represents a compensation for bearing non-diversifiable equity risk.

From the viewpoint of a long-term investor, there would be much interest in a product that also returns a premium around 4–8% but with low correlations to traditional asset classes and reasonable volatility. A properly structured alt beta product should be able to achieve this by collecting multiple risk premia across sources largely uncorrelated with each other. As we shall see, implementing such a strategy through total return swaps, for example, allows for leveraging up the portfolio to achieve a desired risk premium.

Example: Risk Premia for FX

As an illustration, consider an investment in a hedge fund that trades foreign currencies (FX). The hedge fund manager should add value by actively trading the portfolio, after trading costs and fees. Some of this positioning, however, represents exposures to risk factors that have been shown in academic research to provide positive returns over the long run. Such factors include:

  • •  “FX carry,” due to the fact that some currencies pay high interest rates, which provide higher returns that are not fully offset by a currency depreciation
  • •  “FX trend,” due to the fact that short-term currency movements tend to persist and are thus somewhat predictable
  • •  “FX value,” due to the fact that undervalued currencies using a metric such as Purchasing Power Parity (PPP) tend to revert back to their long-term, fair value equilibrium

These factors are well rooted in academic research, which has demonstrated that they provide positive returns, when averaged over multiple years. The averages, or expectations, of these factor returns constitute what we call “risk premia.”

Take the Brazilian currency, the real (BRL), for example. The short-term interest rate on BRL is around 7%, as opposed to 1.5% currently for the dollar in the U.S. So, investing in BRL-denominated cash should provide an excess return of 5.5% if the currency does not move. On the other hand, if the currency depreciates by 5.5%, the investment will be a wash. If the BRL depreciates by more, this will create a loss. Empirically, we observe wide swings in exchange rates, but, on average, higher interest rates are not fully offset by currency depreciations. This is what creates the FX carry risk premium.

Ideally, such premia should be traced to a source of inefficiency. For FX carry, this is probably due to market segmentations. In practice, interest rates are set unilaterally and independently by central banks. The Brazilian money supply amounts to approximately $100 billion, which reflects very large currency reserves. There would have to be very large flows of speculative capital to eliminate systematically this FX carry effect.
Likewise, there should be a good explanation for the “FX trend” effect. Academic research has tied this effect to participants in the currency markets that are not profit-oriented. This includes central banks, which intervene in that market to stabilize currencies as opposed to make a profit, as well as exporters and importers, who are hedging instead of speculating. For instance, any of these participants could be continuously buying the currency, creating a slight appreciation that would persist.

Finally, the “FX value” effect represents slow, long-term movement back to equilibrium exchange rates that evolve according to relative inflation rates. For instance, a country with a currency that is abnormally cheap in real terms relative to others would be expected to have increasing exports because of its cheap manufactured goods. This would create a long-term increase in the demand for that currency, pushing it back to equilibrium.

Alt beta products attempt to replicate each of these “risk premia” by a systematic trading rule following these principles. For example, Binny (2005) uses:

  • •  For FX carry, buying 3 currencies with high interest rates, and selling 3 with low rates
  • •  For FX trend, buying (selling) a currency when its 5-day moving average is above (below) the 40-day average
  • •  For FX value, buying (selling) currencies where the current exchange rate is below (above) the long-term fair value derived from Consumer Price Indices

In practice, there are many different ways to implement these algorithms by changing the sample of currencies, the number of currencies bought or sold, the parameters of the trading rules, the construction of the portfolio, and so on. Evaluating various algorithms requires practical experience in building and assessing such models, in particular their soundness and robustness.

So, what is the empirical evidence in terms of the expected return and risk for these FX risk premia? Table 1 displays estimates over a long, 30-year period, from 1987 to 2016.4 Like the equity premium, all risk premia are defined in excess of the cash rate.

These three FX trading strategies all provide positive average returns, ranging from 3% to 5% per annum, with an annual volatility in the range of 9%. This confirms the existence of FX risk premia over this period, and is in line with the abundant academic research on the topic.

Example: Replicating FX Traders

Armed with these three FX risk premia, we now have tools to evaluate and try to replicate the performance of any FX hedge fund. As a reference, let us use the performance of the Barclay Currency Traders (BCT) Index, which is an equal-weighted composite of manager programs that trade currency futures and forward contracts with a long history.

Over the period from 1987 to 2016, this index has grown by an average of 6.8% annually, net of all management and incentive fees.

Let us now decompose the performance of this index and check whether it can be partially replicated by our FX risk premia. Over this period, cash returned 3.7% pa, so the BCT Index had an excess return of 6.8 – 3.7 = 3.1% pa. How much of this can be explained by the three FX premia?

The most simplistic approach is to assume that these FX traders have fixed exposures to these three risk factors. These exposures can be estimated with a multivariate regression of the BCT Index returns on the three FX factors. Results are shown in Table 2. Two of the slope coefficients are strongly significant, with positive values and t-statistics above 3. This means that FX traders act as trend followers and high carry currencies investors. There is no evidence that they follow value strategies, however.

The final step reports how much of the BCT Index performance can be attributed to FX risk premia, by combining the traders’ exposures with FX risk premia. This is shown in Figure 1.

The figure shows that, out of the 3.1% excess return provided by FX traders, 2.2% can be accounted for by FX risk premia. The remainder is pure alpha, 0.9%. Thus, simple mechanical trading rules can account for a good fraction of the active manager excess returns, in this case more than two-thirds of the total (2.2 out of 3.1%).

So, why pay high fees to hedge fund managers if a large fraction of their returns can be replicated at low cost? Essentially, this is the rationale behind alt beta.

These results do not imply, however, that all hedge funds can be so easily replicated. FX trading takes very few security-specific bets and has a relatively narrow universe of currencies. Likewise, Global Macro funds trade in broad indices, where strategies can be partially replicated by alt beta algorithms. At the other end of the spectrum are hedge fund strategies such as Relative Value that rely heavily on individual security selection. Indeed alt beta factors explain the highest fraction of alpha for Global Macro funds, and the lowest for Relative Value funds.7 Thus alt beta is only a substitute for some categories of hedge funds.

What are These Risk Premia?

Alt beta risk premia represent payoffs on long-short strategies typically used by hedge funds. For classification purposes, they can be usefully sorted into two broad categories, as described in Table 3. The first is by type, e.g., value, carry, trend/momentum, and volatility. These apply across asset classes, e.g., equities, fixed income/rates, currencies, and commodities.

The risk premium in each cell of this 4 x 4 table has been generally supported by extensive academic research and well documented by Ilmanen (2011).8 This research has attempted to explain these premia in terms of (1) rational risk factors, (2) behavioral factors, or (3) market segmentations.

  1. Rational Risk Factors: For example, the extra return on value equities relative to growth stocks could be due to some omitted risk factor, such as default risk, that is not properly measured in the traditional market beta. Exposures to such risk factors may be worthwhile if they carry a high enough compensation.
  2. Behavioral Factors: Momentum in prices could be due to systematic behavioral biases on the part of investors, who tend to buy assets that have gone up recently in price, thereby further pushing prices up. Or, some market participants could act for non-economic reasons.
  3. Market Segmentations: These can justify why prices are not fully arbitraged away between different markets, for a number of reasons including regulations, insufficient arbitrage capital, or disequilibrium between demand and supply. One example is equity carry, where dividends futures trade at an implied rate that can be systematically lower than expected dividend rates. This is due to the issuance of structured products by banks, which are promising clients a return tied to the capital appreciation of a stock index. Banks hedge this risk using total return indices, which leave a residual risk tied to dividend payments. Banks can hedge the remaining dividend risk by selling dividend futures, thus depressing implied dividend rates.

Such systematic explanations are quite useful, because they suggest why these risk premia should persist. The counterbalancing effect is always that arbitrage capital could move to take advantage of these risk premia, potentially reducing their size over the long run.

In practice, this reduction will depend on the size of the capital arbitrage flows. Long/short arbitrage capital typically originates from hedge funds and proprietary bank trading desks. Regulatory restrictions imposed on bank trading since the Global Financial Crisis, however, have decreased this second source of arbitrage capital.

Are These Risk Premia Reliable?

Like all sources of risk premia, the reliability of these positive average returns over time depends on the signal-to-noise ratio, i.e., the ratio of the expected return to its annual volatility. This is typically low, leading to wide swings in returns. So, an investor could experience a couple of years with negative returns even if the risk premium is positive over the long term.

This is not unique to alt beta risk premia, however. Reliability is also an issue with the equity premium. Even though most investors are thoroughly convinced that the equity premium is positive, the size of this premium is relatively small relative to the volatility of equity returns. Assume a 5% equity premium, for example. Say that over the long run, stock return volatility is around 20%, leading to a “Sharpe ratio” of 5%/20% = 0.25. This is rather low, and can lead to many years with negative returns on the stock market. This is illustrated in Table 4.

The second panel asks the question of how many years would be required to ascertain the statistical significance of the equity returns averaged over some period. Put differently, how many years would we need to be reasonably confident that this estimated mean reflects a positive premium?

This question can be answered by computing the usual t-statistic, which is the ratio of the estimated mean to its standard error. Say the estimated mean is indeed 5%. Its standard error depends on the number of observations. With 30 years of returns, this is σ/√Τ = 20%/√(30) = 4.6%. Taking the ratio of 5% to 4.6% gives a t-statistic of 1.10. We usually require t-statistics in excess of 2 to establish significance at the 95% confidence level. Because this t-statistic is lower, we cannot conclude that this mean return of 5% is statistically “significantly” positive.

As the table shows, to get a t-statistic above 2, we would need 100 years of data to prove with high confidence that the equity premium is positive. In other words, it is hard to prove statistically that there is a positive equity premium even though most investors would believe in its existence.

The same issue affects individual alt beta risk premia. Even with positive risk premia, there could be strings of years with negative returns.

This is why statistics based on history must be combined with judgment. Understanding the rationale for the alt beta risk premia is critical to assessing its continued existence. In other words, we need to understand whether the drivers of the risk premium are likely to have disappeared or not. As discussed previously, this includes evaluating (1) rational risk factors, (2) behavioral factors, or (3) market segmentations.

In addition, current market conditions may give useful clues. As an example, take the FX carry risk premium. We showed that this is largely driven by differences in nominal interest rates between different currencies, e.g. 7% on the Brazilian real vs. 1.5% on the U.S. dollar. If the exchange rate does not move, we would expect to reap 5.5% annually. On the other hand, if this difference were to shrink from 5.5% to 0%, we would not expect any FX carry risk premium on the Brazilian currency. Indeed, in the aftermath of the financial crisis, most G-10 currencies had low interest rates, within 1% of each other. So, the FX carry risk premium must have largely gone away for G-10 currencies. Emerging market currencies, however, still enjoy a wide spread in nominal interest rates, so should still benefit from the FX carry. Therefore, making a judgement as to the continued existence of some alt beta risk premia requires a good knowledge of their drivers and current market conditions.

How to Harness Risk Premia?

We have shown that individual alt beta risk premia are somewhat uncertain, like all risk premia. Such risk premia, however, can be harnessed by the power of diversification. These premia should be constructed to have low correlation with general markets. They also tend to have very low correlations across each other, if suitably selected. This can help us build portfolios that take advantage of the “Fundamental Law of Active Management”, using what Grinold (1989) calls “breadth.”9

Indeed, pooling together many risk premia should help us improve the Sharpe ratio of the portfolio. Table 4 illustrates a hypothetical portfolio with ten risk premia, all with fairly low Sharpe ratios, conservatively estimated at 0.25, but with zero cross-correlation. For simplicity, we assume that all risk premia are scaled to the same volatility of 10%, and are all assigned the same weight of 10%. So, all risk premia have the same expected return of 2.5%, in excess of cash.

Since all expected returns are the same, the portfolio expected excess return is also 2.5%. Next, the variance of the portfolio can be calculated at V = ΣN (w × σ)2 = N × (w × σ)2 = 10 × (10%×10%)2 = 0.001. This gives a volatility of 3.2% only. As a result, the Sharpe ratio has now increased from 0.25 for individual risk premia to SR = 2.5%/3.2% = 0.79 for the portfolio.

This shows that cross-sectional diversification across risk premia factors should help lower portfolio volatility, ensuring more stable and reliable returns.

Investors, however, will in general require higher levels of returns than 2.5%. This can be easily achieved by leveraging up the portfolio. For instance, alt beta risk premia can be accessed by total return swaps, which do not need to be fully funded upfront and therefore allow leverage by increasing the notional amount.

Assume that the investor requires a target volatility of σ = 8%. As shown in Table 5, the portfolio can then be leveraged by a factor of 8%/3.2% = 2.5. This would increase the portfolio expected return, in excess of cash, to ER = SR × σ = 0.79 × 8% = 6.3%. Adding a risk-free rate currently around 1.5% gives an expected total portfolio return of 7.8%.

Higher levels of leverage and returns can be achieved as long as the portfolio holds enough cash to meet the initial margin requirements and as a buffer against potential margin calls.

Conclusions

Alt beta products are the next logical step in the progression toward automation of active management. Indeed, such trading algorithms aim to capture compensated risk factors, called “risk premia,” that are largely specific to the hedge fund industry.

This note has discussed the nature of alt beta risk factors and has illustrated some of their salient features. They should be largely uncorrelated with traditional asset classes, providing a “zero correlation” alternative product. They should be implementable at relatively low costs. Perhaps their most interesting feature is their “breadth,” due to the large variety of styles, asset classes, and implementation algorithms. This should lead to a selection of strategies that are largely uncorrelated with each other. As a result, a properly constructed portfolio of alt beta factors should be quite diversified, leading to a Sharpe ratio that is much higher than its components.

This breadth can be implemented through a portfolio of total return swaps, for example. Such swaps can easily allow changing leverage, thereby creating enough flexibility to match the risk/return profile of the alt beta portfolio to that desired by the investor.

 

1  The first index mutual fund was Qualidex, which aimed to replicate the Dow Index. Estimates of the size of the U.S. mutual fund and index mutual fund industries are from the Investment Company Institute’s Fact Book (2017).

2  Financial Times, December 28, 2017.

3  Albourne (Notional AUM Invested in Dynamic Beta Strategies–Survey Results, 2017) estimates the alt beta market (called long/short dynamic beta) at $216 billion.

4  Binny, James (2005), “Currency Management Style through the Ages,” Journal of Alternative Investments 8, 52–59.

5  Source: Binny (2005), or ABN AMRO Bank for data from 1987 to 1989. After that, the risk premia are taken from Deutsche Bank, and are available on Bloomberg. All average returns are taken as monthly averages annualized. This allows an exact decomposition of returns into risk premia components that add up to the total, unlike when using compound returns.

6  This approach has been used by academic research that examines the value added of foreign currency managers. See Levich, Richard and Momtchil Pojarliev (2008), “Do Professional Currency Managers Beat the Benchmark?” Financial Analysts Journal 64, 18–32.

7  See Coupe and Norman (2016), “Don’t Bet it Alt on Beta,” PAAMCO Viewpoint.

8  Ilmanen, Antti (2011), Expected Returns: An Investor’s Guide to Harvesting Market Rewards, Wiley.

9  Grinold, Richard (1989), “The Fundamental Law of Active Management”, Journal of Portfolio Management 15, 30—37.

 

 

Philippe Jorion - PAAMCO

Philippe Jorion, PhD is a Managing Director in the Risk Management Group. He oversees the development and implementation of risk measures for PAAMCO hedge funds, sectors, and client portfolios, all of which are based on full position-level transparency. He is charged with the active management of risk, which involves building tools for monitoring managers, customizing funds, and helping to manage overall portfolios. As chair of the firm’s Investment Oversight Committee, he is involved in all stages of the investment process. He also serves as a chaired Professor of Finance at the Paul Merage School of Business at the University of California at Irvine. He is a frequent speaker at academic and professional conferences and is on the editorial boards of a number of finance journals. Philippe has authored more than 100 publications on the topic of risk management and international finance. Some of his most notable work includes the Financial Risk Manager Handbook (Wiley 6th ed. 2010), which provides the core body of quantitative methods and tools for financial risk managers; Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County (Academic Press 1995), the first account of the largest municipal failure in US history; and Value at Risk: The New Benchmark for Managing Financial Risk (McGraw-Hill 3rd ed. 2006), the first definitive book on VAR. In March 2013, the Financial Analysts Journal honored Philippe Jorion and Rajesh K. Aggarwal’s article titled “Is There a Cost to Transparency?” with the 2012 Graham and Dodd Scroll Award. From 2012 to 2014, Philippe served on the Federal Reserve’s Model Validation Council, an advisory council of economists that evaluates the models used in bank stress tests. Philippe holds an MBA and a PhD from the University of Chicago and a degree in engineering from the University of Brussels. Philippe has over thirty years of experience in investments and risk management.

 

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Miren Portföy Yönetimi A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.

This document contains the current, good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.

Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.

PAAMCO is a Core Supporter of the Standards Board for Alternative Investments.

2018 Outlook: Will Inflation Deflate the Asset Bubble?

01/18/2018

Overview

Many investors seem to be starting 2018 with expectations that conditions in 2017 – moderate growth, low inflation – will continue. As a result, they generally remain bullish on equity markets and expect little upward movement in longer term interest rates or widening in credit spreads. This expectation for a continued favorable economic outlook has been bolstered by the recent approval of tax reform in the U.S. It is prudent, however, to be cognizant of the fact that current equity valuations, low long-term rates, and tight credit spreads are also a result of many years of global monetary stimulus. A broader unwind of this stimulus, as has just recently started in the U.S. and the U.K., should, over time, pose a challenge to current valuations (absent an uptick in growth). 2018 will be a year in which the support from monetary policy begins to transition to fiscal policy support. The impact on markets will largely depend on whether this transition drives real economic growth or rather sows the seeds for higher inflation.

Monetary Policy: Removing the Punch Bowl Globally

We are now entering our ninth year of unprecedented monetary stimulus. Proponents have argued that this global effort has stabilized the world’s economies post the global financial crisis. Critics say the policies were unnecessary and have created massive distortions which may pose a risk down the road. Regardless of whether the policy prescription was correct, we must acknowledge that economic growth is now firing on all cylinders in much of the developed and emerging world. This is coupled with low unemployment and tightening labor markets, though the classic economic measures of consumer price inflation still remains muted. We have argued in an earlier PAAMCO Perspectives why we think this may be the case (see The “Internet” of Stocks and Bonds, Q4 2017, www.paamco.com), but believe that there are factors in 2018 (e.g., U.S. tax reform, potential infrastructure spending in the U.S. and a more positive outlook in China) that may lead to higher inflation readings.

Central bankers are in the process of planning their exit strategy. The Bank of England made its first rate hike this past fall. The U.S. Federal Reserve has hiked rates five times and has indicated plans to hike at least three more times in 2018. Furthermore, last October, the Fed began running off its massive balance sheet. The European Central Bank (E.C.B.) is also planning to remove the punch bowl as it is expected to cease its quantitative easing (Q.E.) program in September. So far markets have responded without a hitch as underlying growth remains strong, stocks continue to reach record highs and long-term yields are contained. Given this backdrop, we expect the Fed to continue its stated plan to raise short-term rates in a consistent and orderly manner despite current low inflation readings.

Source: https://fred.stlouisfed.org and http://www.bankofengland.co.uk. As of January 2018.

U.S. Fiscal Policy: Stoking the Inflation Fire?

Much of the economic discussion in 2018 will be focused on the impact recent tax reform will have on both the consumer and corporations. The focal point is likely whether corporations, who receive the largest benefit, choose to make longer-term investments or just use the savings to shore up their balance sheets. It remains to be seen whether this is a long-term positive or just provides a short-term boost. But, more importantly, will the fiscal stimulus result in real economic growth or is it simply a deficit-led hand-out? The answer could determine the ultimate effect on markets.

It would seem that tax reform could get the system’s inflationary juices flowing again after a decade of dormancy. Corporate tax cuts may effectively improve the financial health and competitiveness of U.S. companies. A simpler U.S. tax code for individuals is a good thing and lower rates will help middle class pocketbooks. There is little argument that the U.S. road, rail, bridges, tunnels, ports and airports are in need of modernization. However, if all of this is being paid for by increasing the deficit, will some of the expected economic gains get crowded out by an increase in inflation?

Inflation Risks Lie Ahead

If this is the direction of U.S. fiscal policy with the stock market at all-time highs and unemployment at near all-time lows, what is going to happen to inflation? Though our expectation is that we will see an uptick in inflationary pressure in 2018, we aren’t expecting a large breakout to the upside. Deflationary forces from mobile technology, e-commerce, and even the newly-adopted blockchain may mitigate upward pressure (again, see The “Internet” of Stocks and Bonds, Q4 2017, www.paamco.com). However, a move in inflation from a range of 1.5-2% to 2-2.5% is likely. Such a move will add further support to the Fed’s plan for gradual rate increases through 2018 and into 2019. It will also likely prompt investors to reconsider the term risk premium in interest rate markets that has been absent for the better part of the last decade.

For now, however, markets are still a good way from anticipating higher inflation. After all, investors have been compensated over the last several years by fading an inflation increase. However, if inflation does emerge, it will hurt both business’ bottom lines and consumers’ purchasing power. If coupled with a backdrop of increasing real interest rates, a dreaded double whammy could be created that would pressure corporate profits and disposal income.

Market Impact

In the U.S., the shift from monetary support to fiscal support should result in markets that once again price more according to economic fundamentals than in response to central bank Q.E. programs. Over time, this should lead to a realignment of relative value within and across asset classes. Negative interest rates, negligible term premiums and sub-5% high yield bonds will very likely fade into the history books. Given the current market’s euphoric feel, a reversal could be dramatic as the ability for market makers to absorb risk around a market turn remains questionable. Perhaps more likely, a shift away from the rosy market scenario of today is likely to play out gradually. Signs of economic slack being absorbed are evident in the U.S. as well as in Europe. Wage pressures are starting to emerge in markets with the lowest jobless rates. If these extend more broadly, they will further justify the Fed’s tightening, perhaps even at a faster pace.

The major investment risk in this scenario of higher inflation will first play out in the credit and volatility markets, which we feel are the most distorted by the years of monetary Q.E. If fiscal policies fail to deliver upticks in economic activity that more than offset the upticks in inflation, credit spreads are likely to widen and volatility will likely increase. How quickly this translates into lower stock prices is harder to call, but the move may be large enough that contagion will spread to equities. Clearly central bankers are aware of such a potential outcome and will try to guide policy accordingly to avert a bad outcome, but the fiscal policies put in place at this stage of the economic cycle may take on an inflation life of their own. Until we see consistently higher readings of inflation, the U.S. stock market will probably continue its upward trajectory, particularly as the positive benefits of tax reform on corporate bottom lines translate into higher earnings. Caution is warranted around midyear as the peak of global Q.E. should occur when the E.C.B. is expected to finish its bond buying program around September.

Portfolio Implications

For years, investors have chased yields and rising prices to find places to “park” their money. This has created “bubble-like” conditions in the high yield markets and has flattened yield curves. However, carry on longer-dated fixed income and from credit spreads is at very low levels and it is time to again realize that holding short-term cash or cash substitutes may be more prudent than chasing carry. Low risk alternative strategies, which have the potential to deliver high Sharpe ratio/low volatility outcomes, are a good place to invest while markets are at risk of correcting. Over the next year, these strategies may deliver mid-to-high single digit returns without the asymmetric downside risk of other more traditional investments.

Investors’ liquid alternative portfolios should be positioned in alpha-seeking strategies that generate a moderate absolute return yet can be repositioned quickly if markets reprice and overshoot to the downside. Beta risk, particularly illiquid beta, could be harshly penalized as Q.E.-supported valuations get repriced resulting in both mark-to-market losses and the inability to capture subsequent dislocations. For the first time since 2008, there is a noticeable return on holding short-term fixed income as two year notes are around 2%. If the Fed follows through with its projected rate hikes during 2018, LIBOR rates could end the year around 2.5%. Therefore, an absolute return strategy that seeks L+500 returns could result in portfolio returns of 7.5% or more. Not a bad outcome for a “de-betatized” portfolio.

Overall, the markets are likely to reward active management over passive as the easy money policies of the last several years will likely become something of the past. The recent approval of tax reform and talk of infrastructure spending in the U.S. may mean that inflation will again factor in business risk assessments. As a result, being respectful of downside risk in the equity, credit and rate markets should be an important consideration in one’s portfolio construction.

 

Basil Williams is a Managing Director and Head of Portfolio Management at PAAMCO. He is responsible for the firm’s completeAlpha approach to hedge fund investing and is the Chief Investment Officer of Horizons, the firm’s fixed-income investment solution. Basil is also a member of the firm’s Investment Oversight and Management Committees. During his career, he has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, he spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980 and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.

 

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Miren Portföy Yönetimi A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.

This document contains the current, good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.

Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.

PAAMCO is a Core Supporter of the Standards Board for Alternative Investments.

The “Internet” of Stocks and Bonds

10/04/2017

Executive Summary

Given the global backdrop of strong U.S. equity markets, increased political stability and growth in Europe, and nascent signs of growth in Japan, why isn’t the bond market softer and why haven’t we seen an increase in inflation? We think technology, in particular the Internet, has been a meaningful driver of the current dynamic between inflation and the bond market. Further, we believe that the Internet is changing the way economic health should be measured and, accordingly, the way investors should position their portfolios.

Today’s asset prices have been propped up by years of easy liquidity and most credit and equity instruments are rich by historical measures. Investors have been chasing yield and do not appear sufficiently focused on risks to current valuations. We believe that investors would be wise to consider a number of factors and ideas as central banks start to remove liquidity from the system:

• Stock-picking and credit selection are likely to outperform broad indices – a focus on investments that can withstand a period of stress is warranted
• Quantitative macro models that rely on consistency across asset classes may be challenged; so too may cross-asset class relative value strategies
• Assets with weak underlying fundamentals that have been supported by yield chasers may suffer as central banks reduce liquidity in the market
• ETFs, particularly those focused on high yield bonds and loans, may sell off significantly because of limited liquidity in corporate bonds
• The time is ripe to shift portfolios to become more “all weather”

The Backdrop

Financial markets entered 2017 with high hopes the Trump administration would provide a strong growth stimulus. Post-election bond yields rose, equities rallied (especially small caps), emerging market currencies got crushed, and inflation expectations showed some signs of life. By mid-2017, the bond market had quickly changed course: 10-year yields have fallen 20 basis points while the 2/30 curve has flattened by 50 basis points.* Many believe the bond market rally is due to a lack of success in the implementation of fiscal policy. However, the equity market rally has continued with large cap stock indexes trading at all-time highs. Even the Russell 2000, which initially gave up most of its late 2016 gains on the lack of new tax initiatives, has reversed course and delivered solid YTD performance.

It is easy to side with the bond market’s reaction to the lack of fiscal progress. So far the new administration’s key agenda items have not materialized (e.g., making the U.S. tax code more competitive, rebuilding infrastructure and repealing Obamacare). Bond market caution was further justified recently by North Korea’s multiple missile launches, and earlier in the year by the uncertainty within Europe leading up to Macron’s election victory.

Then why have stocks done so well? Initially, equities took the cue from President Trump’s victory and the idea that parts of his agenda would be quickly implemented given the Republican majority in congress. Further support came from European political stability following the French elections in May and emerging signs of steady growth on that continent for the first time in many years. Asia has also played a part as global stimulus has taken hold in Japan where the economy is finally growing, albeit at a very gradual pace. Lastly, the fears of U.S. protectionism appear to have been overhyped and emerging market equities and currencies have both appreciated materially with many showing gains over 30%+ in USD terms.*

Given the positive global backdrop why isn’t the bond market softer? Given the tightening labor market in the U.S., shouldn’t inflation be rising? Or has the Phillips curve permanently flattened? What about the bond vigilantes, have they all died off? Is it possible to continue to have steady economic growth without stoking inflation? Is there something bigger at work causing inflation to remain subdued despite a tight labor market? Our answer is that yes, something bigger is at work. We think technology, in particular the Internet, has been a meaningful driver of the current dynamic between inflation and the bond market. Further, we believe that the Internet is changing the way economic health should be measured and, accordingly, the way investors position themselves.

Current Monetary Policy: The Risk of FOMO

Before we address what may be causing this apparent conundrum, let’s also highlight some of the current risks associated with maintaining an accommodative monetary policy. The current abundance of liquidity continues to push up asset prices around the world. Most developed stock markets and several emerging markets are at all-time highs and traditional valuation metrics are also well above their long-term averages. Equity market corrections of even a few percent are bought heavily. Anything with a yield is in demand while markets are not keenly focused on the underlying credit risk and/or creditor protections of bond issues. This is clearly a backdrop of excessive optimism about the future without an appreciation for risk that may be on the horizon.

One of the most blatant examples of this mania is playing out in the world of crypto currencies. It is hard to ignore the potential power of Blockchain technology to eliminate the middleman in financial and real asset transactions. This technological development will likely disrupt many industries, just as the Internet did over the past two decades. However, we question the need for the existence of 800+ crypto currencies, the top 10 of which have a total valuation in excess of $100 billion. Clearly some crypto currencies will be needed to transact using the “chain” and others as an alternative for a potential store of value, á la gold, but the frenzy created by this new “innovation” further supports our view that investors are currently not sufficiently factoring in risks.

Environments that lack a sufficient appreciation for risk often lead people to disregard the underlying investment they are making for fear of missing out (FOMO). As a result, investors feel the need to jump on the band wagon of every hot stock, market, or trend. In addition, the glut of global liquidity has helped fuel the proliferation of ETF (exchange-traded funds) and index products. As downside risk hasn’t really appeared in almost a decade, the comfort investors feel in taking market beta risk to a broad benchmark may be misguided. After all, this has been an environment in which monetary policy has intentionally supported asset prices. As we are now in the early innings of that support being removed, the outlook for these products is unclear should the risk environment shift to a more cautious one, or, worse yet, one in which investors become flat-out scared.

In the past few years there have been three incidents of note that have tested the market liquidity: the taper tantrum in 2013, the flash crash in equities in May of 2015, and the flight to quality in bonds in October of 2015. These incidents are stark reminders of how quickly market liquidity can evaporate. The apparent liquidity that is present during bull markets can quickly evaporate in a bear market and prices can (and often do) gap down quickly.

Lastly, investors are reaching for yield of any sort because of the assumption that the bullish environment will continue. This is most pronounced when looking at recent sovereign debt issues in emerging markets. Recently, new issues by Iraq, Ukraine, and Tajikistan came circa 7% for 10-year debt. Would a pension fund that needs to earn a 7% return really entrust their pensioners’ future to the ability and willingness of these countries to repay? Insatiable demand for long-term bond debt exists, almost without regard for risk of repayment of principal, as long as a yield meets a certain threshold return.

A Connectivity Conundrum

Is this bond-equity distortion – or conundrum as Fed Chair Greenspan called it two decades ago – concerning to central bankers? After all, employment and inflation – not asset price targeting – are the focus (and mandate) of central banks. Further, I proffer that our classic monetary metrics are doing a poor job of evaluating the health of the economy, as the digital economy is very hard to measure in monetary terms. Technology, particularly the Internet, has created significant increases in utility absent any real inflationary uptick. In fact it can be argued that much of the technological development to date and even on the horizon is deflationary. This is likely to continue as the next big wave of innovation, the Blockchain, strives to eliminate middlemen in many areas of the economy. This mismatch between the metrics and what is really going on in the economy could be causing central bankers keep their foot on the gas longer than needed.

Technological innovation may cause inflation expectations to be permanently lower. Further, advancements in technology may mean that traditional measurements of economic health also need to advance and evolve, particularly monetary aggregates. Modern economic theory is based on the idea that money is the ultimate measure of economic activity. Compensation, trade, commerce and investments are all measured in monetary terms. What if one could create a store of wealth that is different than money, as is occurring with crypto currencies? Initially our economies were based on bartering, then we used tokens resembling coins, later gold and then paper currency backed by gold. Then, in 1971, we finished the process of unlinking our paper currency to gold. For decades we have accepted the value of simply paper currency. Why couldn’t data encryption also become a store of value? After all, if enough people agree that data encryption has value as a medium of exchange (not unlike paper currency) then it becomes a currency. The challenge for central bankers is that their classic economic tools are unlikely to measure this potentially momentous change until it is very far along in the process of adoption. Therefore, the current policy prescription of low interest rates may be misdirected.

It is unlikely that the central bankers of today, most of whom are classically-trained economists, will publically lead a change in thinking. But they do appear to be concerned with the asset price “bubble” and may choose to allow real interest rates to rise without seeing the classic measures of inflation rise. Comments following the September FOMC quickly reversed the markets’ expectation of a minimal chance of a move in December to one in which Fed Chair Yellen expects that, despite the low inflation readings, they are still on course for a December hike.

Investment Implications

There will always be value to be found in the markets but, thanks to years of easy liquidity, most credit and equity instruments are currently rich by historical measures. Investors need to be scrupulous to find opportunities that can perform well while withstanding a potential period of stress brought about by an eventual change in risk perception. Investors would be wise to consider a number of factors and ideas:

• Focused stock picking and credit selection should – over the intermediate term – do much better than the broad indexes whose performance is agnostic to fundamental valuation.
• Historical cross asset correlations may have changed and equity and bond performance so far in 2017 represents to many a conundrum. Further, the USD reflects the fact that the U.S., once the model of stability given the steadfastness of our leadership, is now a source of global instability. We should prepare for a prolonged period of USD weakness despite the actions of the Fed. If this is the case, many of the quantitative macro models that rely on consistency in cross asset class behavior could be challenged. Also relative value strategies that trade across asset classes will be more difficult to assess and focus should thus be on those within asset classes.

• We are on the doorstep of a reduction in the Fed’s balance sheet and the ECB is starting to reduce its QE activity (though any moves will likely be measured and well telegraphed). Acknowledgement by central banks that new forces in the economy are dampening inflation readings might lead to the realization that higher yields are necessary to inject a dose of reality about risk into the markets. With the end to QE unfolding, the liquidity tailwind could quickly become a headwind for asset prices, putting pressure on equity and credit prices (particularly investments to which yield chasers have flocked despite weak underlying fundamentals).

• Index strategies are concerning in that they are agnostic to valuation. The more overpriced an asset becomes, the bigger its share of the index, and the more the investment strategy which follows the index must own of the overvalued asset. Such a pattern can easily reverse itself if active investors decide to sell overvalued assets en masse. Therefore, passive index strategies may be hard to beat in good times but active management is likely to prevail when the cycle moderates or turns.

• Finally, ETFs have given apparent liquidity to a sector of the market in which the underlying assets are not that liquid. Of particular concern are credit ETFs that focus on high yield bonds and loans. Should the economy cycle downward, and investors decide to shed credit risk, the selling of these ETFs will quickly test the limited liquidity of the corporate bond market.

 

Conclusion

The time is ripe to shift portfolios to become more “all-weather” and to balance risk. For the months ahead, we believe that a neutral weighting (at best) is appropriate for credit strategies with a beta tilt and equity strategies with a lot of beta. We are becoming a wealthier society given our increased technological utility but one with low inflation due to the Amazon, iPad and, potentially, Blockchain effects. The transition from the classic approach to monetary policy to a more “new age” approach will clearly take time. Most of our central bankers are well versed in classic economic theory and may be resistant to changing their traditional approaches. Furthermore, the outgoing Fed governors are unlikely to make any near term changes leaving measurement of “iPad iNflation” to a new Fed leadership. Technology will continue to change the inflation and utility outlook. Monetary policy must soon adapt to this “Internet of Stocks and Bonds” or risk stoking greater asset bubbles to deal with in the future.

 

*As of mid-September. Bloomberg.

 

Basil Williams is a Managing Director and Head of Portfolio Management at PAAMCO. He is responsible for the firm’s completeAlpha approach to hedge fund investing and is the Chief Investment Officer of Horizons, the firm’s fixed-income investment solution. Basil is also a member of the firm’s Investment Oversight and Management Committees. During his career, he has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, he spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980 and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.

 

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Miren Portföy Yönetimi A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.

This document contains the current, good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.

Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.

PAAMCO is a Core Supporter of the Standards Board for Alternative Investments.

Connecting to More Opportunities in China

08/07/2017

The recent opening of the China – Hong Kong Bond Connect went relatively unnoticed but it could have long lasting implications for global asset allocations and hedge fund opportunities. Alongside the inclusion of some onshore listed A-shares in the MSCI indices, the Bond Connect can be seen to represent a further step in the opening up of Chinese capital markets – allowing access to the second largest economy on the world, the second largest stock market and the third largest bond market. In spite of the recent focus on capital controls around the onshore currency – arguably largely taken to stabilise the onshore CNY-USD rate – increased access to onshore assets through the stock and bond connect programmes should create more opportunities going forward for both outright and hedged investors.

To recap, the Shanghai-Hong Kong Stock Connect was launched in November 2014, allowing overseas investors easier access to the onshore “A-share” markets in Shanghai as well as allowing onshore Chinese investors access to Hong Kong listed names. Since the launch, the number of eligible names has increased and other limitations, such as an aggregate quota, eliminated. Covered short selling is also allowed. In December 2016, the Shenzhen-Hong Kong Stock Connect was launched, adding the smaller but racier and tech-heavy smaller cap Shenzhen exchange to the mix. These two channels have supplemented the existing QFII (Qualified Foreign Institutional Investor) and RQFII (RMB Qualified Foreign Institutional Investor) schemes. Crucially, this permits settlement in the offshore currency (CNH) which allows investors to exchange and hedge freely, albeit with some basis risk to the onshore CNY.

The Bond Connect allows access in a similar way to nearly $10 trillion of assets in China’s fixed income markets, supplementing previous access through QFII and RQFII as well as the China Interbank Bond Market (CIBM) scheme. This includes all types of bond securities tradable on the CIBM including central and local government bonds, central bank paper, financial policy bank bonds, corporate bonds, commercial paper, asset-backed securities and so on, as well as subscriptions for new issues. The People’s Bank of China (PBOC) has said that hedging tools such as bond repos (repurchase agreements) and interest rate derivatives will be available in the future. To an investor, Bond Connect means avoiding lengthy and complicated registration procedures, fewer restrictions such as a lock up on investment principal which was part of the earlier schemes, and more clarity on repatriation of sale proceeds.

In equity markets at the moment, offshore investors have typically invested in Hong Kong listed names (“H shares”) as well as those Chinese entities listed on the US exchanges. Access to onshore markets gives an investor the ability to trade a much wider breadth of industries and over 1500 more stocks of over $6.5 trillion market capitalization[1] (some are dual listed in Hong Kong, but not fungible, leading to relative value opportunities). The offshore markets (Hong Kong has just over 1000 stocks worth just over $2.3 trillion while there are about 90 listed ADRs worth nearly $1.5 trillion[2]) are dominated by the big tech names and state owned financials. Many of the consumer and healthcare names that are potential beneficiaries of the move towards a consumer-driven economy are onshore names.

 

Figure 1

Daily Turnover – Shanghai–Hong Kong Stock Connect and Shenzhen–Hong Kong Stock Connect

Source: Bloomberg. From Nov 17 2014 to July 10 2017.

 

Figure 2

Correlations Between Global Market and Chinese Markets

Source: Bloomberg. From Nov 2014 to June 2017.

CSI300 is an index of 300 large stocks drawn from Shanghai and Shenzhen.

SHCOMP is an index of all stocks that are traded at the Shanghai Stock Exchange.

HSCEI is the major index that tracks the performance of China enterprises listed in Hong Kong in the form of H shares.

CHINEXT is a Nasdaq-style board dominated by smaller tech companies.

 

Figure 3

Performance of State and Private Companies in the Onshore Markets

Source: Bloomberg. From Nov 2014 to June 2017.

To be fair, the volumes crossing the stock connect have probably not been as robust as was hoped for at the launch, as relatively higher onshore valuations and the popularity of many of the (offshore) tech names have kept offshore investors away from onshore listed names (Figure 1).

The recent inclusion of 222 A-shares into the MSCI indices (all standard country and regional indexes, including MSCI China, MSCI AC Asia, MSCI Asia Pacific ex-Japan, MSCI EM, and MSCI All Country World), after much consultation, can be seen as a further step in the internationalisation of the Chinese domestic capital markets. Yet, so far, only 5% of the Shanghai index market capitalisation of ~$700bn is being included bringing onshore Chinese exposure to just 0.1% of the MSCI World. While the impact of this inclusion is expected to be minimal, it is likely that over time its effect will be much greater. Interestingly, with low foreign participation and high retail interest, Chinese domestic markets have historically been quite uncorrelated with global markets (Figure 2) as well as giving differing returns both intra- and inter-sector, and between private- and state-owned enterprises (Figure 3).

In fixed income, the market has been developing quickly onshore – partly as a response to the massive growth in leverage, particularly at the corporate and local government level. While issuance continues to grow, secondary trading and credit discovery are weak. At the same time as the Bond Connect launch, the PBOC announced that qualified international credit agencies will be allowed to operate in the CIBM. This should help improve pricing and align ratings with the almost $1 trillion offshore pan-Asian (including Japan) bond market – at the present time onshore paper can trade at vastly different ratings and spreads from paper issued offshore by the same company (admittedly with differing legal structures and protections). After hedging back to USD, onshore yields are at the moment not particularly attractive. Foreign participation represents just 1.2% of the overall onshore market and 4% of the China Government Bond (CGB) market – much lower than more developed peers. Assuming the global bond index providers follow MSCI’s lead, and particularly at the sovereign level, where the IMF’s Special Drawing Rights (SDR) status should lead to increased ownership, the flow of funds could be enormous. Some commentators are expecting $250-300bn in flows over the next 36 months.[3]

We are not arguing that all is rosy in China – challenges abound at both the macro and the corporate level. Government-driven intervention if problems arise is a fact of life: witness the propping up of the stock market in mid-2015 and the recent short squeezes in offshore CNH funding designed to protect the currency. A cynic might suggest with some credibility that increased access to the onshore markets helps support the fixed income markets and thus the leverage in the economy with overseas capital. Corporate governance and transparency, particularly at the local government level, can differ widely. What the increase in access does provide though, is the opportunity for investors to perhaps better understand and take advantage of the changes in the world’s second largest economy.

 

David Walter is a Director at PAAMCO and serves as Head of Research for Asia. He sits on AIMA Singapore’s executive committee.

 

 

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.

This document contains the current, good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type.  This document may contain forward-looking statements.  These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate.  Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements.  Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.

Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore, Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.

[1] Source for market capitalization: Bloomberg; Source for industry and equity list: https://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Eligiblestock.htm

[2] Source for ADR count and AUM: Bloomberg; Source for Hong Kong equity list and market capitalization: https://www.hkex.com.hk/eng/stat/statrpt/mkthl/mkthl201706.htm

[3] Morgan Stanley – “Implications of Mainland-Hong Kong Bond Connect” July 3, 2017

Co-investments: A Framework for Investors

02/01/2017

Click here for printable PDF.

Over the past several years, the use of co-investments by investors as a means to enhance returns has evolved. While once seen as a high risk/high reward, one-off venture used by aggressive investors and offered by similarly aggressive hedge funds, co-investing is now close to becoming a hedge fund strategy in its own right. However, acceptance of a strategy of seeking out single one-off opportunistic trades comes with additional risks that investors would be wise to heed. As with any market, the supply of opportunity will inevitably rise to meet the demand, meaning that if there are allocators willing to provide capital, co-investment opportunities will undoubtedly appear in an attempt to procure that capital. Managers are especially attracted to the possibility of raising capital quickly and locking it up for longer than their standard offerings. This raises the potential for a riskier overall strategy as less suitable and/or less well-thought out opportunities are marketed across the industry.

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2017 Outlook: Value in Volatility

01/01/2017

 

2016 reminded many that predicting economic and geopolitical outcomes is a difficult task. Global stock and credit markets started the year with a substantial two-month sell-off on the heels of the energy price crash. Bond yields declined and, in many markets, moved into negative territory. On the political front, a wave of populism swept the globe, starting with the Brexit vote in June and culminating with Donald J. Trump’s election in the U.S. in November.

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Hedge Fund Identity Crisis Reshapes Asset Management

01/01/2017

 

Overview

A paradigm shift within the asset management industry is at hand. Disappointing performance across both traditional and alternative investment approaches has opened the door for change. The barriers between traditional asset management and alternative asset management are rapidly blurring. New products that marry the investment goals of traditional active investment mandates with the trading strategies utilized by the best alternative managers are emerging, and institutional investors are taking notice. This innovative hybrid approach seeks to solve the return conundrum created by the low return environment brought on by years of easy monetary policy globally.

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Looking Beyond Brazil: Equity Opportunities in Latin America for Active Managers

10/24/2016

Latin American (“LatAm”) equity markets are the top performers in emerging markets this year. Brazil has been grabbing the headlines because of the ongoing political drama (i.e., the impeachment of now former President Dima Rousseff) and, of course, the Olympics. But, Brazil also carries the flag as the best performing emerging market year-to-date1 (following years of underperformance compared to broader emerging markets indices). The jury is still out on the sustainability of the rally in Brazil, however, given uncertainty around the new administration’s ability to execute promised reforms to improve the deteriorating fiscal situation. While Brazil is dominating the headlines, there are also abundant opportunities in other LatAm countries because of valuation gaps, dispersion, and fundamental drivers.

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