Clients & Friends –
“We were wrong” is a phrase that largely goes unuttered in our industry. I suspect that ego has some hand in this (as well as compliance and legal departments), but the phrase does not exactly inspire great confidence among investors.
In the past I’ve argued that asset management is a business in which hubris sells but humility survives. Yet short-term performance chasing invites a behavioral version of Gresham’s law where “bad behavior drives out good” and managers are incentivized to market with bravado.
Without projecting enough confidence, an asset manager may not survive long enough for humility to triumph. And wrong does not project confidence.
What do you do, then, when the research you conduct suggests that the efficacy of the very systematic style you’ve built your firm upon may be reduced going forward?
* * * * * * *
For the last several years, clients have expressed a feeling that markets had changed, but were largely unable to express precisely how other than the feeling that “things were weird.” Quantitatively, we could not identify statistical evidence that index-level performance was abnormal. Qualitatively, we believed that while markets are always changing, it does not imply that the fundamental tenets by which you invest should necessarily change.
March 2020 challenged that position. While headlines largely focused on the economic impact of the Coronavirus, much of the market turmoil itself appeared endogenous. We watched as cross-asset correlations spiked, Treasury market depth plummeted, currency pairs crashed, short-volatility funds collapsed, mutual fund and ETF returns for identical baskets diverged, central banks intervened, and the phrase “unprecedented” became common. We even started our own Ripley’s Believe It or Not collection of market absurdities.
Most importantly, the experience demanded that we re-evaluate our understanding of modern markets.
* * * * * * *
In September, we published our latest white paper: Liquidity Cascades: The Coordinated Risk of Uncoordinated Market Participants. The paper is the culmination of several months of research into existing narratives explaining the “weird” market behavior. Specifically, we explored: (1) the influence of central bank policy and narrative economics, (2) the growing role of indexed and passive investments, and (3) the liquidity mismatch between high frequency traders and volatility-contingent strategies.
We walked away from the research unconvinced that any one narrative was necessarily sufficient to justify the market behavior we had experienced. As partial contributors, however, their cumulative impact invites a convincing explanation. In fact, these forces may operate in a manner where the sum of the parts is greater than the whole, creating conditional influences that push the market into an increasingly fragile state until an exogenous shock forces a large unwind.
Our attempt to make sense of these forces coalesced into a visual we call the Market Incentive Loop (see top of next page).
The Loop has no clear beginning or end, though, one might argue it was started with central bank intervention in the late 1990s and was accelerated by the 2008 credit crisis. The simple explanation is:
- Central bank policy and narrative economics push investors up the risk curve in pursuit of yield and return.
- Performance, fees, regulatory pressures, demographics, and industry trends have pushed investors increasingly towards indexed and passive investments. Flows from this shift lean into a potentially crowded and de-stabilizing momentum trade. From a micro perspective, this move also increases the amount of basket trading, potentially reducing price discovery efficiency in individual securities and reducing order book friction from lack of depth.
- In stressed market environments, high frequency traders reduce the liquidity they provide (due to both internal risk limits and capital constraints). Simultaneously, a growing scope of volatility-contingent strategies (such as structured products, risk parity, CTAs, and variable annuities) demand significant liquidity in order to de-risk their positions, creating further instability.
- Central bank intervention is necessary to re-establish liquidity and stability, starting the cycle anew.
Did March 2020 serve to accelerate or decelerate this trend?
In the short term, it seems unlikely that another March 2020 will occur – or, at least, with the same velocity and magnitude – as many volatility-contingent strategies remain meaningfully de-levered. This suggests that these products would contribute significantly less negative flow pressures during a downturn than they did in March.
Yet, with 10-year U.S. Treasury rates near 0.7%, many investors are questioning the long-term forward role of fixed income within their portfolios. An informal poll I conducted suggests that rather than simply living with reduced return expectations, many investors are looking for ways to “safely” climb the risk curve, potentially leading to increasing flows in volatility-contingent strategies. With the passage of time, markets could easily find themselves in an increasingly fragile state, where risk is pushed and hidden in the left tail only to manifest when catalyzed by an exogenous event.
With central bank policies supporting a “lower for longer” narrative, investors being pushed further up the risk curve, an increasing transition into indexed and passive strategies, and continued adoption of volatility-contingent strategies, we believe that the regime of liquidity cascades will continue to persist into the foreseeable future. At the very least, until these facts materially change.
* * * * * * *
As long-time proponents of trend following, this research suggests we were wrong, or at the very least, the circumstantial evidence supporting this narrative suggests it. And by wrong we do not mean, “the market path that occurred from 2010 to 2020 is but a single realization of a large number of possible realizations and we just got unlucky.” Rather, it suggests that the very distribution defining how market returns materialize has slowly, but fundamentally, changed over the last decade.
And therein lies the problem.
On the one hand, we have the mathematical foundations and decades of empirical evidence supporting the inclusion of thoughtfully designed trend following mandates within almost any asset allocation. On the other hand, a collection of short-term, circumstantial evidence suggesting that this time really is different (at least, for now). When does the breadth of contemporary evidence supersede the depth of historical data?
* * * * * * *
A long-standing, core philosophy of our firm is that risk cannot be destroyed, only transformed. In order to build more resilient portfolios, we advocate that investors diversify across the axes of what (asset and security diversification), how (style and process diversification), and when (rebalance timing diversification).
For the last twelve years, our research and investment mandates have largely focused on the application of trend following techniques. Our belief was, and remains, that trend following introduces mechanical convexity that can help further diversify risk management within a traditionally allocated portfolio. Why this style commands a premium is predicated upon the idea that in significant economic and market contractions, trends emerge due to fractal, cascading effects that create forced asset sellers.
Trend following is certainly not the only way by which investors can, or should, seek to manage risk. We have encouraged investors to diversify their diversifiers, adopting a multi-manager and multi-process approach that incorporates core fixed income, alternatives, and explicit tail hedges where appropriate.
Nevertheless, our experience has led us to two conclusions. First, while allocators and investors seek to build thoughtful, cohesive portfolios through a combination of investments, they also suffer from “line item” risk. This risk often goes hand-in-hand with hindsight bias, whereby a portfolio is designed to be robust to the many possible, unknown future regimes, but components of the portfolio are scrutinized based upon the single, realized path. With a U.S.-centric 60/40 portfolio posting one of the best realized Sharpe ratios ever over the last decade, this has made it increasingly difficult to defend diversifying styles.
Equally as important is our second conclusion: our research on liquidity cascades suggests an increased probability of rapid market melt-downs and melt-ups. It is our responsibility, as asset managers, to interpret this data as objectively as possible, regardless of existing mandates we manage, and adjust course accordingly.
In light of these conclusions, we went back to the drawing board to ask, “what does a modern, resilient equity strategy look like?” Our approach was to consider the different regimes of equity returns and consider the strategies that may be effective within those regimes.
- Extreme left and right tails may be best hedged using instruments offering convex payoffs, such as a simple ladder of out-of-the-money put and call options.
- In more moderated, positive return environments – especially those tied to economic expansion – momentum tilts may be an effective means for exploiting investor under-reaction and eventual over-reaction to growth and investor confidence.
- In early contractions, quality tilts may provide a relative buffer as investors flee towards companies with stronger balance sheets.
- For more prolonged drawdowns – those that are a function of economic gravity – trend following may still provide a means by which a portfolio can systematically reduce exposure.
- Finally, regardless of market environment, we believe that U.S. Treasuries will continue to serve as a diversifier to equity market returns and can remain valuable if implemented in a capital efficient manner.
To translate these ideas into a portfolio, we bucketed these concepts into three regimes: prolonged declines (e.g. 2000 or 2008), melt-down markets (e.g. September 2008, Q4 2018, or March 2020), and melt-up markets (e.g. 2013, 2017, or 2019). Without a strong conviction as to which market environment is coming next, we would seek to strategically allocate (in a risk-budgeted manner) across all three equally.
The core idea of this all-weather equity approach harkens back to the notion of proactively diversifying our diversifiers. Within we find exposure to fixed income, trend following, stylistic tilts, and explicit left- and right-tail hedges. We find this approach particularly appealing because its core thesis is diversification. Even if the evidence supporting the liquidity cascades narrative proves to be false, we believe the building blocks of this portfolio still lay the foundation for a resilient equity solution.
There are, of course, potential tactical enhancements to consider that will serve as the basis for further research. For example, the conditional probability of going into a melt-down state after just experiencing a significant melt-down state is greatly reduced, as many investors will have already de-levered and introduced hedges, reducing the magnitude of forced selling. Whether a melt-down rebounds and turns into a melt-up (e.g. Q2 and Q3 2020) or whether it continues into a prolonged decline (Q4 2008) is unknown. Therefore, it may be prudent to reduce an allocation to the melt-down sleeve and increase allocations to both the melt-up and prolonged decline sleeves.
Incorporating these sleeve transition dynamics may be accomplished by modeling the current holdings of large volatility-contingent parties (e.g. option dealers, structured product desks, CTAs, risk parity strategies, and variable annuity indices) and estimating how these positions may change given different market movements.
* * * * * * *
In light of this research, we will be making several important changes to our investment mandates in Q4 2020.
- We will be sun-setting our Risk Managed Small-Cap Sectors and Risk Managed Global Sectors mandates=.
- The Risk Managed U.S. Sectors and S. Factor Defensive Equity mandates will be merged into a new Resilient U.S. Equity mandate.
- The new Resilient U.S. Equity mandate will reflect the ideas of the all-weather equity portfolio outlined above and will be available in both separate account and mutual fund vehicles.
- Our Multi-Asset Income mandate will undergo similar changes, seeking to strike a more consistent balance between structural diversification, trend following, and convex hedges.
- Core trend equity exposure will still be available via the Newfound/ReSolve Robust Equity Momentum Index (and any products or funds that track it).
Further details on the specifics, as well as timing, of all these changes will be made available to current clients.
We appreciate the trust you place in having Newfound Research oversee your capital; helping to manage these assets is a responsibility we do not take lightly. We firmly believe that the changes we have outlined will provide our strategies the best opportunity to meet their objectives going forward, seeking to capture a significant portion of market growth while reducing the impact of severe and prolonged market declines.