This year’s NCAA tournament has seen more than its fair share of upsets. For example; a #16 seed took down a #1, and a #11 seed made the final four—only the fourth time in tournament history.

These things are bound to happen, right?

As I contemplated the implications on my bracket, my mind drifted off to what this suggested about investing, particularly in the Small Cap space, and how #1 seeds (of funds) fare relative to the Russell 2000 Index.

In early February, volatility, long absent, made a comeback, as global equity markets sold off and the VIX experienced its largest one day move ever, jumping 116% on the 5th. This was prompted in part by rising inflation fears that pushed bond yields higher around the globe. With output gaps–the differences between potential GDP and actual GDP–closing in both the U.S. and globally, a host of sentiment gauges hitting multi-year highs, and unemployment rates at multi-year lows, fears of inflation are certainly justified. Add in the valuation picture, which suggests that this may be the most broadly overvalued market in history, and you’ve got a recipe for investor angst.

So, where does that leave us?

Villanova over Georgetown in 1985, Bucknell over Kansas in 2005, Middle Tennessee State over Michigan State two years ago … NCAA Tournament history is littered with unexpected upsets. It’s how March Madness got its name. If you’re trying to win a bracket challenge, we suggest you embrace the madness and try to call several upsets this year.

Over the past decade or so, the asset management and advisory businesses have become far more challenging. The forces of creative destruction have been hard at work, calling into question both the value add and fees charged by investment professionals at all levels. Further, the drumbeat of technological progress promises that investors will increasingly turn to cheap, automated solutions for their asset allocation and portfolio construction needs.

Looking to win your office’s March Madness pool this year? Nothing busts a bracket quicker than letting behavioral biases guide the selection process. Use these 10 tips to remove behavioral biases from your own picks and perhaps exploit the biases of others.

Sports are a big part of the culture at 361 Capital, such a part that, in my free time, I coach a competitive youth soccer team. As spring soccer season draws near, I am gearing up for rain-soaked practices and at least seven rescheduled games due to late snow storms here in Colorado. In preparation for the upcoming season, my soccer team participated in a pre-season tournament in Las Vegas this past weekend.

As I reflected on the event, I came to recognize the parallels between soccer (or any sport) and managing a portfolio.

February ushered in volatility like we’ve not seen in quite some time. And whether the first several days were merely a blip on an otherwise steady climb, or the signaling of a broad regime change, we don’t yet know. However, we still believe the U.S. stock market is about as broadly overvalued as it has ever been across a variety of valuation metrics. With inflation fears pushing interest rates higher, now would seem to be a highly advantageous time to shift at least a portion of long-only equity exposure to long/short equity strategies.

As I sit in the office on a Wednesday afternoon and see my phone ring only to discover it is the same person who calls me only when they want something, I politely send the call to my voicemail abyss never to be returned. Why is it that I won’t take this person’s call, but I’ll take others’ calls when I think they might want something too? It is very simple… because the others have opened their network to me in the past and I’m happy to reciprocate (this will be an important word later). But the one-sided individual who has no network, or at least has never opened it up to me in the past…? No thank you.

A long-term trend has been broken, and it has nothing to do with volatility, bull markets, nor economic cycles. In this year’s Winter Olympics, the men’s ice hockey tournament will be played with non-NHL players. The last time this occurred was the 1994 Lillehammer Games. As a fan, it is disappointing to not see the world’s best players putting their professional rivalries aside for two weeks and donning their country’s jerseys. On the other hand, it could be an opportunity to view some rising stars and unsung heroes.

Given the recent market shock, especially to those active in “volatility” markets, we thought it would be an opportune time to quickly re-visit a concept we wrote about two months ago. In that post we examined an often-overlooked cause of volatility (low or high), correlation. We showed that a large driver of low volatility in 2017 was historically low intra-market correlation. The math of volatility is quite simple; as the correlation of assets in a portfolio decrease, the ratio of average asset volatility to portfolio volatility increases. The opposite is also true, as correlations approach 1.0 the ratio of average underlying asset volatility and overall portfolio volatility will also approach 1.0, providing little to no diversification benefits.

In addition to death and taxes, investors could be forgiven for being seduced into the belief that there are two additional certainties in life: 1.) stocks will only ever go up, and 2.) the Patriots will either make it to the Super Bowl, or at least be in contention each year (they have played in the AFC Championship game in each of the last seven years). The remarkable consistency demonstrated by the Patriots is something that any active manager should envy. And believe me, on a team of quantitatively-oriented individuals, there has been much debate about the reason therefor. One of our team members (who shall remain nameless so as to protect him from internet trolls) is resolute in the belief that Tom Brady is merely “average”, and that it’s the system that makes him so good. I’ll have to use that line of thinking when his bonus is next up for debate – it’s not you, it’s our system…but I digress.

Many of you know us from our counter-trend models, which can act as a great complement to trend-following models, but this blog will be focused on trend following given the struggles they’ve had recently.

Using Société Générale’s (SG) Trend Indicator we will see if the reports of trend following being “dead” are true. The SG Trend Indicator is “designed to have a high and stable correlation to the returns of trend following CTA strategies.” They do this by “trading” a simple moving average cross-over model across 55 futures markets in the 4 major asset classes (equities, currencies, fixed income, and commodities); with equal risk across the 4 asset classes.

In a recent article, Morningstar’s Jason Kephart analyzed the performance of long/short equity mutual funds, and concluded that while many managers in the category exhibit stock-picking skill, that skill has been insufficient to make up for the fees charged by the group. Fair enough, as that has to be the case for active managers collectively, whether long-only or long/short. But what caught our eye wasn’t the conclusion, but rather the methodology employed to assess skill: multi-factor regression analysis using the Fama-French factor returns.

One common investment evaluation statistic is that of the well-known Sharpe ratio. This ratio measures an investment’s risk-adjusted return by taking the investment return less the risk-free rate and dividing that by its standard deviation. It is an important tool to help you decide if you are getting adequately compensated for the volatility you are assuming in the investment.

One thing hidden in the denominator of that equation (standard deviation) is that all deviation is not created equal. Upside deviation is a good thing, downside deviation is not—unfortunately the calculation does not take that into account. A fund with 5% upside deviation and a fund with 5% downside deviation could both have an overall standard deviation of 5%, but for my money I’d rather deviate on the upside than the downside.

Active managers are experiencing the market’s own version of a triple crown, as a triumvirate of tailwinds blow more heavily in their favor than at any point in the past several years.

In sports, the triple crown is a highly coveted and exceptionally rare feat. Only 12 horses have won racing’s version of the triple crown. Baseball players have achieved the feat (leading the league in home runs, batting average, and RBIs in the same season) only 17 times. Market statistics don’t line up quite as neatly – there’s no marking the end or beginning of a new “season” – but three factors that gauge the backdrop for active management are in leading positions not experienced in several years.

With all the talk of the current low volatility environment and a large portion of people implying mean reversion is imminent, we thought we would weigh in further on the topic. Volatility is both positively serially correlated and mean-reverting. That might seem counterintuitive, but the way we look at it is that volatility is mean-reverting within regimes and serially correlated between regimes. Even more confused? Stay with us as we dive into more detail with the hope of providing some clarification on a potentially difficult topic to grasp.

Alabama football coach Nick Saban jogged toward the locker room down 13-0 at halftime of the 2018 College Football Playoff Championships. Having previously won 5 national championships, Coach Saban had made some tough decisions in the past to lead his teams to victory. But on Monday night, the seasoned coach probably made one of the toughest decisions of his career, to replace his former SEC Offensive Player of the Year quarterback with a true freshman who had never started a college football game in his life. To him, his rationale was simple, “We knew we needed to throw the football to win the game,” and in his mind the freshman gave him the best chance to win a 6^th National Championship.

Was he nuts? Was he desperate? Had he coached one too many games?

Now that 2017 is in the books with its record-setting market highs, I’ve been asked to share my thoughts on both tax reform and 2018.

A recent article in the Financial Analysts Journal® (subscription may be required) by Feng Gu and Baruch Lev titled, “Time to Change Your Investment Model”, analyzes the effectiveness of predicting earnings surprises. That is, knowing beforehand and owning stocks that meet or beat consensus estimates and shorting those that miss. Their contention is that abnormal returns to such predictions have diminished. The authors present the case that Generally Accepted Accounting Principles (“GAAP”) measurements, particularly earnings, have become less useful to analyze individual companies. Consequently, earnings surprises are less informative than they used to be, evidenced by reduced abnormal gains. As we mention often, earnings surprises, and even more so, analyst revisions, are very important to us.

In a recent Weekly Research Briefing, I discussed holiday shopping’s positive start—particularly if you had an online presence. While Santa’s helpers get busy packing his sleigh, stats are supporting that claim as, according to a National Retail Foundation survey, 59% of consumers planned to shop online accounting for an estimated 51% of total holiday retail sales—resulting in record-highs of $5 billion in online sales on Black Friday alone.

1. You’ve contemplated buying Bitcoin in the last 7 days…

Through December 7th, the global equity markets have advanced by 20% year-to-date, as measured by the MSCI World Index, and they’ve annualized at close to 14% since the end of the Great Financial Crisis. Taking risk in all of its forms has been amply rewarded, and it’s been easy to ignore strategies that can protect on the downside, like Long/Short Equity. But looking at individual fund results for the category, we find that many long/short equity funds have performed quite well this year, with the top performers coming close to, and in some cases exceeding, the performance of long-only equity strategies. Of course, the opposite is true as well, with bottom performers not only failing to keep up, but actually turning in negative returns. We suspect that is a result of trying to time the market and swinging to a net short position.

The table below reflects an interesting analysis from JPMorgan’s head quant Marko Kolanovic. It shows how exposed different investor groups are to equities, relative to their own histories. Unfortunately, it’s not clear how far back this data goes, but there were a few comments that helped to define the time frame. For example, looking at U.S. Households, Mr. Kolanovic says that they are now in the 94th percentile in terms of total equity exposure (meaning that equity exposure has been lower 94% of the time), and that this is above the levels seen in 2007, and only slightly below those of 2000, so we know the data goes back at least to the tech bubble. In any event, the question this raises, is if all types of investors are near their maximum equity allocations, what does that mean for future demand for equities?

The world’s most widely viewed sporting event, the FIFA World Cup, reached 3.2 billion views, with one billion on the final game alone, in 2014. Dating back to 1930, it’s a time when players all over the world sport their home-country colors and multimillion-dollar TV contracts are inked (Fox acquired the $425M rights to the 350-hour programming in the U.S. for the 2018 World Cup).

We are frequently asked how investors should analyze the performance of managed futures strategies. This is quite challenging due to the diversity of the strategies employed, and the non-constant exposure, both long and short, across one or more asset classes (i.e., stocks, bonds, commodities and currencies). Because of the lack of consistent exposure, a standard benchmark like the S&P 500 Index is sub-optimal, to say the least, but there are ways to suss out a manager’s value add.

Investors, and the media alike, have been sounding the alarm about the “unprecedented” low levels of volatility that U.S. equity markets have experienced this year. Either implicitly or explicitly, the over-arching theme is that volatility is cheap, it can’t go lower and it makes no sense…so we must be on the precipice of another 2008. After all, the last time volatility was this low was 2006/2007 and since we know what happened in 2008, watch out for 2018!

While this is a bit of self-promotion, I recently wrote an article for Investment Advisor’s November issue, concerning the daunting challenge facing advisors today. That is, how to generate real returns sufficient to meet the needs of clients over the next decade or so, given stretched valuations across all major asset classes, while protecting against the inevitability of bear markets and black swans.

Our philosophy regarding equities is based in large part on the notion that prices reflect investors’ beliefs regarding expectations of future earnings. When those expectations change, prices move in response to the new sentiment. With constantly changing information, even well-informed investors face difficulties identifying the relevant signals on numerous stocks simultaneously. Another cornerstone of our philosophy is that investors rely on perceived experts when making decisions. In the case of equities, those experts are often sell-side analysts. What those analysts say about the companies they cover can significantly impact prices. Even more powerful, is what they expect in terms of future earnings. Our quantitative models rely heavily on these data points. Naturally, we care a great deal about estimate changes.

We enjoyed reading Jim Paulsen’s recent piece in Barron’s, explaining why it may be a good time for small cap stocks (which we’d encourage you to read as well). We were tempted to simply post it as validation for what we’ve been telling clients, but upon further reflection, figured it would be better to articulate why we at 361 Capital like the asset class generally, and what we believe to be the compelling merits of our approach more specifically.

Michael Santoli pointed out recently that if the current lack of volatility holds through December, the market will print a new record for the number of days without a 5% move. While it is true that on the surface the volatility of the market has been very calm, under the surface there have been several strong currents.

For much of 2017, corporate earnings and Wall Street sentiment enjoyed a happy, healthy relationship. Consider the honeymoon over. Corporate earnings trounced expectations again this quarter, but Wall Street analysts just aren’t viewing those results through the same love-struck eyes.

2017 has seen equity markets steadily moving higher, volatility remaining at historically low levels, and trend-following managed futures strategies continuing to languish. Amid this backdrop, investors naturally ask if this has created a buying opportunity, with the expectation that markets, volatility, and trend-following should revert to longer-term averages. This is a reasonable question and expectation, but what really matters is whether investors can predict when this long-awaited mean-reversion will occur. Conventional wisdom says they can’t, but according to a recent article at ValueWalk, it appears the author believes timing managed futures allocations may be possible. In a recent whitepaper, they address “some of the potential benefits, challenges and opportunity costs” seen for investors who are “seeking to time managed futures allocations.”

Over the past year, the Managed Futures category has suffered net outflows of approximately $2.8 billion, equating to roughly a 10% reduction in total AUM on a year-over-year basis, after accounting for the performance of the category. Those net outflows give Managed Futures the unenviable distinction of landing at the bottom of all of the Morningstar categories that we track, inclusive of both live and dead mutual funds and ETFs, across 8 alternative categories, 18 equity categories, 18 fixed income categories, and 1 commodity category. This may be understandable (albeit unjustifiable we’d argue) in light of the fact that with a one-year category average return of -4.7% through the end of August, only Bear Market (-24.4%) and Long Government (-5.7%) funds performed worse. Interestingly, Bear Market and Long Government funds experienced performance-adjusted net inflows equating to 18% and 5% of total assets under management, respectively, despite their performance. Hmm.

Barron’s latest cover story, Wall Street’s Real Earnings Surprises, suggests that positive earnings surprises are not being rewarded with share price jumps like they used too. It may be true that the one-day response rate has declined, but since this touches close to home, we would like to highlight how we look at this behavior and see if there is reason for caution.

Since inception of the MSCI EAFE Index at the end of 1969, U.S. stocks have outperformed in 23 of 47 calendar years on a price-return basis, or just under 50% of the time. Annualizing those returns, the U.S. has done a bit better, advancing by 7% per year vs. 6.2% for EAFE, again, on a price-return basis (selected because total return data for the EAFE only goes back to the mid 1980s). Further, since 1987 when total return data did become available for the EAFE, U.S. stocks have earned considerably more of their total return through price appreciation, and less from dividends, than have their foreign counterparts. Point being, the longer-term data based solely on price likely gives the U.S. an advantage, and even with that advantage, it’s basically been a coin flip as to whether the U.S. would outperform international stocks in any given year.

So where are we going with this? The opportunity set for equity investors continuously evolves, and we think many investors routinely miss out on the chance to earn higher returns because of the way they structure portfolios (which in turn is a function of how asset managers build and market products, but we’ll leave that alone for the time being).

One of my favorite movies as a kid was “The NeverEnding Story.”  As a nerdy book reader then (and now, for that matter), I could see myself as Bastien as he immersed himself in the land of Fantasia and Atreyu’s quest to defeat The Nothing—the threat to make everything nonexistent.

I recently watched it again and it got me thinking about what some of our advisors are currently dealing with.  We are in the eight year of an equity rally that, aside from a few hiccups, has had minimal declines (markets are supposed to have at least one 20% drawdown every four to five years, and domestically we’ve had zero since the bottom in March 2009).

It’s not enough to have a plan; you have to follow through.

Recently, I was hiking with my family in the mountains a couple of hours west of Denver. During the hike, we were crossing a stream, and in my attempt to help my daughter across, I slipped and came down hard on a pile of rocks. Upon inspection, it was only a surface-level injury, something that I could easily patch up with my first-aid kit—which was in my car about five miles away. I was prepared in that I had thought to purchase a first-aid kit, but I had failed to actually put the kit in my backpack. Preparation without full implementation isn’t particularly useful.

The topic of high valuations remain at the forefront of many investors’ minds with the cyclically adjusted P/E on U.S. stocks still just over 30 currently and having only been higher twice, in 1929 and in 2000. As one might expect, investing in expensive markets doesn’t typically have a big payoff, so when we were recently contacted by a journalist working on a story about investing in an overvalued market we were happy to share our insight. What follows are our responses to the questions posed about the role market valuation has in a portfolio.

My hometown has a locally owned pizza place that’s been a staple of the community for almost 40 years; I even worked there for a stint in college. The pizza they serve is pan style and both the dough and sauces are made fresh daily. Even the toppings are scrutinized for freshness throughout the day. The owner’s life has been dedicated to improving the customer’s experience with the quality of their product. For example, as a delivery driver I wasn’t allowed to chew gum, because “the first thing the customer should smell is our pizza, not your gum.” It’s the kind of food that transcends the body’s basic necessity of fuel and feeds your soul, makes you happy, and causes you to pause, if only for a second, to reflect on the complexity of the flavor.

This past weekend we were fortunate to be invited to participate in David Kotok’s annual fishing trip in the great northern woods of Maine. This event, organized by the co-founder of Cumberland Advisors, dates back almost 30 years, but took on special importance post 9/11. As the attendee list consisted of a collection of economists, advisors, traders, market strategists and portfolio managers, thoughtful discussions and strong opinions were plentiful, augmented by a surprise visit by Senator Susan Collins. Elements of the long weekend were covered by The Wall Street Journal, Barron’s, ETF.com, and frequent market commentator and financial advisor, Barry Ritholtz, all of which I’d encourage our readers to explore.

Total intra-market correlations within the Russell 1000 have fallen from post-crisis highs reached in 2015. As the chart below shows, correlations are now near 15-year lows, suggesting an improved environment for stock-pickers. We find this intriguing, especially in light of the money flowing out of active and into passive strategies, as high correlations have been a factor in active money managers’ challenges in beating the market.

Corporate earnings are riding a truly remarkable hot streak and Wall Street sentiment is higher than it has been in years. Suffice it to say, the bar is raised for companies reporting their next round of earnings, which began in earnest July 17.

We were recently interviewed by a reporter for US News on the topic of Managed Futures—and why investors should consider the category. Since there’s been a lot of press about Managed Futures lately, we thought it timely to address some of the most common questions asked by investors.

As pointed out in a recent article by Bloomberg, trend following funds are having a rough go of it. The article states that “…by some measures, commodity trading advisers are on track to post the worst yearly return since 1987, when data were first collected on the group.” While equities have provided some trends on which to hitch their wagons, fixed income, commodities and currencies have all been more choppy, making it difficult for managers to generate gains. This is a continuation of what we witnessed in 2016.

The first half of the year produced robust gains for the stock market, with the S&P 500 advancing by 9.3%, thanks largely to healthy corporate earnings. In fact, according to estimates from S&P, trailing 12-month GAAP earnings through June are expected to be about 21% higher than over the 12-month period ending in June of last year. However, top line growth is far less exciting – sales grew at about half the rate of earnings in Q1 – and is fighting a headwind of decelerating GDP growth, which has gone from 3.5% in 3Q16, to 2.4% in 4Q16, and to just 1.2% in 1Q17.

Further, the New York Fed’s “Nowcast” is forecasting GDP growth of 1.9% for the second quarter and 1.6% for the third quarter. This isn’t the growth profile that many expected in the early days post-election, and with the Fed poised to begin shrinking their balance sheet in the coming months, longer term rates could move higher, which may hinder growth.

Most people familiar with behavioral economics will probably have heard of Daniel Kahneman and Amos Tversky. They are pillars in the field of psychology and were even the subjects of Michael Lewis’ latest best-selling book.ⁱ Somewhat lesser known, but by no means less influential, is Herbert Simon. Last week marked what would have been the late Herbert A. Simon’s 101st birthday. Simon was a pioneer in the study of decision-making among individuals and organizations, which earned him the Nobel Prize in 1978. His research is applicable to several domains including political science, psychology, and economics.

Morningstar recently publicized plans to change the way they handle the historical track records of mutual funds that have converted from a hedge fund. Currently, they display pre-mutual fund track records with two caveats: they do not include the hedge fund track record in category percentile rankings or when calculating a fund’s “star rating”. The SEC allows fund companies to market the pre-conversion history so Morningstar has included them as well. However, the research team at Morningstar recently concluded that the SEC should change its policy. Leading the way, they will remove pre-conversion track records from their database in the third quarter.

Expectations for small cap stocks have ebbed and flowed recently, especially since the presidential election. The Russell 2000 index is up about 16% since the end of October, but only 1.0% year-to-date through May, on a price-return basis. The number of earnings-per-share (EPS) estimate revisions has been increasing since the beginning of the year. However, the number of negative revisions has also been increasing—and there have been more of them.

Call it the impact of a surprisingly strong economy. Or call it the result of a pessimistic bar set too low in the first place. But don’t call the recent strength in corporate earnings expected. In aggregate, first quarter earnings growth surpassed analyst expectations at a rate rarely seen in the past 15 years, and it may even have sparked a sentiment shift on Wall Street.*

A week ago, doom and gloom headlines abounded as the VIX Index spiked 46% and the S&P 500 Index crashed, falling a panic-inducing 1.79%! Hopefully, my sarcasm is evident, but in case it’s not – I am being sarcastic. It is always amazing to me how recent market behavior can influence our psychology, and usually not in a positive way.

So indexing is passive, aye? While we have nothing against passive investing – we don’t believe that active vs. passive is a mutually exclusive decision; there are good reasons to employ both approaches to accomplish investor goals – we can’t help wonder whether this has gotten out of hand. Thanks to the folks at Bloomberg for putting this little chart together; we had no idea the creative process had reached such extremes.

Much ink has been spilt of late ruminating on the cause of the low volatility environment in which we find ourselves. Indeed, on May 8th the VIX closed at its lowest level since December of 1993. Curious to be sure, given the laundry list of geopolitical and market related concerns facing investors. And while searching for the cause could be instructive, the fact is that volatility will not remain at these levels and investors need to prepare for a return to something resembling normality at some point in the not too distant future.

When AMD missed earnings earlier this week, the stock had a bad day losing nearly a quarter of its value. (Don’t cry for shareholders as they are still up five fold from the 2016 lows.) But there was some chuckling going on toward the largest buyer of stocks in the market, the S&P 500 Index Fund, which just recently added the stock to its portfolio on March 20th. So while the Index missed the big move in the stock for the previous year, it unfortunately did catch this week’s sharp decline. That got some in the market thinking, do the indexes tend to be top tick buyers? Given the cap weighted nature of many indexes, do they tend to buy stocks after a big increase in market cap?

A recent article on the Pensions and Investments website (Crisis Alpha Everywhere) written by Katherine Kaminsky, the Director of Investment Strategies at Campbell & Company, looked at “crises” across various assets, noting that one can usually find a crisis somewhere within the investment landscape at any given time. “Crisis” was defined by Kaminsky as the 10 worst quarters (independently viewed) for an asset between 1990 and 2016. The conclusion was that trend-following tends…

Signs of detachment from economic and market fundamentals are piling up. For one, the lack of market volatility is staggering. The S&P 500 just finished its least volatile quarter since 1968 and the NASDAQ 100 posted its most extreme percentage of positive days in a quarter since the inception of the index; it was in positive territory 71% of the days in the first quarter, something that wasn’t even achieved during the Tech Bubble.

Granted the lack of volatility doesn’t necessarily have anything to do with market fundamentals, but when paired with the following observations, it sure makes us feel uncomfortable.

Our blog post from last week, “Deconstructing Managed Futures Returns”, discussed the drivers of recent negative performance of diversified trend-following strategies, while showing their long-term effectiveness as a tool to both dampen portfolio risk and generate attractive returns. The downside of strategies that produce strong long-term performance, but deviate from equity markets, is that many investors find it hard to maintain discipline in the face of drawdowns, especially when they occur as stocks move ever higher.

The problem is universal for any strategy or asset class that is designed to have low or negative correlation to equity markets; they tend to behave differently from equity markets, which means they will often lose money or make very little during times of strong equity performance. Humans’ bias towards action leads to the much discussed “investor behavior gap” or the tendency of investors to sell an underperforming strategy and replace it with a better performing strategy at precisely the wrong time.

Is there a solution to this problem?

Those familiar with 361 Capital know that our managed futures strategies fall into a particular niche referred to as counter trend, which makes our return patterns quite distinct from more traditional trend following approaches. Nonetheless, as we work closely with many of our clients on issues relating to asset allocation and portfolio construction, we are often asked for insight on the managed futures category more broadly, more so of late because over the last few years – 2016 in particular – trend followers have struggled a bit.   

So with that in mind, we decided to dive into the trend following world and figure out what has been driving returns.

The hedge fund industry continues to battle an environment that is hostile to high fees, lock-ups, and a lack of transparency. Now, if performance were sufficiently compelling, we might have to defend our peers in the broader alternatives world, because we fully agree that there are certain strategies that don’t belong in a daily liquid vehicle. And it has been suggested by more than a few hedgies that investors can’t get what they offer in mutual fund form without giving up something. 

But the good news for mutual fund investors is that lower fees, daily liquidity and high transparency haven’t come with any discernable performance disadvantage. As can be seen from the table below, in multiple alternative categories the mutual fund peer groups have stood up nicely to their hedge fund counterparts.

According to a recent paper authored by Vanguard’s research group, U.S. investors have close to 80% of their equity exposure in U.S. stocks, even though the U.S. stock market accounts for only about 51% of the total market capitalization of global equities (data as of December 31, 2014). While there may be good reasons at times to have such a home country bias, and those reasons are explored in the paper, we question whether or not this is one of those times. In fact, by most measures, U.S. equities look expensive relative to their European and Asian counterparts, both developed and emerging, as can be seen in the following table.

Yesterday, the S&P 500 suffered its first decline in excess of 1% since October 11th. Volatility has essentially been non-existent since the election, with the VIX hovering around 12, well below its long term average of approximately 20. Investor complacency has been building, evinced in part by the record level of flows to ETFs in January and February, as those late to the party increasingly have been throwing money at the market so as not to be left further behind.

So is recent performance indicating a crack in the market’s armor?

Many investors have rules regarding the maximum weighting that their capital can comprise of a fund’s total assets. For example, if an investor wants to be no more than 50% of a fund’s assets (not including the investment to be made) then the most that investor could invest in a $100 million fund would be $50 million. One common explanation for such limitations is concerns about liquidity. If an investor is $50 million of $100 million fund and liquidates, the sale of $50 million dollars could have a negative impact. However, the same is true for a $50 million liquidation in a $1 billion fund, as a $50 million trade will have the same market impact irrespective of fund size.

With March Madness starting next week, it reminds us how coaches take a closer look at their playbooks this time of year in hopes of making it to the Big Dance. Offenses are shuffled, defenses are bolstered, and if the coach makes the right moves, the team walks away a winner.

Investors are at a similar crossroads these days. The eight-year bull market that started in 2009 has helped investor portfolios post remarkable growth—but it won’t last forever. Streaks are made to be broken and the NCAA tournament thrives on them. Almost every year a 12 seed upsets a 5 seed and there would be no March drama without upsets and a “Cinderella Story”.

It’s important then, for investors to re-examine their investment lineup and start preparing now for what will likely be a tougher game in the near future. For many, that means adopting a diversification strategy that goes beyond the standard 60/40 portfolio.

A few months ago we wrote about strategy capacity, specifically, regarding the trend-following managed futures universe. In discussing the issue, we outlined that one of the most important exercises we go through when developing a strategy is to understand the markets we will be trading, the sources and nature of liquidity, and the potential for impacting prices when we trade if we raise significant assets within the strategy. While we were speaking in terms of trend-following strategies, the same lessons can be applied across the entire investment strategy spectrum.

Our process for establishing and updating capacity for any given strategy is the following…

According to a recent survey conducted by Eaton Vance, and as reported by Financial Advisor IQ, advisors and clients have disparate views on volatility, specifically, why it matters.

“The survey also found a gap between how advisors and clients approach volatility. Among advisors, 54% say they manage and harness it, 17% want to use volatility to their advantage, and 18% just want to manage it enough to avoid losses. By contrast, 48% of clients just want to avoid losses, while only 32% want to manage volatility as well as harness it and 14% see it as an opportunity.”

While we’re not exactly certain what is meant by “harnessing” volatility, as that sounds an awful lot like one of the other potential responses – using volatility to one’s advantage – it’s clear that preventing losses is the reason that clients care about volatility, while advisors judge that to be of lesser concern.

The last decade has seen extreme fee pressure on traditional hedge funds, especially as liquid alternatives have grown, providing not only more liquidity and transparency, but typically lower fees. The standard 2 & 20 (2% management fee and 20% incentive fee) has come down for many funds. However, many investors may not be aware of so called pass-through fees, recently highlighted in a Business Insider article.

According to Morningstar, close to half a trillion dollars flowed into passive funds and ETFs in 2016. This at a time when equities are near their all-time highs statistically speaking. The chart below shows the P/E ratio for the S&P 500 as a percentile over time. What does that mean? It means that given the valuation of the market at any point, this chart explains what percentage of observations fell below that reading over the life of this measure. Take the most current observation for example. The trailing twelve month P/E based on reported earnings as of December 31, 2016 was about 23 times earnings (and this will change, as only about 59% of S&P companies have reported earnings thus far). That observation was at the 87th percentile. Therefore, 87% of all P/E observations from 1936 through 2016 fell below the current reading.

Brady or Ryan? Who to wager on in the big game on Sunday? Our partners at Analytic Investors, who sub-advise the 361 Capital Long/Short Equity Strategies, have been putting their notable quantitative skills to the test of predicting the Super Bowl winner for the past 13 years, with enviable results. Coming off last year’s correct prediction that our Denver Broncos would emerge victorious, they are now 10-3 overall.

Given Matt Ryan has never lost a Super Bowl, it seems clear that he is putting together a superior career relative to Tom Brady, who has lost not one, but two Super Bowls. As a Boston College alumni, I want to enjoy the below #AlternativeFacts, though the inference is probably flawed. (But as a lifelong 49er fan, my childhood hero was a quarterback that truly won by not losing. But I digress.) While this “fact” is amusing and purposefully misleading, there is truth in the concept of “winning by not losing.”

Since the turn of the century, markets have been tough on investors. Through December, the S&P 500 has annualized at 4.5%, or less than half of the 10.0% that large cap stocks have earned annually going back to 1925, according to Ibbotson Associates. And to earn that 4.5%, you had to work for it, staying fully invested as your capital was roughly cut in half twice. How many investors were capable of doing that, we cannot say, but we do know that many investors fled to cash and, as a result of being beaten up with such regularity, have maintained larger cash balances ever since.

The fourth quarter rally that put a capper on a fine year for U.S. equities had hardly ended when stories bemoaning the performance of long/short equity began popping up. The S&P returned almost 12% and yet funds, both ‘hedge’ and ‘mutual’, that typically carry net exposures well below 100%, inexplicably underperformed yet again. How could that be? [insert sarcastic looking emoji here]

2016 was a rather boring year for the markets. That is until the surprising November election results left Americans thinking “Now What?”

Between Congressional action and Presidential tweeting, I believe the markets will be on edge in 2017. But even in this time of uncertainty, I do see opportunities in a few major asset classes which I would easily be overweight: Financials, Energy and U.S. Small Caps. While all three assets posted large gains after the election, I still believe they have the potential for further gains. Both Financial and Energy stocks have underperformed the market for the last decade, while Small Caps have treaded water versus Large Caps over the same time frame. All three assets should outperform their peers because of corporate tax and regulation changes, while the strong U.S. dollar could especially aid Small Cap stocks.

There is a tendency in our industry to look at alternative investments as separate and distinct from traditional strategies. But at the most basic level, both alternative and traditional strategies invest in the same assets: equities, bonds, commodities and currencies. Delving a bit deeper, we find that all strategies invest in factors (knowingly or not). Factors are the basic building blocks of return streams. Whether you attribute the payoff to various factors to risk, or to market inefficiencies, value, size, momentum, quality, volatility and carry, among others, they explain a great deal about investment returns.

“And you all know, security is mortals’ chiefest enemy.” – Hecate in Macbeth

One rate hike down, but what lies in store for markets in 2017? According to a recent Natixis survey, as reported by ThinkAdvisor, many institutional investors seem to be increasingly concerned about not only the pace of rate hikes, but also geopolitical issues, and the lack of specifics regarding the yet-to-come domestic policy changes more generally. But at the present, chasing the market higher and hopefully booking solid gains into year-end seems to be the myopic focus, evinced by headlines such as “With S&P 500 Near Record, Hedging is an Afterthought for Traders” and  “By One Measure, Traders Are the Most Bullish on Stocks Since at Least 1997“.

Small Cap stocks received a nice jolt in November when unexpected election results sent the Russell 2000 Index soaring. Currently up 19.08% year-to-date,* the sector has been a beneficiary of the President-Elect’s proposed policies. While some believe this rally could fizzle, we disagree and believe it will continue into the New Year, well past the new Administration’s inauguration—and here’s why.

The recent news that Credit Suisse would be delisting two rather large ETNs, the VelocityShares 3x Inverse Crude Oil ETN (DWTI) and the VelocityShares 3x Long Crude Oil ETN (UWTI), seemed somewhat surprising. As of October 31, DWTI and UWTI had nearly $400 million and over $1 billion in assets, respectively. In fact, the DWTI delisting is the largest in history, beating out the $600 million PowerShares DB Crude Oil Double Long ETN (DXO) which closed in September 2009. Given the success in asset growth of these products, one might wonder why Credit Suisse would make such a move.

In 1962, Ed Thorp, famed hedge fund manager and mathematics professor, wrote the book Beat the Dealer in which he proved that it was mathematically possible to overcome house odds in blackjack by properly “counting cards.” Ever since then, entrepreneurial would-be gamblers have learned his and other methods to stack the odds in their favor when playing blackjack. Done properly, it is a known fact that these “gamblers” have a true statistical edge.

On October 20^th, in our blog post entitled, “Cognitive Dissonance in the Bond Market”, we asserted that investors were ignoring the growing risks in fixed income, and more or less robotically adding money to bond funds. We also Tweeted on the subject and added the hashtag #mondaymorningquarterback to stress the point about investing through the rear view mirror. To which we received a “thoughtful” reply from a fellow Tweeter:

“$TLT is +15% this year. Cry me a river, you know. Just horrible return.”

Well that was unexpected. I don’t think anyone had Hillary Clinton winning Minnesota by ONLY 1.4%, much less the GOP sweeping two branches of the U.S. Government and looking to line up the third branch (i.e., Supreme Court). So now what? What I wrote on Sunday still holds true today: “the markets like nothing more than certainty.” As it stands today, we are very far from certainty. We do not know the exact details of Donald Trump’s plans, but only his ideas and the bits and pieces we learned on the campaign trail or in his acceptance speech last night.

Given our recent discussions with advisors and the never-ending pressure to generate outsized performance across all time-frames and market environments, the results of this recent CFA Institute/State Street Center for Applied Research study are no surprise to us. Even so, it is a bit disheartening that only 28% of investment professionals said “they remain in the investment management industry for the purpose of helping clients in achieving financial goals.”

Increasingly, we’ve been thinking about the way that investors view risk in the planning stages, as opposed to how they experience risk in real time. And no surprise, there is a not-so-insignificant delta between those perspectives. The problem lies in the fact that whether running forward-looking simulations, or drawing conclusions from historical data, both the likelihood of a loss, and the size of the potential loss that an investor could experience over the full investment horizon will appear to have been underestimated when viewed on a continuous basis with hindsight.

To put it bluntly, investors are overly fond of bonds in the face of mounting risks that most acknowledge, but few seem willing to protect against. The proof is in the flows. According to Morningstar, over the first nine months of the year, investors pulled about $1.6 billion from the eight major alternative fund categories, and withdrew about $6.3 billion from the 18 major equity fund and ETF categories that we track. At the same time, they’ve added approximately $193 billion of new money into fixed income funds and ETFs. In fact, of the 18 major fixed income categories that we follow, 13 have experienced inflows this year. Investors seemingly can’t get enough of all things fixed income.  

I was recently reading an article referencing the Harvard Endowment’s 2016 fiscal year loss of $2 billion dollars. A clearly unacceptable outcome (insert sarcasm here). In light of a somewhat scathing student article from The Harvard Crimson, Isaac Presley of Cordant Wealth Partners had some great advice on how NOT to evaluate investment performance. This tends to be a topic we discuss frequently, but that is for a reason. Investor behavior regarding manager performance has been proven to have large ramifications for an investor’s long-term performance. I’ll give Isaac’s bullet points below, but go to his blog and read the details; it will be well worth your time, especially if you follow his advice.

In the current rate environment, we keep hearing arguments that low interest rates justify high stock market valuations because of the competing assets concept (i.e., the relative yields on stocks vs. bonds) and because discounting cash flows at lower rates results in higher present values. The factual nature of the math of the latter point notwithstanding, these arguments, however common, fall flat.

With the recent firing of prominent coach, Les Miles, of LSU, just 24-hours after a loss to Auburn, it reminded us how investors sometimes base their investing decisions on short-term performance. Numerous studies (e.g., Study 1, Study 2) have linked poor investor performance to short-term performance chasing. When determining whether or not to sell an investment, or fire a coach, the decision should hinge on what has changed from the original thesis that led to the hiring/investment in the first place. In this case, did the LSU athletic director believe that Coach Miles had changed his Tiger stripes, or did he make a call that Miles “just doesn’t have it any more”? We’d hazard a guess that it was the later. People love to go with their gut, to be decisive, and to act rather than analyze.

After spiking by 49% on the Brexit vote, the VIX quickly settled back down to levels not seen in over two years. But that all changed late last week, when market participants began to realize that the probability of a rate hike in the near future was much higher than previously thought. As global bond and stock markets sold off, the VIX shot up by 40% on Friday. There was seemingly nowhere to hide, as not one of the 60 or so indices that we track, covering equities, fixed income, commodities and currencies, was able to post a gain. Consider that the areas investors typically flock to in periods of stress, like Treasuries and gold, provided little comfort, as the Barclays US Treasury 20+ Year index fell 1.3% and the LBMA Gold PM price was down 0.9%. But with a new day comes yet another change in outlook, and despite the fact that Asian and European markets experienced meaningful losses overnight, US equity markets are once again up and the VIX is retreating.

All we can do is point to the research, research that shows up everywhere. Below is an excerpt from a recent paper that every investor should read, The Harm in Selecting Funds That Have Recently Outperformed.

A recent post from the Reformed Broker blog, “Volatility Drives Us Mad and Steals Our Future”, pointed out how irrational behavior during spikes in volatility drive investors to wealth stealing decisions, typically selling assets somewhere near a bottom. Josh Brown was referencing the wild volatility of August 2011, but fresher in my memory is the volatility of August 2015. During last year’s market turmoil, I reflected on the emotional impact extreme price swings create, writing about “The 5 stages of Grief… and Volatility.”

A recent article that we came across that focused on alternative investments touched on the need to educate clients on the specific strategies underlying the funds chosen for a portfolio. It alluded to the difficulty of those conversations with laypeople, and even highlighted one advisory firm that flat out said using alternatives, “…requires too much explanation to a client.” As such, that firm has opted not to use alternative strategies at all.

According to National Geographic, the “dog days of summer” has, “…nothing to do with dogs, or even with the lazy days of summer. Instead, it turns out, the dog days refer to the dog star, Sirius, and its position in the heavens. To the Greeks and Romans, the “dog days” occurred around the day when Sirius appeared to rise just before the sun, in late July. They referred to these days as the hottest time of the year, a period that could bring fever, or even catastrophe.”

As is likely the case with other liquid alts managers, we are sometimes asked the question about fee levels. Recently, we received such a question and went on to articulate what we thought was a well-reasoned position, only to receive feedback that our response was inadequate. Such feedback may be expected, so we thought we’d take another stab at addressing how to think about fees in the asset management world.

We can’t help it. Like the cat who can’t stop chasing the light from the flashlight, despite the fact that it can’t be caught, so must we comment on headlines like this, “Hennessee Group: Hedge Funds Underperform in June” even though we know it’s a futile exercise.

The Newfound Research Blog posted a great commentary on the current state of the U.S. Treasury market, showing with simple math why the strong gains being posted in the bond market this year are really being taken from future returns. They also point out the limitation of bonds to provide real protection should we face another financial crisis.

Readers of our Monthly Alternatives Briefing and this blog know that a favorite topic of ours is investor behavior, and the negative consequences that often accompany such behavior. We see detrimental signs of short termism and performance chasing everywhere we look. Case in point, a recent Fundfire article entitled “Institutions Question Wisdom of Global Diversification”. The gist of the article follows:

The Brexit induced volatility we are currently experiencing has forced the issue of volatility mitigation back to the forefront of investors’ minds.  As I think through the problem, if you have a portfolio that includes long-only equities, volatility mitigation, outside of a bond portfolio, can be done in three ways:

1. 1. Hold some long volatility strategies
2. 2. Hold significant zero correlation strategies
3. 3. Close your eyes

“High Net Worth Individuals currently hold less than one-third of their financial wealth with wealth managers” says the newly released World Wealth Report from Capgemini. The report goes on to say that one of the most unexpected trends of the last 20 years has been the “persistently high levels of cash held by HNWIs. Despite overall strong stock market performance around the globe, HNWIs have continued to hold almost a quarter of their financial wealth in cash, an allocation they perceive as necessary…to protect against market volatility.”

Meb Faber recently referenced this BNY Mellon publication regarding institutional investment in alternative assets. It certainly verified institutional investors may in fact be delusional (Meb put it a bit more colorfully) when it comes to return expectations. We thought the State Street report showing the average institutional investor’s expected return of 10.9% was a “bit” crazy.  However, the BNY Mellon report takes crazy to a whole new level; for 2015 67% of respondents expected returns of 12-18% or more with only 1% of those surveyed expecting a much more reasonable 6-8% for their hedge fund investments! Many institutional investors were certainly disappointed and based on the State Street publication’s reporting of the very short time horizon given to managers who underperform, they made portfolio changes that are likely to degrade future returns.

The impact of the highly uncertain macro environment in which we find ourselves, coupled with the near universal expectation that future returns for most asset classes will trail their long term historic averages, can be seen in the increased acceptance of alternative investments. A recent poll of 755 financial advisors, conducted by WealthManagement.com, found the following:

Why do we continuously preach the virtues of lowering portfolio volatility? Well, aside from the fact that our funds are made to do just that, consider this from the Mutual Fund Observer:

“There are funds that still haven’t recovered their October 2007 levels. We screened the MFO Premium database, looking for funds that have spent the past 101 months still mauled by the bear. We’ve found 263 funds, collectively holding $507 billion in assets, that haven’t recovered from the financial crisis. Put another way, $10,000 invested in one of these funds 3,150 days ago in October 2007 still isn’t worth $10,000.”

The hottest headlines in technology, whether it be autonomous driving, government surveillance, targeted ads on Facebook or quantitative investment strategies have been surrounding the ubiquitous idea of “machine learning” and “big data”. Many of the largest quantitative firms are spending significant amounts of their budgets and many years researching artificial intelligence and how it can be applied to financial markets. That said, there seems to be diversity of opinion regarding effectiveness and none seem ready to completely handover their processes to the artificial intelligence robots – the quintessential black box. When doing so a firm that was likely hypothesis-driven would move to being more data-driven, which can certainly have its challenges..”

It’s official. Everyone hates, or at least is falling out of love with, hedge funds. An apocalypse is coming and hedge funds are soon to be no more. Why pay 2 & 20 (by the way, very few actually pay that anymore) for an investment that doesn’t provide “returns better than the market, no matter what the market is doing.” Of course, I’m using a bit of hyperbole, but based on the headlines one might believe it’s the end of the world for hedge funds. And truthfully, in their current form, it might be. As I write this, the headlines on Bloomberg TV states that “Hedge Funds May Lose Quarter of Assets” and “Day of Reckoning Coming.”

Advisors often tell us that they invest with an income focus, reflecting the desires of their clients. But focusing on income as opposed to total return has always been a head scratcher for us, because a desired income stream can easily be manufactured with a mixture of income, dividends and sale of principal. And in the current, painfully low interest rate climate, focusing on dividends and income could end badly, as it requires investors to take on additional risks.

Are liquid alternatives the hedge fund equivalent of Uber? Some seem to think so… I can see some logic in this analogy. As the universe of quality managers expands within the mutual fund space there will be pressure on traditional hedge funds to prove their worth by delivering better returns in exchange for their higher fees and cumbersome structure. Uber is all about delivering competitive/superior service with more convenience and a better cost structure; alternative mutual funds are really attempting to provide the same, hopefully without getting banned in Austin!

REX Shares, LLC recently announced two new exchange traded fund (a long VIX fund and an inverse VIX fund) that will attempt to maintain a weighted average time to expiry in VIX futures of less than 30 days at all times.  The aim is to more closely track spot VIX, which is an un-tradeable index of implied volatilities on S&P 500 Index options. It appears the strategy will be utilizing the newly created weekly expirations for VIX index futures.

“Smart-Beta War Rages On as Cliff Asness Slams Arnott’s Paper” or so says Bloomberg. But perhaps the ideas of war and street smack downs are, dare we say, media hyperbole? AQR’s Asness claims that factors can’t be timed (mostly). Rob Arnott of Research Affiliates says certain factor valuations have become stretched. They’re both right, and the two, who have collaborated on research in the past, would probably agree with each other behind closed doors. But where’s the fun in that? Controversy brings attention, and as they say, all PR is good PR.