Downside analysis to the next level - look at partial moments for an edge

A close look at the VIX index shows a very skewed distribution as low levels push against a barrier. There is more risk that the VIX will rise versus fall. The same can be said for many other asset prices.  Normality is out; non-normality with respect to distributions is in. The value of looking beyond standard deviation is all the more important in the current environment.

These distribution tilts are all the more important impact in any discussion of asset allocation, but does not change the fact that risk management is still about the downside of any distribution. The lower partial movements can capture the deviations from normality and is a generalization of semi-variance that was discussed in a previous post, "Measuring Risk - Working Against the Downside".  The semi-variance is just the lower partial second moment, so there should be little problem looking at the lower partial moment of higher degrees like skew, the third moment. There is simplicity with semi-variance as an extension of risk measurement of the standard deviation, but the work on lower and upper partial moments is not hard to implement in a spreadsheet. 

Why not just look at volatility? Because volatility is too restrictive in a more complex price and return world where normality is the exception. The cost of skew and fat tails are real for those who ignore them. A simple example is shown with two managed futures funds and two managed futures indices. We looked at the standard deviation for each over the last three years as well as the omega, or upside versus downside returns, and the upside return versus downside risk. The fund that has the highest standard deviation or risk also has the highest upside to downside capture and the highest upside return to downside risk. The "riskiest" fund has the best upside opportunity and this applies to different threshold levels beyond zero. 

This work on partial moments can be extended to comparisons with the market portfolio. The covariance/variance (beta) of a stock to the market will be same as the conditional lower partial movement to lower partial moment of the market when the distribution is normal. If returns are not normal, there will be greater deviations between the normally calculated beta and a partial moments beta based on the distance from the average market exposure. This means that your beta measure for alternative assets which may have low market betas will have greater measurement error when there is non-normality. Your measure of risk to the market will deviate from normal beta calculations as the partial moments start to deviate from normal.

Lower partial moments like semi-variance splits the distribution between good and bad volatility as measured by a target that in most cases is set to zero or the mean return, but investors can look beyond symmetric distributions. We have found that downside risk measures relative to a target return are especially useful for pensions. Their interest are whether returns will be below their expected return not the around the average return of the manager. 

Don't be fooled by standard deviation when a little extra effort can generate useful information on downside risk. “Risky” managers, based on standard deviation, may actually be winners as measured by downside risk or lower partial moments.

Big events often capture little attention - Noble Group and credit default swap market failure

There are events that do not capture headlines but can turn into a major market catalyst. Call it the twig snapping in the savannah. One event and the herd starts to move which may begin the stampede. Recent events in the credit default swap market could be one of these catalyst events. The herd may not react right away and this could turn out to be nothing, but we believe this is the type of catalyst that can change market perceptions. 

First, a little background on the current CDS market is necessary. One of the major problems in the Great Financial Crisis was the credit default swap market which grew to a huge size but was lightly regulated. When major players were facing loses, the market moved to liquidity failure. One to the key causes for the market failure was the issue of what represented a credit default. The swap contracts were not perfectly clear on how to handle all contingencies. There was a degree of market uncertainty on what constituted a payout event. 

Moving forward in the post-crisis period, there was a change in rules with ISDA having a determination committee to decide default events. The uncertainty was supposes to be resolved and thus allow for a better functioning market. This should lead to more liquid trading and allow for better protection for those using CDS markets as a mechanism for hedging. All players could further invest in credit products and debt instruments because the credit derivatives markets offered a means of protection and liquidity.

Now we come to the Noble Group events which have been kicking around this summer. There has been a restructuring of some debt contracts given the firm's ongoing financial difficulties. Some players who own CDS on Noble Group say this is a default event which should trigger payment on the swaps. Others, on the opposite side of the trade, say this is not the case. ISDA through its determination committee is supposed to resolve this issue by being the body to decide this event. The committee has stated it cannot make the determination. There is a difference between a hard credit event like a default and restructuring which makes this tricky. Some CDS contracts make this distinction others do not. Hence, we return to pre-financial crisis bilateral behavior which is distributive for the integrity of the credit markets. 

If the structural process does not work, get out of your contracts, sell credit, and head for the sidelines. This is a serious breach of the integrity of the market. Dealers who may be hedging inventory with swaps should unload risks. Hedge funds who are speculators in this market should exit if the criteria of a credit event is in question. This sell-off does not have to be done immediately and there may be some resolution with the next ISDA determination meeting on Wednesday which could nullify some of this discussion. However, if the integrity of the process is questions, we know that liquidity will disappear when the markets are further challenged. An investor should not want to over-exposure in credit at that time.

Clear thinking requires an open mind - Why models may be better than discretion

The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he already knows, without a shadow of a doubt, what is laid before him.  - Leo Tolstoy

One of the painful things about our time is that those who feel certainty are stupid, and those with any imagination and understanding are filled with doubt and indecision.

—Bertrand Russell, The Triumph of Stupidity

"Ignorance more frequently begets confidence than does knowledge." - Charles Darwin, in The Descent of Man in 1871 

It is not in our human nature to imagine that we are wrong.

—Kathryn Schulz

The scourge of the finance MBA is that you become wedded to old ways of thinking which just may not be true given the evidence. The certain with what you think is true leads to a decision trap that cannot be exited. 

The illusion of superiority and control is the key behavioral battle between discretionary and systematic investing. The discretionary manager will have the illusion of control and the overconfidence not to see changes in market structure or behavior. Smart people have a hard time admitting they are wrong. The systematic manager, when allowing for updating and adjustment, will adapt to changes in the market as factor sensitivities change. There is no ego involved with the adjustment of parameters. An optimization is not married to a way of thinking. It can be tied to minimizing errors. 

Follow models with updates as new data become available and leave the overconfidence from what was learned in the past behind.

We will get volatility wrong at transition periods - Need to prepare before the event

A provocative chart from the research piece The Volatility Paradox: Tranquil Markets May Harbor Hidden Risks by the Office of Financial Research Markets Monitor shows the poor forecasting of volatility when there is a regime change. Of course, tranquil markets harbor hidden risks. Low volatility is pricing in a lack of imagination of what the future may hold. The markets usually say that tomorrow's change will be represented by the deviations of yesterday. We have learned from reading Minsky that low volatility will lead to risk-seeking behavior as investors reach for yield, employ leverage, and become complacent. Hence, a shift in regime will lead to more dramatic change in volatility.

Nevertheless, the most telling part of this chart is that when the big transitions come, the VIX index will not fully anticipate the move and realized volatility will move faster than the market's ability to discount regime change.  When market volatility reverses, the move is swift, so asset allocation for these types of events have to be structured today and not when the event is occurring. The cost for preparing a defensive diversified portfolio is the potential performance drag waiting for a big market reversal. 

Carry and trend complements - Blend premiums

Momentum works, whether structured as a times series or a cross-sectional strategy, across many asset classes. Carry strategies or risk premiums also work across a wide set of asset classes. More importantly, we know when these strategies do not work, or we at least know what are times to avoid. Also, when trend-following (time series momentum) does best, carry will likely under-perform and when carry is doing well, trend strategies are likely to under-perform. These are statistical relationships, but there are good narratives for why these two strategies are complements.

Trend-following can be described as divergent trading. It will make money when there are market dislocations away from equilibrium prices. Trends occur when there are transitions between regime, states of riskiness, or changes in fundamentals. Given these divergences are not immediate, prices may react slowly over time which allow for the identification of trends. A dislocation or divergence in any asset class will likely lead to exploitable trends by long/short CTA’s. Carry can be described as a convergent strategy or one based on market stability. You earn a carry premium because markets are stable, or you may earn more carry premium when markets have dislocated and are now moving back to equilibrium. Because each strategy or premium will do well in different environments, they are complementary when building a diversified portfolio.

The question is how to access each in the most effective manner. We can suggest one simple alternative. Buy the carry risk premium through a low cost total return swap exploiting carry through some simple rules or a lower cost manager who offers the pure beta of the premium and buy the momentum or trend-following through a skilled manager who can control the sizing of positions and downside risk. 


In a portfolio, the trend-carry combination can be structured around a simple weighting scheme and rebalancing or a switching mechanism with dynamic adjustments. In a switching model, carry is held or is “on” until there is a risk transition at which time it is turned “off” and requires an exit or switch into greater exposure to the trend model. Research has shown that carry will underperform when the market switches to investor risk-off mode. The excess returns for carry may be associated with the same direction as market risk. Similarly, when markets are in risk-on mode and more stable or trendless, there is a switch away from trend and into carry strategies.

Momentum strategies are known to have crash risk, but it can be managed through position sizing as well as entry and exit signaling. Given the wide variety of markets to be traded, timing of trends, and sizing of positions, trend-following risk can be better managed than a carry trade which is often more focused with a limited set of markets.

Previously, there was a focus on identifying alternative risk premiums, but now the state of the art is the blending of risk premiums and attempting to dynamically adjust these premiums. As our understanding concerning the differences between carry and trend has increased, our ability to blend these premiums has improved. This improvement allows investors to find mixes of risk premiums that provide better long-term return to risk blends.

Risk premium and betas - What do you get from quant managers

Interest concerning alternative risk premiums has surged over the last few years. With this increased interest there has been questions with how to best access these premiums under real market conditions and not just measure them through existing asset classes. Investors want to know how to operationalize the theory and research.

Risk premiums can be obtained directly through two alternatives: access through total return swaps from banks or access through systematic quant managers who construct risk premium strategies. The choice between swaps as pure beta products and risk premiums embedded in quant hedge funds can be broken into a number of value propositions. This decomposition can make it clearer for investors to determine which is the best method for access.

This discussion between a risk premium “beta” swap and the management of risk premium is a variation on the passive and active debate, or variation of the beta and alpha production debate. The swap is completely rules-based and is passive in the sense there is no intervention beyond the rules specified in the term sheet. The swap is also usually viewed as a pure beta expression of the risk premium. The quant manager delivers the risk premium through their model and rules which may include adjustments based on their specific skills as related to the strategy theme. Investors will get some form of the risk premium beta as well as the other activities of the manager.

Using total return swaps has the advantage that they will be the cheapest means of accessing risk premium betas. It is usually priced as just basis points on the notional value with a minimum of margin. What you get is a vanilla rules-based system to access the risk premium beta. An investor can buy a basket of different risk premiums with the exposure weights of their choosing.

The manager who runs an alternative risk premium fund will likely be more expensive than any basket of total return swaps, and the manager chooses the weights on the basket not the investor. The fund product means that the hedge manager controls the mix and sizing of premiums, the entry and exit of any swaps or constructed trades, and the generation of any alpha. The extra expense is associated with the delegated monitoring and management of the set of risk premiums associated with the fund.

A quant manager provides a number of services through their management of a bundle of alternative risk premium. The investor has to determine the value of the set of manager services and whether the extra cost is worth the benefit of having someone manage the bundle.

The services provided by the manager include:

1. The blend of betas - what are the risk premiums that the manager finds that test well? What is the size of exposures to each of these risk premiums?

2. The adjustment of the betas - How or when should these risk premium betas be adjusted? This could be, at one extreme, just a form of rebalancing versus adjustments based on a dynamic set of factors. For example, carry could be increased or decreased based on whether the market is in a risk-on or risk-off environment.

3. The manager’s trading skill - Once an adjustment decision is made, there is still an issue of trading in or out of the premium. The risk premium could be in the form of a swap or it could be constructed in the futures and options markets where the parts have to be disassembled.

4. The manager’s risk management process - Along with rebalancing and dynamic adjustment, the risk premium portfolio has to be monitored and possibly adjusted based on the risks faced. This risk management could be through volatility adjustments, sizing, or stop-loss.

5. The manager skill - All risk premiums are not constructed the same. Someone may want carry or momentum premiums, but there are literally hundreds of ways to access these premiums based on the markets to be traded, sizing, and environmental triggers. The difference between the investment approach used by the manager and some generic swap version is the manager's alpha.

The investor has a choice of buying the risk premiums in some generic form, or he can find a manager who can mix the ingredients. It is the difference between cooking your meal at home of paying for a chef to prepare a meal for you. Paying extra for the chef is a function of what the chef can do to better bundle the ingredients. As more investors show interest in alternative risk premium and as banks and managers develop more alternative risk premium products, the decomposition of alpha and beta becomes more important.