The mighty “long-long” trade

July 13, 2019

One of the most successful investment strategies since the turn of the century has been the risk-parity “long-long” of combined equity, credit and duration derivatives. In a simple form this trade takes continuous joint equal mark-to-market exposure in equity or credit and duration risk. A simple passive portfolio in the G3 would have outmatched most macro hedge funds since 2000, with a Sharpe ratio well above one and not a single annual drawdown. There have been three apparent contributors to this success: undiversifiable risk premia, implicit subsidies paid by central banks, and great diversification benefits from negative return correlations. These forces remain largely in place, but setback risks bear careful watching: excessive leverage in duration exposure, exhaustion of downside scope for yields, attempts of monetary policy normalization, and the possibility of a fundamental shift in macroeconomic policy regimes.

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The rise in risk spreads

July 6, 2019

A risk spread is a premium for bearing economic risk of an investment, paid over and above the short-term real interest rate. Over the past 30 years, risk spreads in the U.S. have increased significantly and consistently: while real interest rates on ‘safe’ bonds and deposits have collapsed, returns on private capital have remained roughly stable. Macroeconomic research suggests that this secular rise in risk spreads owes mainly to higher risk premia charged by financial markets and higher monopolistic rents extracted by companies. The strategic implication for rational investors would be to receive risk spreads, since they seem to pay an elevated reward for bearing economic uncertainty that is augmented by payoffs for the market power of companies.

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Bad and good beta in FX strategies

June 29, 2019

Bad beta means market exposure that is expensive to hedge. Good beta is market exposure that is cheap to hedge. Distinguishing between these is crucial for FX trading strategies. The market sensitivity of FX positions can be decomposed into a risk premium beta (‘bad beta’) and a real rate beta (‘good beta’). FX positions with risk premium betas are associated with a positive price of risk that increases in crisis periods. FX positions with real rate beta are hedges, whose value increases in crisis times. Many conventional currency trading strategies carry either excessive ‘bad beta’ or too little ‘good beta’ and, thus, fail to produce true investor value.

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Active fund risk premia in emerging markets

June 22, 2019

Security returns, adjusted for market risk, contain risk premia that compensate for the exposure to active fund risk. The active fund risk premium of a security can be modeled as the product of its beta premium sensitivity and price for exposure to active fund risk. Both components change overtime and mutually reinforce each other in episodes of negative fund returns and asset outflows. This explains why securities with high exposure to active fund risk command high expected returns. Active fund risk premia are particularly prevalent in local EM bond markets, where on average 20% of securities are held by foreign institutional investors, many of which are sensitive to drawdowns. Empirical evidence confirms that bonds whose returns positively correlate with active fund returns command substantial premia. The highest premia and expected returns would be offered at times of large capital outflows.

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Natural language processing for financial markets

June 15, 2019

News and comments are major drivers for asset prices, maybe more so than conventional price and economic data. Yet it is impossible for any financial professional to read and analyse the vast and growing flow of written information. This is becoming the domain of natural language processing; a technology that supports the quantitative evaluation of humans’ natural language. It delivers textual information in a structured form that makes it usable for financial market analysis. A range of useful tools is now available for extracting and analysing financial news and comments. Examples of application include machine-readable Bloomberg news, news analytics and market sentiment metrics by Refinitiv, and the Federal Reserve communication score by Cuemacro.

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A theory of hedge fund runs

June 8, 2019

Hedge funds’ capital structure is vulnerable to market shocks because most of them offer high liquidity to loss-sensitive investors. Moreover, hedge fund managers form expectations about each other based on market prices and investor flows. When industry-wide position liquidations become a distinct risk they will want to exit early, in order to mitigate losses. Under these conditions, market runs arise from fear of runs, not necessarily because of fundamental risk shocks. This is a major source of “endogenous market risk” to popular investment strategies and subsequent price distortions in financial markets, leading to both setbacks and opportunities in arbitrage and relative value trading.

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Market noise

June 1, 2019

The term “market noise” refers to transactions that are erratic and unrelated to fundamental value. Theory suggests that without market noise profitable trading would be impossible. Yet, while irrational and erratic trading may occur, most of what we call “noise” reflects rationality disguised by complexity. Illustrating that point, a new paper shows that the effect of rebalancing cascades on the net demand for individual assets is not predictable, even if we know everything about the underlying rules and if they are fully rational. Predictions become infeasible because of alternating buy and sell orders, feedback loops and threshold-based execution rules. This cautions against dismissing seemingly non-fundamental market flows as irrational and betting against them.

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U.S. Treasuries: decomposing the yield curve and predicting returns

May 25, 2019

A new paper proposes to decompose the U.S. government bond yield curve by applying a ‘bootstrapping method’ that resamples observed return differences across maturities. The advantage of this method over the classical principal components approach would be greater robustness to misspecification of the underlying factor model. Hence, the method should be suitable for bond return predictions under model uncertainty. Empirical findings based on this method suggest that equity tail risk (options skew) and economic growth surveys are significant predictors of returns of government bonds with shorter maturities.

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How central banks can take nominal rates deeply negative

May 18, 2019

The popular view that nominal interest rates have a natural zero lower bound has become obsolete in modern financial systems. It may be more appropriate to consider this boundary a convenient policy choice that can be revised. Technically, the zero lower bound arises from potential arbitrage at negative nominal rates, in the form of cash withdrawal, storage and redeposit. However, the central bank can break this arbitrage by using its power at the cash window, i.e. by altering the conditions at which commercial banks can withdraw and redeposit paper money. There are two viable options for doing so. The so-called ‘clean approach’ creates a crawling exchange rate between paper money and electronic money, effectively devaluing the former relative to the latter at a predictable continuous rate. The so-called ‘rental fee approach’ charges commercial banks for using paper money and is equivalent to imposing negative rates on cash held by the private sector.

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Systematic trading strategies: fooled by live records

May 11, 2019

Allocators to systematic strategies usually trust live records far more than backtests. Given the moral hazard issues of backtesting in the financial industry, this is understandable (view post here). Unfortunately, for many systematic strategies live records can be even more misleading. First, the survivor bias in published live records is worsening as the business has entered the age of mass production. Second, pronounced seasonality is a natural feature of many single-principle trading strategies. This means that even multi-year live records have very wide standard deviations across time depending on the conditions for the strategy principle. If one relies upon a few years’ of live PnL the probability of investing in a losing strategy or discarding a strong long-term value generator is disturbingly high. This suggests that the use of live record as allocation criterion, without sound theoretical reasoning and backtesting, can be highly inefficient.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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