“The negative gap between investor returns and fund returns is the biggest failure in investment management. Alpha is only a sideshow.”
-John West, Jason Hsu
John West & Jason Hsu of Research Affiliates just published a topical piece called, The Biggest Failure in Investment Management: How Smart Beta Can Make It Better or Worse.
It’s easy to find online, but there are numerous data-driven examples of how realized returns to investors greatly undershoot the time-weighted returns shown in fund strategy marketing materials because of performance chasing.
The paper argues the recent explosion in “factor exposure” commoditization is extremely dangerous because investors don’t truly understand or embrace the high tracking error associated with many pure strategies. Instead, investors navel gaze at the annualized excess returns in the realized or simulated return data.
To summarize one of the timeless takeaways in my own words… More tools, technology, and investing vehicles haven’t changed the fact that the percentage of investors that can sit still in different volatility environments remains small.
Back to the Global Macro Grind…
We’ve pounded the table daily on our recent, Big-Macro pivots. The Chart of the Day helps us reiterate the data-driven view that the most powerful force driving the current macro environment is about the race to lower portfolio volatility and “growth”, “value”, or “sector” rotation are ensuing implications.
More specifically, the Chart of the Day shows the YTD pain associated with factor exposure whip around, particularly if you were blindsided by the introduction of volatility…
As one of our astute clients who is active in the space originally pointed out, the explosion in systematic factor investing has led to an environment (since around 2013) where growth/value/momentum are all now higher beta simultaneously. This fact is why we believe understanding different volatility regimes is more important than ever. Multiple factor exposures can be equally painful at the same time.
If you only own “value” and “momentum” because history and marketing materials show uncorrelated excess returns over the long haul, higher-beta constructions have been extremely painful with the recent pick-up in volatility…
Aside from our own views which you hear a lot of, we’ll finish off with some objective “Where We Are” call-outs to contextualize the fact that domestic, Large-Cap Growth Exposures are where we see the most notable hedging demand in global macro:
- Capitalization Reversal: The Russell 2000 Index may be -12.1% from its YTD high on 08/31, but “growth” index volatility in the Russell 1000 is trending much higher relative to long-term history than Russell 2000 “growth” Index volatility. Large-Cap Growth is where we see the most demand for hedging.
- Broad Volatility Expectations: The Nasdaq 100 Volatility Index (VXN) has repriced to trade with the highest 10Yr percentile reading across a diverse group of Global Equity and FICC Volatility Indices (89th percentile)
- Magnitude of Index Hedging: Investors who used Wednesday’s bloodbath to add Long Exposure in Mega-Cap Growth now have to pay significantly more to hedge after Google and Amazon reported last night. To put this in perspective outside of options lingo, the price of downside protection in QQQ 1 & 2 months forward ended yesterday evening being quoted 2x wide of equivalent upside bets. In other words, you pay 2x for downside protection relative to the equivalent upside calls (major tail risk blow-out in deep and liquid markets).
- Global Macro Context on Hedging Costs: Of our universe of 125 tickers where we track volatility trends globally, the major U.S. equity indices have seen the largest surge in front-month put implied volatility at-the-money which is evidence of capitulation. The pocket of global macro that now has the most expensive hedging costs is , again, in Large-Cap Domestic Equities
- Directional Tilt in Options Markets: Not only has implied volatility at the money surged on U.S. Indices (QQQ in particular), skew has steepened drastically (More bearish) to where QQQ and SPY skew pricing has the #1 & #2 highest Z-Score factors in our global macro universe. Implied Volatility in QQQ that trades in the 93rd percentile on a 10YR window with volatility skew readings that register 6-9x Z-Scores is extremely rare.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 3.02-3.22% (bullish)
SPX 2 (bearish)
RUT 1 (bearish)
NASDAQ 7012-7482 (bearish)
Utilities (XLU) 52.60-55.50 (bullish)
REITS (VNQ) 76.01-78.99 (neutral)
Industrials (XLI) 68.71-73.07 (bearish)
Shanghai Comp 2 (bearish)
Nikkei 21103-22807 (bearish)
DAX 109 (bearish)
VIX 17.30-26.96 (bullish)
USD 94.55-96.45 (bullish)
EUR/USD 1.13-1.15 (bearish)
YEN 111.61-113.52 (bearish)
GBP/USD 1.29-1.32 (bearish)
Oil (WTI) 65.22-70.38 (bearish)
Nat Gas 3.11-3.31 (bullish)
Gold 1 (neutral)
Copper 2.71-2.81 (bearish)
Corn 3.60-3.75 (bearish)
Have a great weekend.
Ben Ryan
Macro analyst
