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Alpha Theory Blog - News and Insights

3 posts categorized "Benn Dunn"

August 17, 2018

Signs of Seasonality

 

One of the members of our Customer Success team was wondering about the difficulty of getting client attention at the end of August. We ran an analysis to try and answer the question, “how active are our clients by month?” We used price target updates, logins, and trades per month as a proxy for investor activity.

 

Signs of seasonality1

 

August was definitely the softest month, but clients weren’t as “checked out” as we expected. We hypothesized that the peak periods would be during earnings season and troughs will be after earnings. Here’s the rub, they’re in the same month. The end of second-quarter earnings season and the before school vacation season are in the same month.

 

To remedy this fact, we created periods starting on the 15th of each month (i.e. August 15th to September 15th). This allows us to catch each earnings season as its own isolated period. Here are the results:

 

Signs of seasonality2(final)

 

There is clear seasonality. The post Q2 earnings season is 2.5 standard deviations from the norm. I suspect that if we broke this down into two-week tranches, we would have seen even more pronounced deviation from August 15th to August 31st.

 

As expected, the Post Earnings Season cohort’s activity was light at 0.7 standard deviations below normal activity, while the During Earnings cohort was busy (+0.8).

 

One of my favorite parts of working at Alpha Theory is that we have a long series of robust, structured data that allows us to ask and answer interesting questions. If you would like to be able to do the same, the first step is collecting and maintaining well-structured data. Then you can ask interesting questions like “what season do we make our most money?”, “who is the best forecaster on my team?”, “how often do stocks go below our risk targets?”, etc.

 

If you would like to learn more about how we can help. Contact us at

 

(866)-482-2177  

sales@alphatheory.com  

 

April 06, 2018

Positive Skew is Negative for Active Managers

 

Let’s play a game. In this game, there are 10 random poker chips in a bag. 9 of these chips will give you a return between -8% and +8% on the money that you bet. The 10th coin will give you a 100% return. The distribution of returns for this game has a positive skew.

 

Screen Shot 2018-04-06 at 9.29.11 AM
 

If offered to put money down on this proposition you would take it because you would expect a 10% return if you could play the game over and over.

 

Now let’s add a wrinkle. Your goal isn’t just to make a positive return, you have to beat the bag. The bag puts 10% of their money on each chip and pulls them all. Voila, a 10% return. One last wrinkle, you can only pick one chip at a time.

 

How many times out of 10 would you beat the bag? Only 1 in 10. 90% of the time you would lose to the bag. It doesn’t matter if we expand the number of chips as long as the bag maintains the same positive skew (we could increase the to 100 chips and you get to pick 10, 100 chips and you pick 1000, etc.)

 

By now, you’ve probably guessed that the bag is the market, the chips are stocks, and you are, well, you. This is the game we play when trying to beat an index. True, you can be better than the market at figuring out the good chips but given that initial conditions for a random game means you lose 9 out of 10 times, it’s really hard to beat the market. Add fees and the likelihood of beating the market goes down even further.

 

Positive Skewness has gotten a decent amount of press over the past year because of the championing of JB Heaton who wrote a paper1 researching the impacts of positive skew on manager underperformance. Heaton’s paper is similar to research from Dr. Richard Shockley in 19982. See below for an article written by Bloomberg News on the topic.

 

Picture1

Source: Bloomberg News (“Lopsided Stocks and the Math Explaining Active Manager Futility” by Oliver Renick)

 

Given that many of the conversations active managers have today revolve around active versus passive, “positive skew” should be top of mind. This is my push to increase awareness.

 

Given that active managers can’t change market skew, what should we do? We could measure skill in a different way. Let’s say I want to measure a manager skill. If I take all of the stocks of the markets they’re investing in and then randomly build 100,000 portfolios with the same number of securities as the manager. I can then plot where that manager falls on the distribution and give them a Z-Score for how far away from the norm they are. I could do the same thing for hedge funds by randomly buying and selling securities in the same universe as the investor.

 

I’m not saying that this excuses active managers from underperforming passive strategies, but it should at least be a more realistic assessment of their skill. My hope is that positive skew becomes just as common an explanation as fees when discussing active manager underperformance. Only by knowing the causes, will we be able to make changes that allow active managers to outperform.

 

 “Why Indexing Works” by JB Heaton, Nicholas Polson, and Jan Witte

2  “Why Active Managers Underperform the S&P 500: The Impact of Size and Skewness” published in the inaugural issue of the Journal of Private Portfolio Management. One of the original authors of the study is Richard Shockley.

Related paper: “Do stocks outperform treasury bills?” Hendrik Bessembinder of Arizona State University

 

March 21, 2016

Ruminations on Risk

We present this month an interview with Alpha Theory Advisors head Benn Dunn.  Alpha Theory Advisors is the consulting arm of Alpha Theory, providing investment process engineering and thought leadership, outsourced risk management, research leadership and tactical portfolio management guidance to numerous alternative investment firms currently managing approximately $6Bn in AUM across all asset classes. Prior to joining Alpha Theory, Benn served as the Head of Risk Management at the CR Intrinsic Investors unit at S.A.C. Capital Advisors and Chief Risk Officer at Weiss Multi-Strategy.

  1. What is making this market environment so different from others where mid- to high-single digit pullbacks have occurred? Index performance does not appear outright disastrous but we have heard of many hedge funds seeing drawdowns disproportionate and unexpected relative to their exposure levels and typically conservative stance vis-à-vis directional bets.

Things have been changing rapidly versus last year, in that there are many hedge fund-specific issues, even outside of macro and market dynamics, starting to occur.  We are seeing a perfect storm where multi-manager platforms that tend to run (by mandate) market-neutral had levered up in some cases very substantially, and then saw their risk models come apart given an increasingly damaging – and self-perpetuating – unwind in momentum but also other segments.

Crowded growth names like LinkedIn, Tableau and others during earnings season saw declines of as much as 50% in a day – unprecedented in their stock histories – after reporting ugly results.  A widely circulated note from Cornerstone in January essentially fit this increasingly talked-about narrative (that momentum was set to unwind), and that only contributed to the perfect storm.  The short of it is that many risk models, which had until last week been predicated on being market-neutral, factor-neutral, sector-neutral, etc., no longer held up as such.

When this kind of thing starts to happen, the primary and pervasive response is to cut gross exposure.  A big part of the stealth correction and behind-the-scenes damage in the early part of this year can be attributed to reductions in gross, and the result was that crowded names with “small exits” became very dangerous.

  1. What advice, as a result, are you giving clients?

While the contrarian in me suggested some buying of beaten-up but quality assets, I also suggested clients be somewhat defensive, and indeed keep gross exposure in check, for a few reasons.  There is still a very unclear macro environment at the moment, whether it’s the Fed, China, energy company debt problems, Mid-East geopolitics, etc.  The list of reasons the market could go down remains much longer than the list of reasons the markets should go up.

In addition, asset allocators, who tend to avoid over-staying their welcomes and sometimes redeem first and ask questions later, seem in some cases to be pulling out of the multi-manager platforms that were supposed to behave more neutrally.  So that has added to what seemed for too much of this year to be a self-perpetuating risk environment, and the reduction in gross exposure that can have knock-on effects.  One note I saw out of Morgan Stanley in February highlighted that gross exposure started the year at the highest it had been since 2008.  And yet we have been hearing some very well-known and substantial market-neutral platforms have experienced drawdowns that are very atypical for their style and approach.

  1. What can stop the bleeding or draws a line in the sand?

The downside is sustained until CROs (Chief Risk Officers) get their funds’ risk levels back in line and some of these multi-managers are done cutting gross exposure.  Some funds will eliminate individual sector groups for violating drawdown limits, so capital exposed comes down to risk levels that are within appropriate limits.  And finally, some stocks may go to equity values that are below any rational level associated with even liquidation values.

  1. What might happen at the macro level to help the dust settle?

One silver lining here of late is the weakening dollar.  If the narrative was China being forced to weaken its currency and emerging markets hurting due to the strengthening dollar, then these problems start to get alleviated as the dollar backs off its recent strength.  Oil prices go up, along with other commodities.  Of course while all this helps, there are some big market-neutral platforms that saw drawdowns of as much as 5%-20% for January, and this on top of at least one immediately prior weak year.  So many allocators will pull back from these platforms and try to high-grade their books even as some of the dust is settling.

  1. If the contrarian in you has you tempted to do something, what is it?

The contrarian in me is wanting to back up the truck and buy equities of companies without debt maturities in the near term or significant debt at all, where there is a sustainable business model, positive free cash flow, no need for access to capital markets.  These are stocks that represent babies being thrown out with the bath water.  The next trick is whether a fund has something closer to permanent capital – or at least locked-up capital, because that allows a fund to wait for and survive the bottom and benefit from the inevitable reversion to the mean.

  1. If a fund does not have permanent capital and is somewhat levered and net long exposed, what is the most appropriate advice?

One has to de-gross or take down overall exposure.  Of course, this exacerbates the downside among crowded names, where everyone is selling the same things at once.  But the problem with a levered fund is that risk becomes existential, there is actual business risk for a fund, and my job as a CRO is to prevent that above all.

  1. Should funds reduce net long exposure or should they focus on gross?

Over the past couple of months gross represents risk.  When the multi-strategy funds are unwinding or their longs have sold off well more than their shorts, they can't just cover their shorts and let themselves get off-balance on that score.  So they are just de-grossing; they cannot organically take one side of the book down without doing so on the other side.  What this means is that even with an up tape, funds can still get hurt badly if they own some crowded names.

  1. Are there some over-arching themes to be aware of in addition to all this?

It’s been talked about for some time now that liquidity has become extremely limited among some stocks in the market, especially as you go down the market cap ladder.  This causes exits to be very narrow and even if only one fund has to unwind its book, there are simply not enough incremental buyers to take on the stock for sale if the selling has to be fast and sizeable in nature.

There can be secondary and even tertiary effects where the fund exiting a set of names has overlap with names of a second fund that cause the second fund to become stressed, which in turn could impact a third fund holding only a couple of the second fund’s assets.

For a fund with longer-dated capital, this kind of forced or artificial liquidation can represent an opportunity.  Going through the big holdings of what are known to be highly stressed funds and correlating to market volumes and trader scuttlebutt to build a sense for completions to unwinds, name-by-name, is not an uncommon practice.

  1. For funds that lack a CRO (or the means to pay for one), what advice would you give?

There are available tools that can help a fund measure its exposure to any number of factors; even Bloomberg can be of help.  One should be aware of some common mistakes and pitfalls from a risk standpoint: beta, thematic or industry mismatch.  Being long software and short semis – even if beta matched – can prove to be a sector mismatch; one can be too heavily long growth and short cyclicals without being completely aware of such nuances and potential consequences.  There are things that can go wrong on the earnings front that can shift how the fund appears to a risk model, even overnight.

  1. What other risk variables are commonly overlooked?

The Barra model now counts so many factors (I think there are something like 64 industry groups alone).  There is country exposure, basis risk, and even temporal variables to be aware of.  For instance, the short energy/long consumer trades people put on may appear appropriate at first, but the consumer names only see their up move resulting from low energy prices with an extreme lag (up to6 months to a year).  A fund can have balance sheet mismatches, where one is long companies that need access to capital and short some less levered ones.  Or, a fund could be long a few European banks and short some U.S. financials, where the market’s treatment of those different categories cause downside from a geographic mismatch.

  1. What aspects of Alpha Theory can a PM make use of to be more risk-aware and mindful of exposures?

The Confidence Checklist is certainly one element of the application that can allow users to score or grade for risk factors of any kind.  Re-underwriting one’s price targets – even to incorporate recessionary earnings scenarios or market multiples – can also be a potential help.  Just focusing on individual company outlooks and prospects for their own sake and ignoring some of the noise can be a constructive exercise that Alpha Theory forces.  Analysts should be making these company-by-company assessments regularly.