I am still in a quant-mood at the moment, so today I will go through some work I’ve done on portfolio optimization with US large cap equity sectors. I am doing this to augment my current MinVar framwork, which I use for my own investments. A quick re-cap on the basics of portfolio optimization, with advance apologies to PMs reading this and lamenting that I’ve missed something. Finance has two workhorse models; the tangent portfolio, which places the investor on the efficient frontier, where risk-adjusted return—or the Sharpe ratio—is maximised. Or the minimum variance portfolio, which offers exposure to the combination of assets with the lowest variance, or standard deviation, regardless of return. These portfolios often are estimated given a set of constraints, as I explain below. Assuming most portfolio allocation decisions start with one of these ideal models in mind—you either want to achieve the best risk adjusted return or the lowest volatility—the difference between the textbook models and real-time allocations is governed by the following layers of complexity.
Read MoreApologies in advance; it’s been too long since my latest report, mainly because I think observing markets has been a bit like listening to a broken record. To re-cap; central banks—mainly the Fed and the ECB—made a dovish pivot at the start of the year in response to the swoon in Q4 18. Whether they meant this to be a relatively modest shift or not, investors ran with the story. Within a few months, markets were bullying Powell into rate cuts and by September, and pricing-in rate cuts and QE by the ECB. In other words, the multiple-expanding support from a firm central bank put—perhaps even with a sprinkle of fiscal stimulus hopes—has reigned supreme in equities, and driven yields lower, even as fundamentals have deteriorated. Against this backdrop, the Fed and ECB have delivered, by and large, forcing markets to consider a shift in the Narrative™ that is now too persistent to ignore. I’d break it down into three separate themes.
Read MoreThat screeching sound you heard in equities last week was caused by a train wreck underneath the surface of a steady uptrend in the market as a whole. The hitherto outperformance of growth and momentum reversed sharply, a move that coincided with a steeper curve and a tasty outperformance of value and small caps. The dramatic rotation across equity sectors, and the steepening yield curve, vindicate the story peddled on these pages recently. But the question is whether this is the beginning of a sustainable shift in markets, or whether it’s merely an invitation to buy the dip in an eternally winning strategy? It’s difficult to say. Robert Wiggleworth’s expertly written overview of the flurry in the FT certainly suggests that strategists have taken note, equating last week’s gyrations to the so-called “Quant Quake” in 2007. Apart from the fact that the event is significant enough to merit at least a small footnote in modern finance history, the quotes garnered by Robin indicate that strategists are at least mulling the idea that the shift has legs. This, in turn, presumably means that they’re advising their clients to run with the reversal, which almost surely would do nicely for the portfolio.
Read MoreLast week I complained about information overload, but as we close the book on Q1, the overall story is relatively simple: It has suddenly become a lot more difficult for investors to extract value from markets across all major asset classes. My first chart shows what happened at the start of the year. Specifically, it shows the volatility-adjusted performance of the main asset classes in Q1 compared with their recent 12 month performance. The butcher’s bill for anyone who haven’t been sitting on piles of cash, and long volatility exposure, has been large. Equities have struggled, bond yields have increased, the dollar has weakened, again, while commodities and gold have outperformed.
The volte-face in equities has been extraordinary. The MSCI World, in dollar terms, was down 1.2% in Q1, while its 90-day volatility increased by about 55% compared to the 360-day trailing volatility. This is in stark contrast to the trend before the swoon at the start of February, when low volatility and a gentle rise in headline indices were the only the story that mattered. Across regions, emerging market equities have done relatively well, eeking out a small positive return in Q1. The S&P 500 is flat—the NASDAQ is up marginally—while European and Japanese equities have been underperforming—in local currency terms—primarily because these indices are very sensitive to FX.
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