One Thing All Investors Can Take From CTA’s and Risk Parity Funds

If you follow the alternative investment landscape at all then you have heard of both risk-parity funds as well as CTA’s-Commodity Trading Advisors.  Regardless of what you think of either strategy there is one thing that most investors should look at adapting to their particular style of trading/investing.

What “thing” am I talking about? Well the one component that most of them use in their trading process is to equalize the risk on each of their positions. Most CTA’s use a volatility based position sizing model of sorts while one of the goals of risk-parity is to bring each asset class up to the same risk level hence the parity in risk-parity.

In the case of a CTA they might use the last 20, 60, or 100 days to measure the volatility of the instrument. They might use standard deviation, average true range, or any number of other volatility based measures. Risk-parity funds tend to look at the long run historical volatility of an asset class. The time frame is of course dependent on their average holding period. Most risk-parity funds are relatively slow moving asset allocation shifts as volatility rises and falls while most CTA’s are medium term trend followers. So while a risk-parity fund might only adjust their allocations once a year a CTA could have 300% turnover in a year.

But while their time frames are different the ultimate goal remains the same. In both cases they are trying to normalize risk in an algorithmic fashion. This does two things. One is obviously to normalize risk across assets. The second is to take the human decision out of the equation.  Both reasons have a lot going for them but I suspect that most investors would benefit from the second reason more than anything else.

In general humans tend to be over or under confident. When it comes to investing it is almost always hubris that hurts but in some cases it is still under confidence.  By being as systematic as possible we can eliminate, or at least reduce, our bad tendencies while accentuating our good tendencies.

As an example I have always been far too risk adverse. I started off as a broker catering to very active traders. In this environment I saw a few people make a ton of money and a ton of people trade their accounts into oblivion. This experience made me very risk adverse and consequently my drawdowns have always been very small. The bad part of very small drawdowns is that it makes it that much harder to have very good upside. I always rationalized that “I will add more to the position later” when in practice that rarely happened. Over time I realized that if I doubled my drawdown size I would be fine and yet my upside would also double. To put this in perspective I have never had a -10% drawdown.

I always paid lip service to position sizing models but usually ended up taking 1/2 and sometimes even 1/3 of the suggested position.  I have a solid risk management process but I was never maximizing my risk taking. Overly cutting off your upside is almost as bad as NOT cutting off your downside as they both lead to far less than optimal outcomes.

I finally decided I was done with that and worked out a position sizing algorithm that in theory I was happy with. I then committed myself to following it….no matter what. I now type in my volatility measurement, buy/short price, stop price, volatility measure and it spits out how big a position to take. My results have not only been far better but also more consistent and all this with drawdowns that are still tolerable. With my revised sizing regime I will eventually have a drawdown larger than -10% but barring some huge gap risk it should never be larger than -20%.

What I have seen across many investors accounts is that equalizing their risk, or at least really understanding how unequal risk is across positions, is a huge benefit to them. Take the traditional 60/40 stock bond portfolio. If you measure your risk you will see that you have far more risk in equities than the 60% would indicate.  If you are really OK with this than fine but most investors….and even most of their advisors don’t even know this.

I could obviously go on and on about this topic and maybe will in a future post. In the meantime I would recommend that you go read up on risk-parity as well as CTA strategies. Whether you like their overall strategy or not is up to you-some people don’t want to lever up bonds to match their equity risk or go long/short soybeans-but they both have some systematic and very useful risk management concepts.

Finally I would say, just like half the industry would say, that the number one thing between many losing or at least under-performing investors/traders is a poor risk management and portfolio construction process. The word “process” sounds so cliche anymore and yet it is a real thing. If you don’t focus on process over outcomes then you will under-perform and likely lose money over time.

Happy Trading,

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The Futility of Buzz Lightyear and QE to Infinity and Beyond

We have all seen a chart similar to the one below of the effects of QE on the stock market.  When the Fed is buying the market moves higher and when it sells it helps the market move lower.  Of course what we have all noticed, well everyone except for Buzz Lightyear at the Fed, is that each successive buy program has led to a smaller and smaller rise in the market.  So the question is with a zero interest rate policy and with an additional and infinite buy program in place, at what point do we decide that maybe it is alright to fight the Fed?  The more we look at it the more we think that their stance is sufficiently weakened that shorting may soon be, and indeed may already be, a viable option.

Looking at the situation from a smaller time frame the results are basically the same.  Here is a table showing how Fed buy days compare against sell days as well as all days for the SP500.  As you can see the out performance was fairly consistent since the end of August 2005.  If you bought the market at the open on the day of a POMO buy and sold at the close you outperformed by a wide margin.  If you held for 10 days you still were winning.

When we go to the latest finished action of operation twist however we can see that, like the large chart above shows, the effects of Fed buying have been drastically diminished.  Buy days still outperform the SP500 by a small margin but does not fare so well against the sell days.  Wen you take it out to 10 days the out performance is almost non-existent showing that Fed buying is not what it used to be.

All of this combined with out slowdown/recession forecast gives us more and more reason to look for shorting opportunities.  If we are entering an earnings led recession and the Fed’s efforts are falling on investors with less and less force than it is getting closer and closer to being safe to fight Buzz Lightyear Bernanke and the Fed.

Happy Trading,

Disclaimer-In our model portfolio we are long TLT.

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Sentiment Indicator Disconnect

As of late we have heard a lot about how sentiment was too bearish and that this justified the market rally.  While we no doubt got a rally, we have to question the idea that sentiment is overdone to the downside.  In the world of sentiment indicators there are more then a few ways to look at things.  You can look at polls like Investors Intelligence or the AAII numbers, you can look at anecdotal indicators like covers at the magazine rack or listening to your shoeshine boy, and finally you can look at market derived indicators.

Looking at poll data alone would have you thinking that either the world is coming to an end or that we are due for a large counter sentiment trade.  The first chart here is of the Investors Intelligence Bulls to Bears ratio popularized by Marty Zweig.  As you can see in the chart it is hitting lows not seen since 2008.

Investors Intelligence Bulls Bears Ratio


If you want an equally extreme way to look at it below is a chart of the Investors Intelligence percent bears.  As you can see we are spiking to new highs not seen since the dark days of 2008.

Investors Intelligence Percent Bears


Looking at just these two charts makes the trend followers short and happy, and the contrarian leveraged long.  Of course we have a lot more tools at our disposal then just the Investors Intelligence poll data.  We like to check the poll based data against the market based data to see if it is inline with what investors are actually doing.  Usually it is, but sometimes it gets out of line.  As you can probably guess now is one of those times.  In the chart below we have taken the VIX and overlaid the percent bears.  As you can see both indicators usually move roughly to the same beat but lately the poll data has been getting more and more negative while the market derived data, data that actually shows where people are putting their money, has been getting more positive.

VIX and Investors Intelligence % Bears


Because of this disconnect we think that sentiment is not overdone to the bear side and that there is still some room to the downside.  In fact one of our short term sentiment indicators is showing exactly that as the 5-day equity only put call ratio hit .55 yesterday.  This level is significant as it has done an excellent job of showing when things are in fact too optimistic and has a good record calling tops in the equity market.  So while we aren’t calling for some Dow 1,000 crash, our analysis which includes sentiment data, does show room for more downside.

5-Day Equity Only Put Call Ratio


Happy Trading,

Disclaimer-In our model portfolio we are long some SPY puts.

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The Carry Trade and Volatility

In our ETF based newsletter, the carry trade is one of the strategies that we employ. For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries. You short a low-yielding currency and go long a higher-yielding currency.

You can make money in two ways. You earn the “carry” if the currencies remain very stable, and neither move. You can also make money in this trade by being correct in the direction. For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar. The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates. Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007. As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69. If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces. Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility. While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets. We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well. On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts. The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean. When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out. On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX


The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it was able to break out to the upside.



Finally we have the DBV itself. As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it broke out to the upside.

DBV-Carry Trade ETF


Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting. If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis. While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

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Title: The Carry Trade And Volatility