The Volatility Enigma

It is worth noting that the increased popularity of ETF investing may also have a significant role in reduced market volatility. A well-diversified equity index such as the S&P 500 typically exhibits half the volatility of the average stock in it. Marketing programs for “buying the market” or for “buying a sector” with a single stock reduce investor focus on individual stock characteristics and overall capital market volatility.

There are a number of investment strategies that have evolved in this eight year low volatility environment. For example, an ETF that shorted the VIX index returned 170% in 2017. Also, a number of hedge funds key off volatility indices creating a feedback loop of low interest rates, debt expansion, asset volatility, and trading algorithms. Some have called such algorithms the new “portfolio insurance,” raising fears of October 1987-like instability. While the specifics are different, the general issue of highly leveraging small changes in volatility can result in market eruptions when unforecastable economic or geopolitical risks emerge.

The Federal Reserve is in the process of winding down their eight year stimulus policies. Three short-term interest rate increases have been voted on this year, and the balance sheet is being slowly sold off. But, elections can matter. With the presidency and congress in the control of the Republican Party, the lack of interest in fiscal policy has reversed. The most notable event is the end-of-year tax cut law, signed without a single bipartisan vote.

Tax cut legislation can be welcomed for many reasons, particularly when some regulations seem perverse. From a global perspective, the business tax corporate rate at 35% seemed out of balance relative to many other countries. The new 21% rate should provide some positive benefit for economic growth in 2018. However, since the average effective corporate rate for companies in the S&P index was about 26%, any expected jump in corporate earnings may be relatively modest.

We can expect some significant market volatility as tax law winners and losers in 2018 are sorted out. REITs will likely benefit from the new law since pass-through businesses will have an enhanced tax deduction. But the new law will likely curb the appeal of home ownership in high tax rate states with the cap on the home ownership tax deduction.

Unfortunately, the law has many longer-term flaws, such as limited benefit for the middle class, while highest income percentiles will experience the bulk of tax relief on a percentage basis. In addition, corporate legislation is permanent while tax reduction benefits to individuals will be scaled back to current levels. In effect, except for the first year, individuals can expect a tax increase for the next nine years if the law is not amended.

The lack of market volatility has not been kind to many hedge fund managers. There have been an increasing number of pension funds and financial intermediaries who have terminated hedge fund strategies, and hedge fund managers who have terminated their practices this year. It is also not possible to ignore at least a mention of the recent astronomical rise in value of cryptocurrencies, particularly Bitcoin. Many past manias can be rationalized in hindsight as some fundamental technological innovation that would, however, need some passage of time to properly value. There is no doubt that Bitcoin represents a significant transformation of market exchange technology at the global level. Gold is, in many ways, Bitcoin’s closest competitor from a conceptual point of view. The start of futures trading at the Chicago Mercantile Exchange is a welcome step toward ultimate normalization. For the moment, it is not an asset that belongs in a strategy for reliable long-term risk-managed investing. In the meantime, don’t lose your password.

Look Ahead

A general economic consensus exists that the U.S. economy is in robust health. The passage of the new tax law has reduced some uncertainty that the Republican Party is able to govern. In addition, the tax law should provide some positive stimulus for economic growth near term. But continuing partisan political dysfunction can take a toll in subtle ways. The decline of the dollar with respect to the euro, one of the few assets that lost value this year, is a reflection of economic power sentiment tilting towards Europe and Asia.

Another concern for 2018, however, is that American economic policy is currently self-inconsistent. While the Fed is tapping on the brakes, the new tax law is adding fuel to the economic engine. The result may be a sugar high. If the objective is to create jobs, given robust GDP growth and the current nearly full employment 4.1% rate, the net effect may be to fuel inflation and weaken U.S. competitiveness relative to some global economies. In this scenario, any surge in the market may reflect a long-term hollow center.

A potential hollowing out of the recovery will be no friend to the bond market. With tax cuts favoring equities, a flattening yield curve, the Fed trimming the balance sheet, and tighter monetary policy ahead, there are good reasons to carefully manage bond risk in the New Year. One side effect of the listless market has been that it is very difficult for bond traders to make money. Revenue from banks’ fixed income sales and trading units have been falling all year. Bond traders, often the most heavily compensated in the financial community, may be facing limited or donut-hole bonuses this year.

In its single year, the Trump administration has reversed an unusually long list of long-standing American policies and principles, many going back to the Revolutionary War. While North Korean nuclear threats were inherited by the Trump administration, bluster from both sides has unnerved much of the world’s geopolitics. More generally, the long-term impact of “America First” immigration, military, economic, and trade policies has yet to be measured. From a domestic perspective, Russian meddling and tough talk about the Mueller investigation from Fox News adherents creates a great deal of uncertainty for governance and economic value. However, against this widespread backdrop of political and economic policy uncertainty, the markets have remained almost preternaturally calm.

Risk Factor Independent Strategies

New Frontier (NF) multi-asset ETF portfolios are sometimes mischaracterized and misunderstood as passive “value” strategies. One reason is that value and NF strategies are low-turnover. But NF investment philosophy and process are very different.

Value managers (VMs) typically believe investors make systematic mistakes and have investing biases. Consequently, managers wait for the market to return to its senses and value securities correctly. They often estimate the return or value of a security by computing the internal rate of return of current price relative to estimates of future earnings, dividends, etc. The result is the notion of “undervalued” or “ignored” securities which presumably takes time to be recognized by the market.

NF portfolios are neither “value” nor “growth” strategies. Our process focuses on efficient frontier portfolio risk management and not on individual security factors. The Michaud optimization process tends to place traditional “value” securities in the lower portion of the Michaud frontier because they tend to have lower levels of risk. Similarly, traditional “growth” securities tend to populate the upper portion of the Michaud frontier because they usually have higher risk levels all other things the same.

The reason NF is a low turnover portfolio strategist has nothing to do with patience, the market recognizing errors, or biases in market participants. The portfolio rebalancing decision is based on a patented probability measure regarding whether the current portfolio is statistically similar to or different from the current optimized portfolio. A statistical similarity framework for deciding when, or when not, to trade is an active management decision that can avoid trading in noise while enabling trading when likely to be effective independent of calendar considerations. For portfolio strategies with long-term well-diversified risk-managed objectives, such as NF’s current multi-asset strategies, the Michaud-Esch rebalancing rule is tuned to trade conservatively by design.

The usual definitions of value or growth factors, or indeed most popular “smart beta” factors, are irrelevant to New Frontier’s investment strategies. NF strategies avoid the episodic character of most factor based investment strategies. NF portfolios are unique due to patented and proprietary investment technology and as a consequence of holistic efficient frontier risk management.

Richard Michaud
January 2, 2018

© New Frontier Advisors, LLC

© New Frontier Advisors

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