One Strategist Compared Hedge Funds to Passive Index Funds: “The Results Were Breathtaking”

By Heisenberg

Earlier today, we brought you some highly amusing excerpts from a recent BofAML note.

You’ll recall the following main points:

  • Shorts squeezed by “Trump Rally” in Q4 2016. Based on the quarterly 13F filings and estimated short positions of the equity holdings of 958 funds, we estimate that hedge funds short-covered the most stocks during Q4 2016 since the end of 2009.
  • HF least net short ETF since 2012; record long positions. Hedge funds increased their ETF long notionals by $7.4bn to a record high of $45.1bn (from Q2 2011), while decreasing their ETF short notionals to the lowest since Q2 2013.
  • Hedge fund net short notional in ETFs fell to the lowest since 2012, driven by equity class which saw the least HF short in record.

The implication there is obvious. Having failed miserably when it came to anticipating the post-election Trump rally, hedge funds turned relatively (although still characteristically net short) bullish equity ETFs. Here’s the graphic that illustrates the latter two bullet points:


Well consider that as a prelude to the following out earlier today from Bloomberg’s Cameron Crise who notes that “hedge funds’ alpha is vanishing as they turn to indexing.”

Via Bloomberg

Two of the main issues confronting asset allocators these days are the benefits of active vs. passive investment styles and the utility of investing in hedge funds. At the heart of each of these is the question of whether it’s possible to beat the markets consistently. I decided to have a look at whether hedge funds can really outperform.

  • The HFR equity hedge fund index, which provides monthly readings on hedge fund performance going back to 1989, was the basis for my analysis of the issue. While it is true that such an index has survivorship and selection biases, so does the S&P 500: companies that quit making money get booted out and replaced with those who do.
  • Over the period of my study, the hedge fund index had an annualized return of 10.9% vs. total returns for the SPX of 9.1%. At the same time, the annualized volatility of hedge funds was 8.7% vs. 14.5% for a passive equity index investment. Game, set, and match to hedge funds, right?
  • Not quite. What we’re looking for is consistency over long periods of time, so we need to dig a bit deeper. I compared 5-year rolling total returns of the S&P 500 with three different measures of hedge fund performance:
    • The HFR index, as published
    • The HFR index adjusted to generate the same level of volatility as the SPX
    • The as-published HFR index adjusted to account for performance before fees (assuming a 2 and 20 payout structure), which ostensibly measures the underlying skill of the managers in the index
  • In looking at the data, a few things become immediately evident:
  • Historically, hedge funds have demonstrated a significant ability to outperform the S&P 500
  • That ability seems to have vanished for much of the last decade
  • The “lower vol” offered by hedge fund indices seems to be largely a function of fees.
  • The deterioration in hedge fund performance over the past several years is really notable, and almost certainly explains the pushback against fees and the industry in general.
  • I regressed hedge fund returns with SPX returns and compared the correlation to a measure of hedge fund outperformance. The results were breathtaking.
  • Hedge funds’ returns have started to track the SPX more closely. As that happens, their ability to outperform has collapsed. This makes intuitive sense; there’s no way you can beat an index when you’re paying 2 and 20 on an investment vehicle that largely replicates the return of the index!
  • It’s hard to know which way causality works — are funds underperforming because they hug the index, or do they hug the index because they’re underperforming? There’s probably a little bit of both at work.
  • The investment landscape has clearly changed since the crisis, both in terms of allocators’ willingness to tolerate drawdowns and the hurdles required to launch a fund with a modest amount of AUM (smaller funds typically outperform their larger brethren).
  • Either way, the industry probably cannot go on as it has been. Hedge funds have demonstrated the utility of active management in the past; if they’re going to outperform in the future, they need to be willing to take risks — and investors need to be willing to go along for the ride.

Jesus, Will Someone Wake Up the VIX? It’s Passed Out Drunk

By Heisenberg

Yeah, so picking up mid-stride where we left off this morning on how anyone buying equities at this point has, to quote SocGen, “a problem,” we would note that there’s one saving grace.

That is, while buying at ridiculous multiples dooms your excess returns (i.e. returns above risk-free Treasurys), it doesn’t necessarily mean you’ll wake up tomorrow to a massive drawdown that will wipe out half your investment.

See the thing is, you can buy at valuations that are in the 80-100th percentile versus history as long as volatility remains passed out drunk on the couch. Don’t believe us? Just look:



See there? Everything will be fine as long as vol stays glued to the proverbial flatline.

Seen in that light, it’s no wonder buying equities worked in Q1, because as Goldman notes, we just witnessed the calmest first quarter in terms of average VIX level of all time.

Via Goldman

Lowest Q1 VIX level on record

  • Despite a quarter characterized by elevated policy uncertainty and an intense focus on tax reform, infrastructure spending and deregulation, U.S. equities had one of their lowest volatility quarters on record.
  • The average VIX level in Q1 was 11.69, the lowest first quarter in VIX history. Low volatility levels were persistent, with the VIX trading in a tight band between 10.6 and 13.1 over the first quarter.
  • If we include all calendar quarters, Q1 2017 was the second lowest quarterly average VIX level back to 1990; only ranking behind Q4 2006, when VIX averaged 11.03.


S&P 500 realized volatility: lowest Q1 in five decades

  • Was the low Q1 VIX justified? Judging by SPX realized volatility the low Q1 VIX was not that surprising. The VIX is a market based expectation for S&P 500 realized volatility and when the market isn’t moving the VIX will reflect that by dropping to the low end of its historical range. And the market really wasn’t that volatile in Q1.
  • While the VIX has only been around since 1990, we can use S&P 500 realized volatility to provide broader context. S&P 500 calendar quarter realized volatility was 6.69, the 4th lowest Q1 since 1929 and lowest Q1 since 1965. S&P 500 realized volatility over the first quarter of 2017 ranked in the fourth percentile across all quarters back to 1929.

Low VIX does not suggest an impending market decline

  • In our “VIX as a market timing signal” report we showed that contrary to popular belief, a low VIX has not historically signaled an impending market decline. After a VIX decline below 11, median VIX levels over the next week, month and quarter were all fairly low at 11.1, 11.4 and 12.1, respectively. This quarter followed that script perfectly, averaging 11.7.
  • Economic data also points to a low VIX: Estimating the VIX based upon payrolls, ISM levels and economic policy uncertainty suggests an average VIX level of 13.7, two points higher than the Q1 average.

Trader: You’re “An Emotional Train Wreck”…

By Heisenberg

Trader: You’re “An Emotional Train Wreck” – But Buying-The-Dip Might Help

Having spent Monday contemplating how and why traders have lost their confidence, and Tuesday explaining that although the jury is still out on the viability of the reflation narrative for FX and rates, equities will continue to stick with the “tax cuts are coming so BTFD” mentality, Richard Breslow is back on Wednesday asking you to “stop acting like an emotional train wreck.”

We like today’s missive from Breslow because it underscores the point that you really do need to take a holistic approach to markets (which means thinking macro) and use that approach to inform your day-to-day trading decisions.

And, in keeping with the theme that’s dominated the discussion so far this week, the former FX trader turned Bloomberg contributor says one of the main big-picture questions you need to answer for yourself is whether and to what extent the central bank put will remain in place.

More below.

Via Bloomberg

On Receipt – Stop Acting Like an Emotional Wreck

We’ve been moving away from a world where investors were willing to say, “I see it, but I don’t believe it” and do something about it. The contrarian view, where you hope to win big by standing your ground or catching the market offside just before prices reverse. There are few more empowering feelings than the belief that you’ve just got confirmation that you’re smarter than the next guy. And nothing more intimidating if you’re that next guy.

  • In the new zeitgeist, you’re more likely to hear, “I let my emotions get the better of me.” Only day traders can get away with and thrive being wildly bullish one day and sure everything will collapse the next. Yet that’s increasingly the trap real investors are falling into
  • It’s a tough trading environment and fair to say that confidence is low. Yet all you hear is people expressing themselves in binary absolutes. Which is a problem when the noise level is deafening and many of the issues that are driving markets analyzable only to the extent of supposition
  • Having a big-picture view is very important. And then you need to file it away for context. Markets are behaving like they’re in a step class, but the real economy and global demographics don’t bounce up and down at the rate people seem to think
  • Decide questions for yourself like whether global growth is expanding or not? At the end of the day is there likely to be additional or less quantitative easing pumped into the system? Are sovereign wealth funds apt to continue to increase their commitment to global equities or go back to sovereign debt coupon clipping?
  • The answers won’t help you trade the very real, if unfortunate, emotional panics and analytical excesses, if you don’t have technical discipline. But will provide the grounding to understand why a buy-the-dip mentality continues to exist in equities, emerging markets have been so happy or where the range in Treasury yields is likely to migrate to.

“Keep Your Composure!” Dollar Finds its Footing, Markets Dodge Trump-Induced “Freak Out”

By Heisenberg

Well, looking out across markets on Tuesday things have got that “we just dodged a bullet” feel to them.

The dollar looks to be consolidating a bit, 10Y yields have an up-ish feel to them, and hey, at least the yen’s not staging a furious rally. Or, visually:


That’s right! “We’ve come too far, there’s too much to lose!”

Which is why you should be happy to see this on a Tuesday morning:


When you pan out, you can see why we’ll take whatever we can get:


That’s your reflation narrative right there and what you see is it dying. Dollar under (lots) of pressure, erasing post-election gains and Treasurys bid heavily taking yields dangerously close to 2.37 below which God only knows what happens as whatever’s left of the 10Y short after last week’s “pruning” gets covered.

“The greenback consolidated on Tuesday as dollar bears adopted a more subtle approach after Monday’s reversal in Trump-reflation trades,” Bloomberg wrote this morning, adding that “investors with short dollar positions across the board took profit after the London open, after dollar-yen closed on Monday above 110.63, the low of the previous two days.” Fast money accounts initiated fresh longs, European FX traders said.

Here’s SocGen:

Bloomberg’s ‘most read’ news story overnight was entitled “equities rebound as worries ease, dollar steadies”. That sets the tone for today. Bond and FX market participants’ reaction to the failure of the healthcare bill has been to re-price Treasuries and the Dollar under the assumption that President Trump has lost a little of his shine. Equity market participants have taken a look at the lower yields and weaker dollar and decided that since absurdly low rates are the elixir that the equity bull market lives on, they might as ‘buy the dip’ yet again. And that kind of attitude is going to have the FX market off in search of high-yielding currencies in the blink of an eye.

Sound familiar? Here’s what we wrote earlier:

Monday was interesting not necessarily for how we closed but rather for how we opened. FX and rates told the story, equities followed but as usual, BTFD reasserted itself even though we still closed red. And as Breslow notes in Tuesday’s missive, there’s still a “the sky is falling” feel to things every time SPX is red.

In any event, Asian stocks are higher with the Nikkei buoyed by the well-behaved yen. European stocks seem quiet.

  • Nikkei up 1.1% to 19,202.87
  • Topix up 1.3% to 1,544.83
  • Hang Seng Index up 0.6% to 24,345.87
  • Shanghai Composite down 0.4% to 3,252.95
  • Sensex up 0.6% to 29,399.95
  • Australia S&P/ASX 200 up 1.3% to 5,821.23
  • Kospi up 0.4% to 2,163.31
  • FTSE 7293.48 -0.02 0%
  • DAX 12066.92 70.85 0.59%
  • CAC 5018.23 0.80 0.02%
  • IBEX 35 10339.00 36.10 0.35%

We’ll get Yellen today after lunch on the East coast and that’s not all in terms of Fedspeak:

  • 12:45pm: Fed’s George Speaks in Midwest City, OK
  • 12:50pm: Fed Chair Janet Yellen Speaks
  • 1pm: Fed’s Kaplan Speaks in Dallas
  • 4:30pm: Fed Governor Jerome Powell Speaks

And you know, what else can we tell you this morning that you’ll be interested in? Probably not much. So just make like Frank The Tank (shown above) and try to keep your goddamn composure.

“The Sky is Falling”: When Stocks Go Down, Everyone Panics

By Heisenberg

On Monday, former FX trader turned Bloomberg contributor Richard Breslow said Friday’s action suggested traders had lost their confidence.

No longer are market participants looking to get the jump on their peers. Instead, everyone is waiting on someone else to set the narrative.

And understandably so. After all, we’ve gotten used to operating in an environment where the narrative, however many times it wobbled, was still the narrative. “Reflation” has been the story since November 9 and last Tuesday that narrative suffered a stroke. It subsequently died on Friday with the GOP health bill.

Monday was interesting not necessarily for how we closed but rather for how we opened. FX and rates told the story, equities followed but as usual, BTFD reasserted itself even though we still closed red. And as Breslow notes in Tuesday’s missive, there’s still a “the sky is falling” feel to things every time SPX is red.

More below.

Via Bloomberg

Well, we had some nice excitement yesterday and markets have been doing their best imitation of a weekend warrior only too happy to get safely back to the couch. There’s more of a mood of relief at dodging a bullet than self-examination of a pretty predictable trading opportunity forgone. But, as they say, lessons have been learned.

  • We now definitively know that little of the grand plans for a miraculous set of changes in U.S. policy will come easy. So we need to re-handicap them accordingly. Including the timing. Also recalibrate our thinking on which asset classes care more about which policies
  • And don’t let anyone try to tell you that stock-market pullbacks, including modest ones, are something investors and policy makers can now handle with aplomb. You can calculate financial-conditions indices with all sorts of back-fitted weightings but when stocks go down, everyone still goes into “The sky is falling” mode
  • There’s no shortage of Fed speakers for the balance of this week. Any of them willing to submit to Q&A should be asked how much and in what potential form fiscal stimulus figures into their forecasts. They like to say it doesn’t very much. But it’s in there somewhere, hard to believe anything else. And can’t not affect their assumptions for rate rises. Just how strong do they really think this and the global economy are on their lonesome? Frankly, it’s just not good enough to settle for we’ll see how things pan out
  • Clearly dollar and bond traders think the jury is out. And want to see some infrastructure proposals. Equity traders are comfortable banking on deregulation and tax cuts. They have their own priorities. If the party in power needs a “win” that’s where the push will come from. And perhaps sooner than analysts expected, with health reform no longer standing in the way
  • For currencies the best read on short-term attitudes remains USD/JPY. Using 111.70 as a pivot is as good as it gets for judging momentum. It’s clean and clear. If you insist on trading EUR/USD, use 1.0760. It’s close and will determine the mood. It’s more ambiguous because it will also hinge on how much fire Europeans are willing to play with talking about rate rises
  • Gold didn’t make a new year-to-date high in yesterday’s panic. That remains in play and is close. For Treasuries, keep using 2.37% on a close as the pivot to judge just which range we are in
  • Remember, equities remain, and will continue to do so, the ultimate sacred cow

The Inverse Trump Trade

By Jared Dillian

The market dumped on Tuesday. For a good graphical representation, look at the three-day chart of the S&P 500 I keep on my desktop.

I like three day charts. If you want to know where you’re going, it’s good to know where you’ve been.

You can see a pretty radical change in price action from one day to the next.

What happened?

The job of financial journalism is to try to explain the day-to-day variations in the stock market. Oftentimes, there is nothing to report—lots of randomness. This time, on the other hand, stocks went down hard—so there must be a story behind it.

Is there?

As far as I can tell, the best explanation as to why stocks dumped on Tuesday is because it became increasingly unlikely that the “repeal and replace” of the Affordable Care Act would pass, because of a group of about 26 holdout Republican legislators.

For what it’s worth, I agree with the holdout legislators. The proposed law isn’t a repeal at all. It’s a collection of tweaks designed to get the original Obamacare working properly—along with a giant tax cut.

It is not the tax cut I disagree with. Tax cuts are great. But here’s the thing: if this doesn’t pass, the market doesn’t get the tax cut. And the market cares about tax cuts more.

Furthermore, if the ACA repeal doesn’t pass, it will cripple the Trump administration politically and delay a complete tax reform package even further, possibly into next year—if it happens at all.

Remember, the whole reason that the market ran up after the election was because Trump was this can-do businessman, capitalist president, who was going to cut corporate and marginal rates to the bone. That is looking less and less likely. Maybe even impossible.

I have been telling people (privately) that it was a big mistake for the Trump administration not to pursue tax reform first. Instead, we issued a couple of ham-handed executive orders that pissed everyone off and lost a lot of political capital, and then dove into the hornets’ nest of healthcare.

It’s odd—this group of people who were pretty smart about winning the election are turning out to be pretty dumb about legislative priorities.

Worse, both Trump and Mnuchin have said that people can use the stock market as a yardstick of the administration’s performance.

Continue reading The Inverse Trump Trade

What’s next for the Dollar, Gold & Stocks?

By Axel Merk

Two rate hikes since last year have weakened the dollar. Why is that, and what’s ahead for the dollar, currencies & gold? And while we are at it, we’ll chime in on what may be in store for the stock market…

The chart above shows the S&P 500, the price of gold and the U.S. dollar index since the beginning of 2016. The year 2016 started with a rout in the equity markets which was soon forgotten, allowing the multi-year bull market to continue. After last November’s election we have had the onset of what some refer to as the Trump rally. Volatility in the stock market has come down to what may be historic lows. Of late, many trading days appear to start on a down note, although late day rallies (possibly due to retail money flowing into index funds) are quite common.

Where do stocks go from here? Of late, we have heard outspoken money manager Jeff Gundlach suggests that bear markets only happen if the economy turns down; and that his indicators suggest that there’s no recession in sight. We agree that bear markets are more commonly associated with recessions, but with due respect to Mr. Gundlach, the October 1987 crash is a notable exception. The 1987 crash was an environment that suffered mostly from valuations that had gotten too high; an environment where nothing could possibly go wrong: the concept of “portfolio insurance” was en vogue at the time. Without going into detail of how portfolio insurance worked, let it be said that it relied on market liquidity. The market took a serious nosedive when the linkage between the S&P futures markets and their underlying stocks broke down.

I mention these as I see many parallels to 1987, including what I would call an outsized reliance on market liquidity ensuring that this bull market continues its rise without being disrupted by a flash crash or some a type of crash awaiting to get a label. Mind you, it’s extraordinarily difficult to get the timing right on a crash; that doesn’t mean one shouldn’t prepare for the risk.

If I don’t like stocks, what about bonds. While short-term rates have been moving higher, longer-term rates have been trading in a narrow trading range for quite some time, frustrating both bulls and bears. Bonds are often said to perform well when stock prices plunge, but don’t count on it: first, even the historic correlation is not stable. But more importantly, when we talk with investors, many of them have been reaching for yield. We see sophisticated investors, including institutional investors, provide direct lending services to a variety of groups. What they all have in common is that yields are higher than what you would get in a traditional bond investment. While the pitches for those investments are compelling, it doesn’t change the fact that high yield investments, in our analysis, tend to be more correlated with risk assets, i.e. with equities, especially in an equity bear market. Differently said: don’t call yourself diversified if your portfolio consists of stocks and high yielding junk bonds. I gather that readers investing in such bonds think it doesn’t affect them; let me try to caution them that some master-limited partnership investments in the oil sector didn’t work out so well, either.

I have argued for some time that the main competitor to the price of gold is cash that pays a high real rate of return. That is, if investors get compensated for holding cash, they may not have the need for a brick that has no income and costs a bit to hold.

Continue reading What’s next for the Dollar, Gold & Stocks?

“Where the Wild Flowers Are”: Equity Funds See Largest Inflow in 13 Weeks Before Fed

By Heisenberg

There’s been no shortage of discussion this year about flows into US equities.

Over the past several weeks, more than a few commentators have suggested that the flood of Johnny–come–lately retail money into stocks may be proof that they do in fact “ring bells at the top.”

Of course these flows have been catalyzed and perpetuated by the “Trump trade” meme. Headlines advertising the “Trump rally” and Dow 20,000 have been plastered across every newspaper in the country, fueling retail demand and ensuring that as is almost always the case, “mom and pop” are buying when multiples are stretched and are thus almost sure to be underwater in the medium- to near-term as the market finally corrects.

Well, for those interested, below find a few charts from Deutsche Bank which, to borrow from Maurice Sendak, show you “where the wild flows are”…

Via Deutsche Bank

As shown below, US equity funds accumulated $55 billion of inflows over the past twelve months ( $100 billion since November alone)…


Last week, DM equity funds (+) with US & Japan (+) vs. Europe (-): DM equity funds rose to their highest level in the past 13 weeks (+0.2%, MFs: -0.1%, ETFs: +0.7%) as significant ETF inflows outweighed MF redemptions…



So as noted, those weekly flows were before the Fed.

It’ll be interesting to see what the lagged numbers look like this week.

DJI Oscillator Positive Index

By Tom McClellan

DJI Oscillator Positive Index

DJI Oscillator Positive Index
March 17, 2017

The DJIA itself might be hanging around all-time highs, but its components are telling a different story.  When a higher index high is made on declining participation, that’s a problem.

The indicator in this week’s chart is one I thought up about 20 years ago, one of a set of indicators that look at the 30 Dow stocks to see what they are doing.  This is a type of “diffusion index”, which describes an indicator that looks at the behaviors of each member of a group in order to generalize about the group.  All market breadth indicators are diffusion indices, for example.

In this case, the indicator is looking at the Price Oscillator for each of the 30 Dow stocks to see if they are above or below zero.  When we refer to our Price Oscillators, what we mean is an indicator calculated as the difference between the 10% Trend and 5% Trend (19-day and 39-day exponential moving averages, as some people call them) of closing prices.  This is the same math as we use for the McClellan A-D Oscillator, which uses the daily A-D difference as its raw data.  The Price Oscillator uses closing prices.  This is similar to the math involved in Gerald Appel’s MACD, which typically uses 12-day and 26-day EMAs.  Interestingly, Appel came up with that idea in 1969, the same year that my parents developed the math for the McClellan Oscillator (and independently from Appel).

Here is a Price Oscillator for General Electric, for example:

GE Price Oscillator

The DJI Oscillator Positive Index seems to follow the underlying trend of the market quite well.  That’s a nice property, especially since it is less noisy than the DJIA itself.  It is all the more valuable when it shows a change in that trend by crossing its own 15-day moving average.

That is the condition we have right now, with a slight down move for this indicator taking it below the 15MA.  It says the presumptive trend for the market right now is downward.

For the bigger picture, this indicator can also give useful messages about high and low extremes.  Here is a longer term chart:

DJI Oscillator Positive Index

When it gets to a true extreme, and especially when it shows a nice divergence relative to the DJIA, that can be a powerful message.  We do not have that sort of message now, just a more ordinary type of downturn that begs for a minor pullback, but not a major bear market.

Subscribe to Tom McClellan’s free weekly Chart In Focus email.

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Chart In Focus Archive

“Quick, Buy That (Macro) Dip!”

By Heisenberg

Earlier today, we noted that the correlation between implied vol and equities is breaking down as traders buy cheap protection on expected surges/plunges while the market continues to grind ever higher.

As WSJ writes, “cash flooding in from private investors has pushed up the market overall, but has also led professionals to worry a little more about the risks—both of a meltdown and, conceivably, a ‘melt-up,’ when the market soars 10% or more in short order. The prospect of either big losses or big gains prompts buying of options, pushing up their cost, proxied by implied volatility.”


We also noted that when it comes to realized vol, January was the 5th calmest month on record and, to quote WSJ again, “the calm on the surface means it is cheaper than normal to hedge.” You can thank – in part – collapsing stock and sector correlations:



Well, when it comes to suppressed realized vol, we found the following chart from BofAML to be particularly interesting. Have a look at how quickly spikes in volatility have rapidly mean reverted during recent shock events like the US election and Brexit, versus history:


Consider that, and think back to the following from JPMorgan’s Marko Kolanovic:

Various quantitative and qualitative metrics indicate that markets have become more macro driven and react faster to the new information. A qualitative example shows the reaction time for recent major events (August ’15 selloff, Brexit, US Election, Italy Referendum) that has compressed from weeks to hours. Quantitatively, we are noticing a higher density of market turning points. The average variability of asset trends (averaged across major asset classes) that show turning points occurring at the fastest pace in recent history (~30 years).Given the engagement of central banks with markets and geopolitical developments, it should not be a surprise that markets are more macro driven.


In short: buy that f*cking (macro) dip. And right quick.