Knowing where to look

Macro Man's already come to grips with his basketball defeat and rationalized it away.   A little bit of measuring last night revealed that the Macro Boy, while still an inch and a half (3.5 cm) shorter than his old man, already has a longer wingspan.  No wonder Macro Man had so much trouble rebounding!  In any event, he can still whip the kid where it matters, i.e. on a bicycle.

He still has a few tricks up his sleeve when it comes to Mr. Market, as well.   Sure,  the quants can data mine a model to their hearts' content, and it will work great, too....until it doesn't.   One of the benefits of a bit of age and experience is knowing where to look to see if the wheels are going to fall off.

Take an old standby from recent years: Spooz and Blues.  This strategy, coined by David Zervos at Jefferies,  simply involves buying a given amount of Spooz and an equivalent risk-weighted amount of blue (i.e., 4th year) eurodollar futures.   Macro Man actually ran a bit of this strategy at his old fund, and no doubt the quant legends and risk parity heroes are doing something similar, if a little more sophisticated.   It's not hard to see why; even given the ruptures of August and September, the returns of the strategy have remained strong; much stronger, it must be said, than the pre-fee return profile of most macro funds out there.

Of course, the model doesn't necessarily have the same path dependency that most macro punters operate under; if it has a bad day or week, there's no threat of a tap on the shoulder and a cut in the risk allocation.   Like the honey badger (also popular at the time of the Spooz and Blues heydey), it just doesn't care.

The six years comprising this return history would seem like a pretty decent sample period, justifying a good amount of faith in the strategy.  In reality, the entirety of the period doesn't even resemble a sniff of a full market cycle; indeed, the sample covered in the chart above has been dominated by a policy regime more or less explicitly geared to make Spooz and Blues work (i.e., by pushing down yields and interest rate expectations to benefit risky assets.)

If we look at a longer sample of the strategy covering actual market cycles, we find a return profile that is somewhat less impressive.   Macro Man ran the performance of Spooz and Blues since 1992, and while the performance is still positive the information ratio goes from 1.16 to 0.61.

Now, it seems pretty obvious that different policy regimes are going to deliver different type of results for this strategy...and guess what?  It's true!   Macro Man ran a simple filter of model performance based on Fed policy regimes, and whaddya know: Spooz and Blues does best when  the Fed is easing and worst when it is tightening!

Now, Macro Man doesn't expect anyone to be particularly blown away by this insight, because frankly it's not that insightful.  Heck, even some of the clever models might pre-emptively filter for this sort of thing and reduce risk....then again, given the propensity to focus on ex post rather than ex ante returns these days, perhaps not.

The point is, however, that having a certain degree of experience to understand the existence of different regimes and to forecast their arrival can be incredibly useful in dodging the odd bullet.   This is clearly a simple example; not only did Macro Man know where to look immediately, but he suspects that most model designers would, too.  However, in more complex systems and models, it's not always so easy or obvious to know where to look...or when to turn the machines off.

It's hard to believe that the great "Quantmageddon" of 2007 was more than eight years ago, and clearly a new breed has sprung up in place of those that have faded away.  One of the benefits of youth is having a short memory, and not being scarred by the traumatic experiences of earlier years.  Then again, one of the dangers of youth is not being scarred by the traumatic experiences of earlier years and possessing a false sense of infallibility.

It's a fine line between wearing blinders on the one hand and seeing monsters behind every door on the other.  Quants and kids can mine data...but give me a macro guy any day to understand the data....preferably one with gray hair!  Readers are invited to judge for themselves whether the investment regime of the last six years is going to continue, a world of JBTFD and Spooz and Blues and Unicorns.  History suggests that it won't, and while history doesn't repeat, it usually rhymes....