Of Volatility and Tail Risk Management

On April 15, 2013, Pensions & Investments published a special volatility management section.  Ever since the credit crisis of 2008, institutional investors have been seeking protection against volatility.  In the article Investors adapting portfolios to volatile environment, Christine Williamson and Kevin Olsen identified eight ways investors were solving this:

• Portfolio diversification using traditional or risk factor asset allocation
• Liability-driven investment - have a bond portfolio to match the institution's liabilities and an equity portfolio for enhanced returns
• Risk parity - set target risk levels and divide equally across diversified, low volatility and uncorrelated assets; use leverage to enhance returns of the low volatility assets.  AQR Capital Management has $25 billion in assets under management with this approach.
• Invest in low volatility equities and bonds.  Some fund managers in this strategy are AJO LP ($1 billion in equities), Acadian Asset Management ($5 billion in equities) and GAM USA ($15 billion in fixed income).
• Invest in active volatility trading strategies to hedge against tail risks and to provide extra returns. PIMCO ($20 billion AUM) and Capula Investment Management are two funds in this sphere.
• Tail risk hedging from drawdowns of 20% or more
• Use derivative overlays to protect portfolios from downside volatility.  The practitioners in this space are Russell Investments ($5 billion) and NISA Investmtne Advisors ($20 billion).
• All-in-one solutions that use the some or all of the above methods

Other investors are using the all-in-one approach.  Healthcare of Ontario Pension Plan (HOOPP) is using a liability hedged portfolio of liability-driven investment(government and real return bonds), portfolio diversification (real estate), equity derivative overlay and absolute return.  From 2003 to 2012, their annual return is 10.3% versus 8.9% for their benchmark.

The Fairfield County Employees' Retirement System is using liability-driven investing (leveraged fixed income portfolio and equities), portfolio diversification (real estate and commodities) and absolute return (global macro, multi-strategy and distressed credit funds).  Their 10 year return is 10.4%.

In the Alternative Investment Analyst Review, Andrew Rozanov, CAIA, Managing Director, Head of Permal Sovereign Advisory recommends using global macro hedge fund strategy to hedge tail risk instead of investing in a tail risk fund.  Global macro fund managers have more flexibility than tail risk managers.  They can be long or short volatility.  They are cheaper and have the potential for better returns.

Mike Sebastian, Partner at Hewitt EnnisKnupp, Inc. and Zoltan Karacsony, CFA, Investment Consultant at Hewitt EnnisKnupp, Inc. like low volatility equities, managed futures and global macro strategies for tail risk protection.  The issues with low volatility equities strategy are that it is difficult to predict the future volatility of a stock, trading costs weigh down returns, the strategy is not effective at all times and not proven to outperform the benchmarks conclusively.  Managed futures are good hedges in low volatility and bad markets.  They tend to underperform in high volatility and trendless markets.  They agree with Rozanov and like global macro for its flexibility.

Four people from SSgA:  Robert Benson, CFA, Senior Quantitative Research Analyst, Advanced Research Center; Robert Shapiro, CFA, CAIA, Investment Solutions; Dane Smith, Investment Strategist, Alternative Investments and Ric Thomas, CFA, Head of Strategy and Research, Investment Solutions analyzed nine variations of four tail risk strategies.  They were long volatility (VIX 1 month futures, VIX 5 month futures, variance swaps on the Standard & Poors' 500 for 1 month and 3 month 6 month contracts), low volatility equities (long low beta stocks and short high beta stocks of the Russell 3000 Index and short bias strategies), trend following (Barclays CTA Index) and equity exposure management (buy out of the money puts of the S&P 500 and go long/short when 10 month moving average is below/above the trend line).  The strategies with the highest certainty of protection and lowest performance drag were trend following and long low beta and short high beta stocks strategies.

Investors should take an overall approach that encompasses a diversified, risk-based model with sufficient hedging (against inflation, deflation and interest rate risk) plus a global macro allocation to be long volatility.

The sources for this article can be accessed below:

Investors adapting portfolios to volatile environment by Christine Williamson and Kevin Olsen

Investors keep a watchful eye on the horizon for risk by Christine Williamson and Kevin Olsen

Alternative Investment Analyst Review, Q1 2013

"Long Term Investors, Tail Risk Hedging and the Role of Global Macro in Institutional Portfolios" by Andrew Rozanov, CAIA, Managing Director, Head of Permal Sovereign Advisory

"Tales from the Downside:  Risk Reduction Strategies" by Mike Sebastian, Partner at Hewitt EnnisKnupp, Inc. and Zoltan Karacsony, CFA, Investment Consultant at Hewitt EnnisKnupp, Inc.

"A Comparison of Tail Risk Protection Strategies in the U.S. Market" by Robert Benson, CFA, Senior Quantitative Research Analyst, Advanced Research Center, SSgA; Robert Shapiro, CFA, CAIA, Investment Solutions, SSgA; Dane Smith, Investment Strategist, Alternative Investments, SSgA and Ric Thomas, CFA, Head of Strategy and Research, Investment Solutions, SSgA.

Hedge Funds Want Retail Investors

The number of hedge fund mutual funds or liquid alternative funds has increased from 343 at year end 2007 to 838 at year end 2012.  Assets under management are $90.3 billion, an increase of 14% over the same timeframe.  Neil Siegel, Managing Director and head of global marketing and product development at Neuberger Berman, and Evan Mizrachy, head of retail alternatives at BlackRock Alternative Investments, believe that retail investors and their 401(K) and IRA accounts are under-served by and under-allocated to alternatives.  Expanding into this segment would diversity hedge funds' client base.  On the other hand, retail investors demand daily liquidity requirements which would limit their investment universe and, maybe, performance.

According to Morningstar, the strategies run by these funds are led by long/short ($25.8 billion), market neutral ($19.5 billion), multi alternative ($17.5 billion), currency ($11.7 billion), managed futures ($8.5 billion),  short ($6.8 billion) and trading ($449 million).  Of course, these assets under management are clearly miniscule when compared to the $13.1 trillion in US mutual funds according to the Investment Company Institute.

The oldest fund, Merger Fund, has been around for 23 years using merger arbitrage strategy to give investors assets with low correlation to stock markets and volatility.  Two major institutions, FMR and Blackstone have also moved into this space.  FMR, parent company of Fidelity Management, uses Arden Asset Management to manage their alternative vehicles while Blackstone Alternative Asset Management is building their business organically.  The largest manager by far is PIMCO but their investors are mainly institutional.

The source for this article can be found at Pensions & Investments.

Hedge Funds Are Not An Asset Class

Capital Generation Partners (CGP), an investment advisory firm, analyzed portfolio diversification ideas.  They concluded that there are only three asset classes:  debt, cash and equity.  Alternative investments such as hedge funds should not be classified as an asset class.  They should be classified based on their underlying positions.  Hedge funds are merely investment strategies for these assets.  There are four strategies based on two points:  directional versus arbitrage and systematic versus discretionary.  These four strategies and three asset classes combine to create twelve buckets.

Equities
directional & discretionary - equity long/short, long only, real estate, private equity and 130/30 funds
directional & systematic - equity index trackers and quantitative funds
arbitrage & discretionary - equity market neutral and event/risk arbitrage
arbitrage & systematic - equity statistical arbitrage and systematic CTAs

Cash & Commodities
directional & discretionary - global macro, physical commodities and currency (carry) trading
directional & systematic - trend following CTAs, commodity ETFs and money market funds
arbitrage & discretionary - commodity/macro curve trading and volatility arbitrage
arbitrage & systematic - statistical arbitrage and systematic CTAs

Fixed Income
directional & discretionary - fixed income long/short and distressed debt
directional & systematic - bond indices
arbitrage & discretionary - global macro and structured credit
arbitrage & systematic - fixed income arbitrage and systematic CTAs

Proper diversification includes having non-correlated assets in a portfolio.  CGP analyzed returns from 2000 to 2010 for the twelve categories.  Their conclusions were:

• Alternative investments are not real diversifiers of a traditional equity/fixed income portfolio
• Hedge funds should be allocated across the twelve categories and not be treated as a separate asset class
• Fund managers should be closely monitored for style drift
• Correlation map indicates that larger allocations should be made to hedge funds

The correlation heat map from the paper confirms an earlier study by Welton Investment Management.  Global macro and managed futures (Barclays CTA Index in this case) are not correlated to other hedge fund strategies.  In CGP's chart, equity market neutral can be added.

The source for this article can be accessed here.

Managed Futures Selection Factors

Managed futures are marketed as having low correlation to stock and bond markets.  However, within the strategy, returns between managers (known as commodity trading advisors or CTAs) have varied.  According to David Kavanagh, CEO of Grant Park Managed Futures Mutual Fund, and Greg Anderson, Chief Investment Officer of Princeton Fund Advisors, returns are affected by four factors:  type of market securities, trading strategy, timeframe and research methodology.  They may trade in different futures covering currencies, energy, equity, fixed income, food or metals.  Obviously, the trading strategy - whether it is trend following or contrarian - affects returns.  Timeframes are how long a security is held.  They may be held for days or months.  Research methodology determines the trading signals for the manager.  They can be quantitative, top down or technical (charts).

According to Anderson, the four risks in the managed futures space are selecting the wrong manager, poor design of the investment portfolio, trading strategies becoming obsolete due to changing markets and tail risk.  Kavanagh adds understanding the edge of any CTA over its competitors.  The manager selection process considers several factors:  track record, trading strategy, fund's operations and back office, experience of the principals and fit within a portfolio.  On a more detailed level, Anderson would consider the interest income, cost structure (including trading commissions), trading results and an audited performance history.

This article can be accessed here at www.finalternatives.com.

Mutual Fund of Hedge Funds

Hatteras Funds manages $2.1 billion in the alternative investment space.  One of its products is mutual fund of hedge funds.  FINalternatives posted a recent interview with the President of Hatteras Funds, Bob Worthington. Their funds invests in five strategies:  long/short equity, equity market neutral, relative value long/short debt, event driven and managed futures.  The hedge funds have between $25 to $500 million in assets under management.  The mutual fund is diversified with 23 managers in a portfolio of $550 million.  Hatteras thinks that they can manage $5 billion in assets with 35 managers.  The managers have to meet compliance/risk control standards as well as being a good fit in the overall portfolio.

The mutual fund has daily liquidity.  This allows great flexibility in determining a tactical asset allocation.  Hatteras usually does not make adjustments on a daily or weekly basis but they can adjust if market conditions change dramatically.  The fund increases liquidity and transparency when compared to more illiquid fund of fund or hedge fund vehicles but has less risks and returns.  However, the fund gives the investor access to hedge fund strategies.

The article can be accessed here.

Regulated Hedge Funds: UCITS and Mutual Funds

SEI published a white paper on the growth of alternative investments called Regulated Alternative Funds: The New Conventional.  Because of the credit crisis of 2008 and the current Eurozone crisis, more and more investors have clamoring to be able to invest in alternative investments to lower downside volatility and offer returns uncorrelated with long-only mutual funds. In the first 8 months of 2011, $61 billion flowed into these investments. $22 billion (39% of all investment capital) were invested UCITS funds. There are now more than 1,500 UCITS funds managing $254 billion. $39 billion were invested through US mutual funds and ETFs. They now compose 4.4% of mutual fund assets and are growing at a 17% rate since 2007 when they were 2.2% of mutual fund assets. There are approximately 730 of them with 118 launched in 2011. Mutual fund families such as Ategris, BlackRock, PIMCO, Nuveen and First Eagle have funds that invest in traditional hedge fund strategies such as managed futures, long/short, credit, commodities, arbitrage and absolute return fixed income.

Internationally, they are constructed in an evolving vehicle known as Undertaking for Collective Investment in Transferable Securities (UCITS). Success has brought on investors. There are established funds with good returns, transparent investment and risk management strategies, and strong brands. The largest fund is the Standard Life Investments Global Absolute Return Strategies with $13.6 billion in assets under management. Other large funds include Julius Baer BF Absolute Return, Newton Real Return, JP Morgan Income Opportunity and PIMCO GIS Unconstrained Bond.

Within the US, they are launched within mutual fund families and ETFs. The largest are, in order of size, the SPR Gold Shares ETF, PIMCO Commodity Real Return Strategy, Ivy Asset Strategy, and iShares Silver and Gold Trusts. For investors, both structures offer more transparent risk management, liquidity, counter party diversification and limits on leverage. Investors are seeking better returns, lower volatility and to protect capital. Mutual fund families are aggressively marketing to and educating investors and registered investment advisors through white papers, instructional videos, fact sheets, regulatory filings and road shows.

Mutual funds are seeking to increase their fee structure. Alternative asset managers are seeking to have a more varied investor base.

When new products are launched, rules are reviewed. They are on the third iteration for UCITS. In the US, the SEC has stopped approving new funds and ETFs to review the effects of derivatives on portfolios. Within Europe, Luxembourg and Ireland are expecting to conform with UCITS regulations with the bonus of having additional flexibility. This may make them preferable to certain investment strategies and investors.

Demand is growing from sovereign wealth and national pension funds in Asia, Latin America and the Middle East and US institutional, high net worth and retail investors.

Commodity Funds: Best Performers for the Second Quarter

There was a sell-off in commodities in early May causing the average commodity fund to fall 5.12% for the second quarter.  The best commodity fund was up 6.8% in the same timeframe.  Obviously, it was a short fund - PIMCO's CommodityPLUS Short Strategy.  This fund bases its portfolio on the Dow Jones - UBS Commodity Index and takes the opposite side of the trade.  Other strong performers were gold and market neutral funds.  In fact, seven of the top ten best performers of the quarter were gold funds.  They invest in gold buillion, futures and miners.

The source for this post can be accessed here.

Allocations to CTAs by Institutional Investors

According to Don Steinbrugge of Agecroft Partners, managed futures funds run by commodity trading advisers (CTAs) are becoming more attractive investments for institutional investors.  Hedge funds using this strategy hold of 15% of assets under management for all hedge fund strategies.  During the internet and credit bubble of 2000-2002 and 2008, CTAs generated positive returns while stocks were down significantly.  In 2008, returns for various asset classes were:

• Barclays CTA Index +14%
• Dow Jones - UBS Commodity Index -35%
• US equity -40%
• Emerging market equity -50%
• High yield bonds -30%

The advantages of CTAs are liquidity on a monthly basis, transparency, risk management and good infrastructure (research, technology, operations and legal/compliance).  Some CTAs have weekly or daily liquidity.  More information about managed futures can be found here.

The source for this post can be found here.

Managed Futures: An Asset Class?

Hedgeworld alerted me to an article regarding the question:  Is Managed Futures an Asset Class?  In an earlier post, I had mentioned that it was according to the curriculum for the CAIA program.  The article defines an asset class as "...investment opportunities that behave and are treated in a similar manner."  The four characteristics are:    common regulatory guidelines, large amounts of assets under management, singular performance when compared to other asset classes and common risk/return profile within the asset class.  The first three answers are definitely yes.  The fourth is a maybe.   Even though the performance of managed futures sub-strategies are not correlated,  they all have position level detail, separately managed accounts and liquidity.  The article then goes on to rebut three counterarguments:

• Not all managed futures strategies react to market events in the same way
• Managed futures' underlying assets include stock indices, currencies and bonds and not only commodities
• Performance is not easily replicated within managed futures space

Managed Futures: Risk Management

Since the credit crisis, fund managers have put more emphasis on managing their funds' risks.  The following managed futures article by Attain Capital lists the various methods of how Commodity Trading Advisors do this and diversify their investments.

• Money management - involves budgeting risks across different futures markets;  done by balancing the equity at risk for each trade
• Market selection - ensuring the position is liquid or using exchange traded futures to minimize counterparty risk
• Market diversification - investing in multiple, uncorrelated markets;  diversifying trades over different sectors or contract maturities
• Model diversification - using multiple trading models within the fund
• Timeframe diversification - creating trading models based on different timeframes
• Trade structure - using options to limit risk such as buying put options or spread trades
• Delta neutral - using spread trades to limit volatility
• Manager skill - using the manager's judgment;  this flexibility comes with a higher risk of large losses

First Quarter 2011 Scoreboard: S&P 500 Beats All Hedge Funds

The first quarter of 2011 is in the books and the S&P 500 Index is beating the Dow Jones Credit Suisse Hedge Fund Index by a score of 5.92% to 2.21%.  The best performing strategies:  convertible arbitrage and multi-strategy returned barely above 4%.  As expected, short strategy is the worst performer at -6%.  Only other strategy with a negative return is managed futures.  The chart can be viewed at Pensions & Investments.

Interview with Managed Futures Manager

In Europe, managed futures funds have 20% of the assets under management for hedge funds.  In 2008, the strategy was the only one with positive returns.  There is an interview with Philipp Polzi of Qbasis, a fund with a return of 145% since 2008, on www.finalternatives.com.  Qbasis uses trend following and countertrend trading strategies within the fund.  It has a proprietary signal called early trend recognition to identify trades.  The manager has $50 million in AUM and can handle $2 billion before hitting capacity restraints.  His last comment is that the growth of managed futures means that investors believe in the performance of the strategy in the future.  But how much of that is money chasing after recent performance?

Is Your Portfolio Truly Diversified?

During the credit crisis of 2008, all assets (equities, fixed income, real and alternative assets) declined in value.  Welton Investment Management wrote a research report regarding asset allocation.  According to Modern Portfolio Theory, the most efficient portfolios have assets that are not correlated.  This minimizes any excessive decrease in assets during a crisis.

They tested this theory by taking 24 indices representing the 4 asset types and calculated the correlation of returns over 10 years across 2.5 business cycles.  They discovered that 80% of alternative assets and 75% of real assets were correlated with stock returns.  The alternative assets were private equity, event driven, long/short equity, distressed securities, multi-strategy, fixed income arbitrage, convertible arbitrage and risk arbitrage.  Only global macro and managed futures were non-correlated.  For real assets, infrastructure, real estate and TIPS (Treasury Inflation Protected Securities) were correlated.  Commodities was the only real asset that had non-correlated returns against equities.

The 4 revised asset types should be:

• Equities, correlated alternative and real assets
• Global macro and managed futures funds
• Commodities
• Fixed income

The research report may be accessed here.

Risk Measurement for Managed Futures Funds

There are five main types of risk management formulas that apply to managed futures funds.  Each has their limitations and caveats.  They also are separate measures.   They are:

• Margin-to-equity ratio:  This is the initial margin (in cash or Treasury bills) needed to establish the portfolio divided by the amount invested.  A low percentage means high leverage.  This may be misleading as the manager may have long and short positions or may be trading across different exchanges.
• Capital at risk:  When managers add a position, they attach a stop-loss rule to limit their losses.  This ratio calculates the total of the portfolio's losses if each position triggers the rules and divides it by the amount invested.  This is not an exact number because of the terms of the stop-loss rule.  The rule begins a transaction when the price is hit.  In a extremely volatile market, the actual trade price may be very different from the stop-loss price.  Capital at risk also does not account for offsetting long and short positions.
• Value at risk:  The potential loss for a given period and confidence level.  For example, a 95% one month figure of $10 implies that the portfolio has a 5% chance of losing more than $10 and 95% of losing less than $10.  Since the credit crisis of 2008, this has been the subject of some papers as measuring tail risk inadequately.  This is because the calculation is based on a normal distribution.
• Maximum drawdown:  This figure calculates the largest percentage loss for an investor for a specific period.
• Stress test:  This calculates a portfolio's losses by running different scenarios on the individual holdings to determine the effects on each scenario.

Managed Futures Basics

Managed futures funds invest in futures and forward contracts on currencies, commodities, financial indices and ETFs.  The funds, called commodity pools, are run by a commodity trading advisor (CTA).  The management fees are between 0% to 3% of assets under management (AUM) and the incentive fees are between 10% to 35% of profits.  The fees are also called "2 and 20".

Most CTAs use a black box to establish trading rules.  There are managers that act as mutual fund managers and create their positions.  They are a minority though.  The rules are not static and adjusted constantly due to copycats, poor trade execution, AUM growth and changing market conditions.  The three types of black boxes are trend following, non-trend following and relative value.

Trend following strategies are based on action of the asset prices; much like technical analysis for stocks.  The moving average strategy uses the average price of an asset to buy or sell.  The moving average may be calculated in various ways:  any number of days or different weighting of prices.  If the current price is higher than the moving average, the fund buys.  If the current price is lower, the fund sells.  This strategy works well when the asset moves steadily in one direction.  It does not work well in a volatile market or a market in a narrow trading range.  The break-out strategy uses the same buy and sell signals as the moving average strategy.  Instead of using the average of prices to trigger the trade, the fund uses the price range of the asset.

Non-trend following strategies include countertrend and pattern recognition strategies.  Countertrend strategy uses models to identify trades.  Pattern recognition is similar to technical analysis of stock charts where the CTA will find trading opportunities based on the price action of the asset.

Relative value strategies invest in related futures contracts that have experienced a short term price difference. The manager may perform an arbitrage trade as the prices return to their historical relationship.

Further information on managed futures can be accessed at Attain Capital's managed futures blog.

Managed Futures

I received an article regarding managed futures from Albourne Village named "Decoding the Myths of Managed Futures".  In several hedge fund indexes, managed futures are listed as a strategy.  Within the CAIA program, they are a separate category.  The report talks about its recent growth and elaborates on some controversies:

• Opaqueness regarding their "black box" trading strategy
• Non-correlation to equity returns
• Investing in non-commodity instruments
• Volatility
• Homogeneity of funds