Category: Alternative Investment

Posted on

Finding Alpha in 2018

Given the current macro-economic environment, where should investors focus their search for sources of alpha in the year ahead?  By asking enough economists or investment managers you will find as many different opinions on the subject as would care to, no doubt many of them conflicting.  These are some thoughts on the subject from my perspective, as a quantitative hedge fund manager.

SSALGOTRADING AD

Global Market Performance in 2017

Let’s begin by reviewing some of the best and worst performing assets of 2017 (I am going to exclude cryptocurrencies from the ensuing discussion).  Broadly speaking, the story across the piste has been one of strong appreciation in emerging markets, both in equities and currencies, especially in several of the Eastern European economies.  In Government bond markets Greece has been the star of the show, having stepped back from the brink of the economic abyss.  Overall, international diversification has been a key to investment success in 2017 and I believe that pattern will hold in 2018.

BestWorstEquityMkts2017

BestWorstCurrencies2017

BestWorstGvtBond

 

US Yield Curve and Its Implications

Another key development that investors need to take account of is the extraordinary degree of flattening of the yield curve in US fixed income over the course of 2017:

YieldCurve

 

This process has now likely reached the end point and will begin to reverse as the Fed and other central banks in developed economies start raising rates.  In 2018 investors should seek to protect their fixed income portfolios by shortening duration, moving towards the front end of the curve.

US Volatility and Equity Markets

A prominent feature of US markets during 2017 has been the continuing collapse of equity index volatility, specifically the VIX Index, which reached an all-time low of 9.14 in November and continues to languish at less than half the average level of the last decade:

VIX Index

Source: Wolfram Alpha

One consequence of the long term decline in volatility has been to drastically reduce the profitability of derivatives markets, for both traders and market makers. Firms have struggled to keep up with the high cost of technology and the expense of being connected to the fragmented U.S. options market, which is spread across 15 exchanges. Earlier in 2017, Interactive Brokers Group Inc. sold its Timber Hill options market-making unit — a pioneer of electronic trading — to Two Sigma Securities.   Then, in November, Goldman Sachs announced it was shuttering its option market making business in US exchanges, citing high costs, sluggish volume and low volatility.

The impact has likewise been felt by volatility strategies, which performed well in 2015 and 2016, only to see returns decline substantially in 2017.  Our own Systematic Volatility strategy, for example, finished the year up only 8.08%, having produced over 28% in the prior year.

One side-effect of low levels of index volatility has been a fall in stock return correlations, and, conversely, a rise in the dispersion of stock returns.   It turns out that index volatility and stock correlation are themselves correlated and indeed, cointegrated:

http://jonathankinlay.com/2017/08/correlation-cointegration/

 

In simple terms, stocks have a tendency to disperse more widely around an increasingly sluggish index.  The “kinetic energy” of markets has to disperse somewhere and if movements in the index are muted then relative movement in individual equity returns will become more accentuated.  This is an environment that ought to favor stock picking and both equity long/short and market neutral strategies  should outperform.  This certainly proved to be the case for our Quantitative Equity long/short strategy, which produced a net return of 17.79% in 2017, but with an annual volatility of under 5%:

QE Perf

 

Looking ahead to 2018, I expect index volatility and equity correlations rise as  the yield curve begins to steepen, producing better opportunities for volatility strategies.  Returns from equity long/short and market neutral strategies may moderate a little as dispersion diminishes.

Futures Markets

Big increases in commodity prices and dispersion levels also lead to improvements in the performance of many CTA strategies in 2017. In the low frequency space our Futures WealthBuilder strategy produced a net return of 13.02% in 2017, with a Sharpe Ratio above 3 (CAGR from inception in 2013 is now at 20.53%, with an average annual standard deviation of 6.36%).  The star performer, however, was our High Frequency Futures strategy.  Since launch in March 2017 this has produce a net return of 32.72%, with an annual standard deviation of 5.02%, on track to generate an annual Sharpe Ratio above 8 :

HFT Perf

Looking ahead, the World Bank has forecast an increase of around 4% in energy prices during 2018, with smaller increases in the price of agricultural products.   This is likely to be helpful to many CTA strategies, which will likely see further enhancements in performance over the course of the year.  Higher frequency strategies are more dependent on commodity market volatility, which is seen more likely to rise than fall in the year ahead.

Conclusion

US fixed income investors are likely to want to shorten duration as the yield curve begins to steepen in 2018, bringing with it higher levels of index volatility that will favor equity high frequency and volatility strategies.  As in 2017, there is likely much benefit to be gained in diversifying across international equity and currency markets.  Strengthening energy prices are likely to sustain higher rates of return in futures strategies during the coming year.

Posted on

What Wealth Managers and Family Offices Need to Understand About Alternative Investing

Gold

The most recent Morningstar survey provides an interesting snapshot of the state of the alternatives market.  In 2013, for the third successive year, liquid alternatives was the fastest growing category of mutual funds, drawing in flows totaling $95.6 billion.  The fastest growing subcategories have been long-short stock funds (growing more than 80% in 2013), nontraditional bond funds (79%) and “multi-alternative” fund-of-alts-funds products (57%).

Benchmarking Alternatives
The survey also provides some interesting insights into the misconceptions about alternative investments that remain prevalent amongst advisors, despite contrary indications provided by long-standing academic research.  According to Morningstar, a significant proportion of advisors continue to use inappropriate benchmarks, such as the S&P 500 or Russell 2000, to evaluate alternatives funds (see Some advisers using ill-suited benchmarks to measure alts performance by Trevor Hunnicutt, Investment News July 2014).  As Investment News points out, the problem with applying standards developed to measure the performance of funds that are designed to beat market benchmarks is that many alternative funds are intended to achieve other investment goals, such as reducing volatility or correlation.  These funds will typically have under-performed standard equity indices during the bull market, causing investors to jettison them from their portfolios at a time when the additional protection they offer may be most needed.

SSALGOTRADING AD

This is but one example in a broader spectrum of issues about alternative investing that are poorly understood.  Even where advisors recognize the need for a more appropriate hedge fund index to benchmark fund performance, several traps remain for the unwary.  As shown in Brooks and Kat (The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors, Journal of Financial and Quantitative Analysis, 2001), there can be considerable heterogeneity between indices that aim to benchmark the same type of strategy, since indices tend to cover different parts of the alternatives universe.  There are also significant differences between indices in terms of their survivorship bias – the tendency to overstate returns by ignoring poorly performing funds that have closed down (see Welcome to the Dark Side – Hedge Fund Attribution and Survivorship Bias, Amin and Kat, Working Paper, 2002).  Hence, even amongst more savvy advisors, the perception of performance tends to be biased by the choice of index.

Risks and Benefits of Diversifying with Alternatives
An important and surprising discovery in relation to diversification with alternatives was revealed in Amin and Kat’s Diversification and Yield Enhancement with Hedge Funds (Working Paper, 2002).  Their study showed that the median standard deviation of a portfolio of stocks, bonds and hedge funds reached its lowest point where the allocation to alternatives was 50%, far higher than the 1%-5% typically recommended by advisors.

Standard Deviation of Portfolios of Stocks, Bonds and 20 hedge Funds

Hedge Fund Pct Mix and Volatility

Source: Diversification and Yield Enhancement with Hedge Funds, Amin and Kat, Working Paper, 2002

Another potential problem is that investors will not actually invest in the fund index that is used for benchmarking, but in a basket containing a much smaller number of funds, often through a fund of funds vehicle.  The discrepancy in performance between benchmark and basket can often be substantial in the alternatives space.

Amin and Kat studied this problem in 2002 (Portfolios of Hedge Funds, Working Paper, 2002), by constructing hedge fund portfolios ranging in size from 1 to 20 funds and measuring their performance on a number of criteria that included, not just the average return and standard deviation, but also the skewness (a measure of the asymmetry of returns), kurtosis (a measure of the probability of extreme returns)and the correlation with the S&P 500 Index and the Salomon (now Citigroup) Government Bond Index.  Their startling conclusion was that, in the alternatives space, diversification is not necessarily a good thing.    As expected, as the number of funds in the basket is increased, the overall volatility drops substantially; but at the same time skewness drops and kurtosis and market correlation increase significantly.  In other words, when adding more funds, the likelihood of a large loss increases and the diversification benefit declines.   The researchers found that a good approximation to a typical hedge fund index could be constructed with a basket of just 15 well-chosen funds, in most cases.

Concerns about return distribution characteristics such as skewness and kurtosis may appear arcane, but these factors often become crucially important at just the wrong time, from the investor’s perspective.  When things go wrong in the stock market they also tend to go wrong for hedge funds, as a fall in stock prices is typically accompanied by a drop in market liquidity, a widening of spreads and, often, an increase in stock loan costs.  Equity market neutral and long/short funds that are typically long smaller cap stocks and short larger cap stocks will pay a higher price for the liquidity they need to maintain neutrality.  Likewise, a market sell-off is likely to lead to postponing of M&A transactions that will have a negative impact on the performance of risk arbitrage funds.  Nor are equity-related funds the only alternatives likely to suffer during a market sell-off.  A market fall will typically be accompanied by widening credit spreads, which in turn will damage the performance of fixed income and convertible arbitrage funds.   The key point is that, because they all share this risk, diversification among different funds will not do much to mitigate it.

Conclusions
Many advisors remain wedded to using traditional equity indices that are inappropriate benchmarks for alternative strategies.  Even where more relevant indices are selected, they may suffer from survivorship and fund-selection bias.

In order to reap the diversification benefit from alternatives, research shows that investors should concentrate a significant proportion of their wealth in the limited number of alternatives funds, a portfolio strategy that is diametrically opposed to the “common sense” approach of many advisors.

Finally, advisors often overlook the latent correlation and liquidity risks inherent in alternatives that come into play during market down-turns, at precisely the time when investors are most dependent on diversification to mitigate market risk.  Such risks can be managed, but only by paying attention to portfolio characteristics such as skewness and kurtosis, which alternative funds significantly impact.