Tuesday, April 17, 2018

The "3 by 5 index card" on "Divergent" and "Convergent" hedge fund strategies

This is the second in our series; all you need to know about a topic should fit on a "3 by 5" index card. We think the complexity of hedge fund investing can be simplified if the simple dichotomy of divergent and convergent trading is used as a primary method of describing potential return pay-offs. 

If you strip away all of the activities and the just get down to basics, strategies are based on the world view of the manager and will either make money when prices move away from the mean or equilibrium price or prices revert to the mean or equilibrium price. If a manager believes the world is knowable, stable, and rational, he will be comfortable taking relative value arbitrage risks. If a manager believes the world its unknowable, dynamic, and subject to mistakes and biases, he will be comfortable with strategies that make money from market dislocations. 

Investors will be rewarded from convergent trading when prices are stable and times are normal. You will be rewarded with holding divergent strategies when there are large market dislocation and price movement away from the mean. This is not the end of the story on hedge fund investing but a good start for any discussion.

See: Mark Rzepczynski "Market Vision and Investment Styles: Convergent and Divergent Trading" Journal of Alternative Investments (Winter 1999).

Long/short commodities - Adds value to equity and bond portfolios

Static investments in long-only commodity indices have had a checkered past since the financial crisis. With the end of the commodity super-cycle, there has been a long commodity unwind and passive investing in commodities has generated negative annualized returns for investors for years. There has not been any bounce to pre-crisis level like we seen in equities. The interest in commodities as an inflation hedge has waned with this poor performance.

Of course, the dynamics of commodity prices are different from other asset classes where value is determined by discounted future cash flows. Commodities indices, as constructed through futures contracts, are driven by current demand, production, and inventory changes and not long-term future cash flows. Nevertheless, the investment environment may be changing in favor of commodities. See:

Over the past decade, there have been a explosion of commodity alternatives often referred to as second and third generation indices that have reduced risk and provided positive returns independent of the long commodity cycle and long-only indices. These long/short indices have focused on commodity risk premium and have included momentum, carry and fundamental focused rules-based investments. Expressing commodity exposure through the underlying risk premium in these markets allows investors to capture the behavior of commodities but in a way that is not as sensitive to the long swings in price and can exploit the unique differences across markets include in a commodity basket. See:

Recent research from Tom Erik Sonsteng Henriksen, "Properties of Long/Short Commodity Indices in Stock and Bond Portfolios" in the Spring 2018 Journal of Alternative Investments further confirms the distinctive features and value of long/short commodity investing through analyzing some existing investment funds available to investors. There has been a significant decline in performance since the launch of these funds, which corresponds to the post-Financial Crisis period, but the shortfalls relative to the pre-crisis periods are significantly lower the what has been seen with long-only investing. When added to portfolios of stocks and bonds using a variety of portfolio allocation methods including variations on risk parity, the author finds that returns are lowered especially in the post-crisis period, but there also is significant risk reduction and a general improvement in the return to risk ratio.

Our take-away is that employing long/short commodities indices comprised of risk premiums have diversification benefit but the potential for return enhancement is mixed and affected by the time period analyzed. Since the study looked at funds that have singular purpose like momentum or carry, there is still room for further analysis on the impact of bundled risk premium portfolios. Nevertheless, there is value in looking at enhanced commodity allocations at this time given the higher potential for inflation, better overall commodity environment, and the continued global economic growth.

Monday, April 16, 2018

Option strategies over hedge funds - Why not? The number tell a good story

There has been a consistent drumbeat that investors should use hedge funds as a core means of portfolio diversification. This has been at the expense of other methods of hedging. A diversification strategy makes sense when there is no investor information advantage or no view on the direction of markets, but in reality, investors often have some view on market direction or risks at the extreme. However, given the uncertainty on market direction and the inability to form conditional hedges, the investor focus is usually on strategy diversification through hedge funds. 

Nevertheless, option strategies can be effective alternatives to hedge funds especially if there is a market view. We mention the issue of market view because low cost option strategies will often buy puts to protect a percentage of the portfolio or protect against a specific sized move and selling calls is used to generate premium to pay for the puts. The call selling is based on either a market view or a willingness to limit upside. 

There is a close link between hedge fund pay-offs and option pay-offs. A number of researchers have used options pay-offs to describe hedge fund returns. For example, managed futures have often been described as being long a straddle. Some relative value strategies have been described as being short options. Given this link between the non-linear pay-off of options and hedge fund strategies, it would seem natural to compare the two to see which actually perform better when equalized on volatility or market exposure. 

On the one hand, investors access the skill of the hedge fund manager versus the direct pay-off from options which do not include all the fees associated with a hedge fund. Given that option should be cheaper, a simple question is whether hedge fund skill can cover their costs and also outperform an option strategy. 

We think this work has been under-researched, yet that is changing with a recent paper in the Journal of Alternative Investments. (See "alternatives to Alternative Assets: Assessing S&P 500 Index Option Strategies as Hedge Fund Replacements" by Wei Ge.) The author compares seven different option strategies on an equity index against 14 different Credit Suisse hedge fund indices that cover all of the major hedge fund strategies. The comparison is done through either beta volatility matching.  

The results show that the combined option strategies of buying puts and selling calls against the index generated higher returns and have better return to risk characteristics. The numbers are economically significant and should be persuasive even to motivate any investor to take a closer look at the value of these strategies as a hedge fund alternative. 

There are a host of management issues with trying to implement options strategies as well as regulatory barriers, but all of these can be effectively addressed. Why limit diversification alternatives to hedge funds when there are option strategies that can provide better choices?

Sunday, April 15, 2018

Morningstar star prediction - Signal to noise is low

Morningstar star ratings - Do they really work or are they a dangerous tool? This is important to revisit given the increased number of hedge funds that now have '40 Act fund structures that are ranked by Morningstar.

Like most tools, if they are used inappropriately, there will be problems. There is an ongoing controversy between Morningstar and others on the signaling value of a 5-star rating or for that matter any ranking. The ranking today may not provide predictive power on future ranking or performance. Our view is that their ranking system is a good start for analysis but should not be used as a definitive measure. Some of the problem with the ranking are associated with just understanding what is being measured.  

The ratings are a risk adjusted ranking of funds within a defined investment category. While the approach accounts for downside risk, the stars are nothing more than a ranking system. A 5-star fund will be in the top 10 percent of the funds within the category. Morningstar grades on a curve, it is hard to maintain a 5-star rating. It is backward-looking based on performance and says nothing about the quality of the manager, their philosophy, or what the fund will do in the future other than to say for the sample periods it has a high ranking. Morningstar also has analyst rating which are forward-looking and rank by a colored shield but this approach is not as popular as the risk rating. The ranking is also weighted by the time outstanding for the fund. 

We think the ranking value may have less signaling in alternative investments for two reasons. One, the sizes of the categories has changed significantly over the last few years with the growth in alternative investment funds. Two, the categorization of alternative investments is not as precise as in some of the more traditional categories. Hence, there may be noisier investor information in these ranking measures.

Predictability comes with a positive correlation between ranking today and the performance tomorrow. The research on predictability is mixed. A ranking could still remain high but there can be a decline in returns. A ranking could fall and there be better risk-adjusted performance next period. The risk ranking does to account for any changes in the fund structure. Hence, it is hard to place too much emphasis in the ranking until you define carefully what is being measured. 

  • Do you want to predict return? 
  • Do you want to predict future rankings? 
  • Do you want to predict absolute return to risk? 
  • Do you want to make a prediction about return or ranking versus other categories?
There needs to be more research on the value of rankings for alternative investments in order to provide investors with better advise on allocation to these growing categories of funds.