Wednesday, October 5, 2016

Skew risk, volatility risk, and managed futures

Some new research on risk parity makes some provocative comments on the risk and potential value of managed futures in a portfolio. We have cited this recent work in one of our previous posts suggesting that accounting for skew can be helpful relative to a risk parity approach focused on volatility. See Messy markets, mixed distributions, and skew - Thinking about downside risk. What was noted with this work is that hedging volatility will not eliminate skew risk. Volatility diversification or holding negatively correlated assets can reduce volatility but actually increases tail risks on a relative basis. There is a floor with skewness diversification because it is hard to hedge jump risks. Calm or low volatility assets may actually have higher jump risk.

The authors in "Risk Parity Portfolio with Skewness" make an interesting conjecture that managed futures with its low correlation with traditional assets and its better performance during a crisis can help a portfolio, but may not solve the risk from skew or short-term jumps in price. 

This is an interesting comment that is worth exploring in more detail. Put differently, one may expect that managed futures will do a good job of diversification when there is an increase in volatility from some macro event. It may actually perform well during these periods of stress and higher volatility. The same cannot be said when there is heightened skew in the distribution of asset prices from jump risks. 

My bias on this conjecture is with the authors. Longer-term trend-following managed futures managers will not do well during periods of high skew which is another way of saying high jump risk. This is consistent with the view that managed futures managers are long long-term volatility and short short-term volatility. Short-term skew from a jump may not last long enough for traditional managed futures managers to exploit.

This conjecture would suggest that high skew periods should not be good for managed futures. Nevertheless, a possible corollary to this view is that short-term managed futures managers will actually do better during periods of high skew when there is jump risk. Their short-term investment horizon may make them better able to take advantage of jumps which create skew.

This impact of skew on managed futures is research we will be conducting in the coming weeks. It may have strong implications with portfolio construction. Longer-term trend-followers should be matched-up with short-term systematic managers to be able to exploit higher long-term volatility and shorter-term situations of higher skew. 

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