Investors often do not focus on extreme value theory to analyze the benefits of hedge funds because extreme events just do not happen that often and the mathematics is not as easy as looking at just looking at correlation and variance. Nevertheless, building a portfolio should account for what happens at the extreme because this is when a large portion of wealth is lost. If wealth preservation is a critical issue for a money management advisor and causes more anxiety than gains for investors, understanding the dynamics at extremes is all the more important.
Using extreme value theory in portfolio management is more than just looking at correlations to provide diversification. What is important is not the average correlation but what is the relationship across assets at the extreme levels and the shape of the distribution. Fat tails and skewness really matter once you move to extremes. If you add assets that have more non-normal shapes, you will change the distribution of the overall portfolio.
This is consistent with our thoughts on fragile and anti-fragile strategies. Investors would like strategies that do especially well in the extreme especially relative to traditional assets. Let's take the performance of two simple assets against the stock market. They can both have a low correlation on average. However, one may get more uncorrelated on large down moves. As a diversifier, this may be a more important asset to hold all else being equal.
These differences occur because the return profile of many strategies are not normally distributed. Kurtosis is surprise risk in the sense that you may not know whether there will be big up or down move. You do know that a big move is more likely than what will happen with a normal distribution. Skew is a tilt or non-linear risk. It places more tilt in the probabilities of a distribution to one side of the mean. Returns will be pushed in one direction relative to a normal distribution.
This is consistent with our thoughts on fragile and anti-fragile strategies. Investors would like strategies that do especially well in the extreme especially relative to traditional assets. Let's take the performance of two simple assets against the stock market. They can both have a low correlation on average. However, one may get more uncorrelated on large down moves. As a diversifier, this may be a more important asset to hold all else being equal.
These differences occur because the return profile of many strategies are not normally distributed. Kurtosis is surprise risk in the sense that you may not know whether there will be big up or down move. You do know that a big move is more likely than what will happen with a normal distribution. Skew is a tilt or non-linear risk. It places more tilt in the probabilities of a distribution to one side of the mean. Returns will be pushed in one direction relative to a normal distribution.
Using the distribution properties of the strategies can help with determining the behavior of a portfolio in the extreme. Simulations can be run which account for behavior when there is a strong stock move.
Some older work from two FoF managers provides some good insights on this matter. In the extreme, distributions matter. Whether you have fat tails and skewness have a large effect when you move to the extremes, so hedge funds which are less normally distributed will have an impact on the extreme value of any portfolio. An analysis of stock and bond portfolios which have the addition of different types of hedge fund portfolios from conservative to defensive show the value at the extreme. The benefit to a stock portfolio will be greater than for a bond portfolio. For a stock portfolio, the benefit of hedge is as great as the amount that can be held. For bond portfolios, a 50/50 mix with hedge funds proves to be the best at reducing risk at the extreme. If you have a mixed portfolio, the amount of hedge funds to be added is less clear since you get some natural diversification with the safe bond asset.
What is clear is that managed futures will provide the most benefit for portfolios at the extreme given its independence with traditional assets at the extreme and its unique distribution qualities. You may not always be happy with managed futures when the world is calm, but when divergences and dislocations occur, the behavior of managed futures is valuable. Protect your portfolio by playing the extremes.
What is clear is that managed futures will provide the most benefit for portfolios at the extreme given its independence with traditional assets at the extreme and its unique distribution qualities. You may not always be happy with managed futures when the world is calm, but when divergences and dislocations occur, the behavior of managed futures is valuable. Protect your portfolio by playing the extremes.
No comments:
Post a Comment