Thursday, July 2, 2020

CTA style dispersion higher - These are times when the pain from regret grows

Investors do not want to suffer from regret or  making a decision that proves to be wrong relative to  set of alternatives. Formally, regret is the emotional response associated with the value difference between a made decision and an optimal decision. The potential pain from regret will increase within a hedge fund style choice if there is greater return dispersion within the style category. Dispersion will increase the difference or penalty between any choice and the maximizing choice. 

There can be a wide set of alternative managers to choose, but the hope is that the investor's choice will be close to or above the median. Investors may use a min-max strategy to reduce the ratio of pay-offs versus the best or median choice. 

It should be expected that return dispersion will increase if there is higher market volatility; however, that also means regret will also increase with volatility. Higher dispersion occurs when there is higher market volatility because small differences in strategy may translate into greater differences in manager return. For example, the CTA's category an include everything from trend-followers, to carry and value managers, to market sector-focused managers. A cluster of the best managers may have different style than those in the bottom decile. The regret may have more to do with the choice of style within the CTA category over choosing a bad manager.  

If there is an increase in return dispersion like found in 2008 and 2020, the cost of being wrong, either by manager style or skill, may be especially high. These are the times when regret increases and there is higher frustration with hedge fund managers. It may not be the fault of managers. There is just more pain from regret.

Chart and table from All About Alpha:


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