WHAT GOES UP… How long can it go on? The bull run since the depths of the global financial crisis has seen the S&P grow from a low of 682 to a recent high of 2742, a staggering 17% CAGR over nine years. Just this morning the Dow topped 26,000 for the first time. Other markets have also exhibited surprising behavior: worldwide yields – initially driven down by central bank intervention – have remained low, oil has largely maintained its post2014 collapse levels, and virtually all markets have seen a dramatic drop in volatility. Investors insatiable search for the stability of dividend-like returns has driven volatility out of nearly every financial market. In hindsight, its been an equity investors dream: rising equity prices, low-yields, low inflation and low volatility.
But todays high – some might say exorbitant – equity valuations are a growing concern for investors. Last years US tax cuts have furthered bulls optimism, but recent rises in bond yields have cast a shadow on that exuberance. Historically, high equity prices have been supported by low-yields like the ones weve had over the past decade. Those days appear to be numbered. Equity investors have traditionally looked to bonds and cash for diversification, but if yields rise it would pose a double-whammy by eroding equity valuation support and simultaneously lowering bond prices.
Despite the turbulence in world politics, markets volatility was eerily low in 2017. While the S&P was up 19% last year, the VIX had its quietest year ever – turning long volatility plays into losses. Hedging has become a very expensive activity and fewer investors are bothering with paying for such protection. Recent CFTC data shows that more hedge funds hold short volatility positions than long volatility positions: a bet that can backfire spectacularly. With fewer funds holding equity hedges, when the inevitable down-turn comes, more funds will have no choice but to rush to sell their shares, thereby amplifying the volatility and a price plunge.
…DOESNT HAVE TO COME DOWN AS HARD Enter the notion of Crisis Alpha, the concept that some strategies are able to provide uncorrelated returns in normal markets and positive returns during market crashes. While many traditional managers count on bonds to provide this sort of hedge, as demonstrated in the classic flight-to-quality maneuver during equity sell-offs, fixed income doesnt often provide positive returns during such crises. The correlation between bonds and stocks, which on average is about zero, can oscillate in a matter of days between extremes of +0.8 and -0.8 according to our studies. What was put on as a strong hedge can quickly unravel into a doubling-down, providing a surprising sting to an unsuspecting investor.
On the other hand, momentum investing in commodities, known as trend-following, has a demonstrated record of uncorrelated returns to equities and profit generation during market dislocations. The managed futures industry has long touted its history of uncorrelated returns as a natural hedge to traditional investments: equities and fixed income alike. The trend-following approach is applicable to any asset-class: take a long position in upward price movements and a short position in downward markets. Getting in on a trend early seems to be less important than properly timing the exit: hard-earned profits can be eaten away quickly if a trader stubbornly holds onto the position past the trends end. The futures markets are particularly well suited for this sort of trading because they are highly liquid, well-regulated and have significant volumes around the world. Crucially, they allow investors to follow both upward and downward trends because shorting is relatively easily in futures when compared with other markets.
By their very nature, trend following strategies are non-directional: they do not examine the fundamentals of an investment nor do they have long or short biases – they invest in the direction that is prevalent and have the ability (and obligation!) to reverse course swiftly when warranted. They are, in a word, adaptive. In their book Trend Following with Managed Funds Alex Greyserman and Kathryn Kaminski examined 800 years worth of commodity data to study trend-followings relationship to traditional markets over the long term. They found that including an allocation to trend-following not only reduced a traditional 60/40 (equity/fixed income) portfolios overall volatility, it also significantly reduced the periods of maximum draw-down precisely because the trend-following portion of the portfolio posted positive returns during both equity and fixed income crises.
While trend-following strategies have equity-like volatility on their own, because of their anti-correlation with equities especially during crises, their inclusion in a portfolio reduces the overall risk in the portfolio when its needed most. This can be understood using the StatPro VisualVaR triangle:
The traditional investment – equity/bond portfolio – has a risk level represented by the bottom blue arrow and the CTA has a risk level represented by the red arrow pointing up and to the left. On their own, they each have comparable risk levels as depicted by their lengths, typically about 20% per annum. When combined in a portfolio, however, they significantly offset one another. The arrows are oriented according to their correlation: a significant negative correlation positions them as shown in the diagram. The net result is shown by the third black arrow: a portfolio with less risk than either of its constituents.
BY THE NUMBERS We looked at five crisis periods over the past ten years to better understand how institutional investors and hedge fund managers can evaluate the effectiveness of an allocation to strategies that may provide crisis alpha. Crisis periods were chosen based on an upward spike in the VIX that also corresponded to a drop in the S&P.
A more detailed study, also by Greyserman and Kaminski, examined individual CTAs rather than a blended index and found that those CTAs with a long equity bias unsurprisingly provided the least amount of crisis alpha. Those CTAs with no equity directional bias had strong negative correlation with both the equity and bond markets and systematically provided positive returns in market crisis periods. The key to isolating crisis alpha seems to be identifying trend-following managers who do not exhibit a directional equity bias.
We next examined how an institutional investor could evaluate an allocation to such a crisis alpha generating manager. The same technique can be used by hedge funds to understand how well their strategy benefits an allocator. Starting with a typical institutional portfolio made of worldwide equities (50%), global investment grade and high-yield fixed income (40%), commodities (5%) and FX (5%), we studied allocations of 10% and 20% to CTAs.
A 20% allocation to trend-following CTAs can, during significant equity down-turns, save the portfolio up to 35% of the losses it would otherwise suffer. Institutional investors can use similar stress testing techniques to evaluate an individual funds effect on their portfolio as part of their investment due diligence process. Similarly, savvy hedge funds can simulate their own funds impact on a prospective investors portfolio. Such analysis would give the hedge fund insight into which institutional investors are likely to make an allocation based on the benefit the fund imparts on their portfolios.
Whenever it happens, the inevitable end to the current bull run will be accompanied by a spike in volatility, the predictable flight-to-quality and, unfortunately, heavy losses in most institutional portfolios. Risk analyses like the correlated stress tests above should be performed prophylactically to evaluate a funds preparedness. Those investors who preemptively place money with funds providing crisis alpha will not only stem their losses during the next down-turn, but they will have positioned themselves as astute investment managers worthy of future allocations.
Damian Handzy, Ph.D. is Global Head of Risk, StatPro
