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CFA Institute Enterprise Investor Building Anti-Fragile Portfolio


Long or short volatility?

I once worked as an equity derivatives intern at Credit Suisse First Boston in London. Like other investment banks, the team had three distinct members: salespeople, merchants, and structures. The latter were almost exclusively polymaths of the top schools of French engineering who had fewer job opportunities in Paris but were surprisingly well compensated across the English Channel.

Their main role was to create innovative new products that they presented to the team during the 7 a.m. meeting every day. At one such meeting, the managing director asked if the proposed product was long or short volatile.

The structure was stumped and could not run fast through complex derivative solutions. So he was embarrassed and scolded that he would come back later with the answer.

The question has stuck with me ever since. This is not common in the asset management industry. Most investors are almost identical in asset classes and their investment philosophy is easy to compare after a brief conversation, whether they allocate capital in stocks, bonds or real estate. They buy something because it’s cheap, they follow trends, or invest in quality.

In contrast, talking to someone who works at the Derivatives desk is almost alien encounter. It’s all about gamma, delta-hedging and similar terminology borrowed from the Greeks.

But after many years in the investment industry in a variety of roles from real estate investors to hedge fund managers, I’ve come to question whether a portfolio has risen almost to the top in long or short volatility when it comes to long-term asset allocation.

Let me sue.

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Variety of paper

Most wealth class bets on economic growth. Companies struggle to raise revenue when growth is slowing and the default rates on corporate and sovereign bonds are rising.

Some asset classes – private equity or real estate, for example – offer apparently diversity benefits. But that’s just on paper. Their income is calculated using logging and smooth assessment. When the economy is in recession try to sell that private company or commercial building in its latest valuation.

Looking almost like a huge ponzi scheme, everything depends on the continued expansion of the world economy.

So what drives economic growth? Broadly speaking, it is a change in productivity and working age population. The first is a vague idea, the latter is crystal clear.

Theoretically, technological innovations in recent years should have resulted in massive productivity increases. But economists have not been able to make a statistical case for this.

In contrast, population trends are easy to understand. The population of most developed countries and many emerging countries are shrinking. China, for example, is expected to lose 400 million people by 2100 from now on. This is more than the current population of the United States.

Lack of productivity and population growth leads to moderate to long-term low or perhaps negative global economic growth. Japan serves as a real life case study. To be sure, my own point of view may have prevented me from living in Japan for years. But I think the whole villages are completely deserted due to population decline. Against such structural progress, the obsolete monetary policies of recent years seem to be completely inadequate.

From this perspective, the diverse endowment-style portfolios among the asset classes are ice cream with more or less the same taste. They need economic growth and benefit from low or declining economic and market volatility.

Say another way: these are brief instability.

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Long volatility strategy

Naturally, some strategies show less correlation with conventional asset classes. The hedge fund universe comes to mind. But most hedge funds have a high correlation of equity (long-short equity), a tendency to fail in crisis (merger arbitrage), provide little alpha for a long period of time (equity market neutral), or are not hedged at all (two ressed bad debts). And almost everything is expensive.

The managed futures division is a notable exception. Managed futures have a structurally low correlation with stocks and bonds, supported by extensive academic research and are available as low-cost mutual funds and exchange-traded funds (ETFs).

However, having a low relationship with equities and doing well when economic and market volatility increases or stays high year after year is not the same thing. EurekaHage, a hedge fund data provider, generates indicators for funds that focus on tail risk and long volatility strategies. Both strategies have shared some performance trends over the past 15 years – which may be expected due to similarities in portfolio building – but there are also some differences.

The Tail Risk and Long Instability Fund created high returns during the Covid-1 pandemic epidemic in 2020 and therefore distributed crisis alpha. But long-term volatile strategies have improved in the years leading up to the global financial crisis (GFC) and subsequent high-volatility years. Although the Long Volatility Index also lost money as volatility eased due to quantitative easing after 2011, returns were much lower than those of the Tail Risk Fund.

Since we are looking for a strategy that benefits from increasingly and structurally higher volatility rather than a single extreme market event, this analysis will focus on long-term volatility strategies.


Long volatility and tail-risk strategy vs. VIX

Source: Eurekaheze, Factor Research

For the past 30 years, bonds have provided attractive diversification benefits when equity has declined. But those days are over. Bonds have become much less useful in asset allocation as yields in most developed markets are low or negative. The last private equity of the fixed-income bull market reduces the return outlook for leveraged asset classes such as real estate, which is in declining interest rates.

But most critically, none of these resource classes can be expected to perform well in a world of declining growth. After all, they offer similar exposure to what we would call the economic factor. As such, diversified portfolios across these public and private asset classes are short-lived and largely fragile.

So how do investors build a fragile anti-portfolio ready for declining economic growth where fixed income and portfolio building do not play its traditional theoretical role? Long volatility strategies may be an option. Their relationship with the S&P 500 and bonds was -0.32 and 0.26 between 2004 and 2020, respectively, and they gave incomplete returns. Of course, their performance was suffering from declining instability. And sometimes they have been painful to hold on to. Yet the same can be said for any other asset class. There was certainly no equity picnic during the bear market from 2007 to 2009.


Long volatility strategy vs. US equities and bonds

Long volatility strategy vs. US equity and bond illustrated chart
Source: Eurekaheze, Factor Research

Adding long-volatile strategies to a 60/40 portfolio

How would a traditional thematic US equity and bond portfolio perform with an assignment of long volatility strategies? We looked at 1 year between 200 and 2020, a period that included many years of bull markets in equities and bonds, as well as two fatal stock market crashes.

Although the 20% allocation for long-term volatility strategies reduces the annual earnings of the 60/40 portfolio somewhat, the volatility is further reduced, thus increasing the risk-adjusted income. But the real advantage of a less-fragile portfolio is displayed by calculating the maximum draw-down, which is reduced by about 50%.


Adding long volatile strategies to the 60/40 US equity-bond portfolio

Source: Factor Research

Creating a portfolio that is less sensitive to economic factors feels intuitive, and the simulated results show the benefits of attractive diversity for traditional equity-bond portfolios. But hedge fund indicators are prone to various biases that indicate an increase in income and a decrease in risk. The Eurekahead Long Volatility Index currently has only 10 components, which is much higher than in the past, which means investors need to be wary of historical historical returns.

Fund managers start reporting to their return database when they are doing well and shut down when performance stops. We can partially correct the bias in this report by reducing the annual revenue of long volatility strategies between 250 and 750 basis points (bps) per year. Although it reduces the performance of an anti-fragile portfolio, it does not change the significant reduction in maximum drydown during a GFC or coronavirus crisis.


Consistent long volatility strategy for reporting bias: maximum drawdown

Source: Factor Research

However, the favorable risk characteristics of the Eurekahead Long Volatility Index may be due to a single manager and therefore the product of fortune is more than efficiency and not caught by other managers. We do not have the data to answer this, but it will be worth evaluating further.

More thoughts

The Covid-1 crisis reminds us of how fragile the world is. Unfortunately, other events can have similarly devastating effects. Solar explosions can carry energy grids and satellite communications. Massive volcanic eruptions in Mexico City or Naples could leave North America or Europe in a cloud of dust for months. The quake could hit the California Bay Area – the list goes on.

But protection against natural disasters is not the only rationale for a fragile anti-disaster portfolio. Weak populations can hamper global economic growth and create social unrest. What if pension funds in the United States and Europe start to go bankrupt and cut benefits?

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And if it doesn’t create meaningful problems for society, there is always a purely man-made disaster on the horizon. Argentina was once one of the richest countries in the world, Myanmar was the richest country in Southeast Asia and Venezuela has the largest oil reserves in the world.

The future of humanity is bright. But it won’t be a smooth ride. Over the past three decades, thanks to increased economic and productivity around the world, investment has been like driving a German automobile. There have been several twists and turns, but it’s basically a fast, steady and incapable drive.

But that is changing. The journey of the next decade will have bandits, holes and broken glass parts. So invest in some good insurance and a car that can handle the road ahead.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / George Fearbine


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Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).



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