The Hunt For Risk-Adjusted Returns In The Brexit Aftermath

| About: SPDR S&P (SPY)

Summary

How to get the best risk-adjusted returns.

All alternatives products are not created equal.

Tests to see if an “alternative” strategy provides true diversification.

(Article written by Kevin Jamali)

The U.K. made history in late June with its vote to exit the European Union after nearly a half century, thus sending financial markets into upheaval. The reverberations of this decision cannot be underestimated. In the early morning hours after the vote was called, assets were impacted across the board. Oil prices plummeted, the Pound plunged to its lowest level since 1985 and other commodities and FX markets followed suit. In an environment such as this, where volatility and uncertainty rule, risk comes to the forefront. In such scenarios, an investor should not solely focus on where to get returns; but, more importantly, on how to get the best risk-adjusted returns.

What amount of risk does one have to assume in the quest for growth and return on investments? This is a tricky question even under normal circumstances, as each investor's appetite for risk will vary. But, too often, it is forgotten that returns should go up with an increase in appetite for risk.

One way investors try to manage risk is through diversification, but they frequently fall into the trap of allocating to a product that bills itself as an "alternative" without doing proper due diligence as to whether it truly provides diversification.

A simple due diligence test to see if an "alternative" strategy provides true diversification is correlation analysis. Many funds categorize themselves as "alternative." This category tends to see an increase of assets when markets are in flux (as they are currently); and there is a heightened need for "alternatives" exposure. But they often fail to run a basic correlation analysis to determine if they are truly different. For diversification purposes, you want the correlation to be nearer to zero. The higher the number, the more correlated the product is to another; and thus not a diversifier to a portfolio. You are inversely correlated if the number is negative which does not solve your problem either. There are various ways of calculating correlation. You could do a basic calculation on an excel sheet; but there are many analytics software programs available which provide correlation numbers as well.

But just having diversification isn't enough. There's also the question of how much risk is being taken to earn a given return. All alternatives products are not created equal in this regard.

The first step to find how much risk is being taken in is understanding the Fund's investment process and its behavior - the philosophy of the fund. There are also various statistical metrics which are used to gauge a program's risk such as Sharpe, VAR, Sortino and Calmar.

One important metric to look at is the historical maximum peak-to-valley drawdown, which is defined as the percentage decline from the fund's highest Net Asset Value (peak) to the lowest Net Asset Value (trough) after the peak. There is a probability that many investors are not aware that the S&P 500 (along with a myriad of "Traditional Funds") at times have experienced more than 50% in Max Drawdowns, such as in 2008, effectively wiping out years of positive returns in less than 12 months.

Another mistake investors tend to make is solely looking at returns without paying attention to the underlying volatility or standard deviation of the program. For example, a fund that has a 15% annualized standard deviation compared to one that has 9% is taking about 1.6 times the risk. Therefore, if the fund with an annualized 9% standard deviation isn't making 1.6 times the returns, that's a problem in that the fund is getting less return per unit of risk. They should also take the max peak to valley draw down into the equation as well. The goal of a rational investor should be getting the maximum amount of return per unit of risk.

Last but certainly not least is gauging diversification tactics. Portfolio theorists have long debated optimal diversification strategies. The common underlying theme among them is decreasing risk exposure to any one category while striving to minimize overall portfolio losses. In times such as this: where the future of the EU is at stake, where there is a potential hard landing in China and where there is the prospect of slower growth in the U.S. and British economies, diversification to uncorrelated assets is more important than ever.

Certain funds offer true diversification through various uncorrelated strategies, sectors, markets and time frames. Funds with such strategies can achieve material risk-adjusted returns and provide the best downside protection in the current environment. It allows an individual(s) to invest money in an uncorrelated product (check the correlation first) to the broader stock market which could thus provide a strong risk management tool. And as we have all seen, equities are very susceptible to taking a beating over the slightest indication of potentially bad news, such as the Brexit vote. This reiterates the point that a product with solid risk-adjusted returns with little-to-no correlation to the stock market could be a very nice complement to one's portfolio.

There is no crystal ball to foresee the future of the Eurozone and the global economy. There are no clear determinants of what might happen next. But there are several options to choose from as investors hunt for Funds in this cloudy marketplace. Only those strategies that meet certain barometers will perform well in market downturns such as the current environment and uncertainties moving forward.

Kevin Jamali is senior portfolio manager of the Catalyst/Auctos Multi-Strategy Fund (MUTF:ACXAX).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.