A multi-strategy program presents a number of key benefits to investors, and this includes a source of uncorrelated returns from equity and fixed income market returns. Therefore, as a diversification tool, investing in a selected range of CTA strategies contributes significantly towards portfolio protection.
Empirical evidence from research into hedge fund investing has concluded that utilizing a multi-strategy investment approach improves the return profile of traditional portfolios through strategy diversification. Allocating to a selection of CTA strategies that exhibit uncorrelated returns to the broader market improves performance opportunities, whilst simultaneously diversifying risk across a range of trading strategies.
A Changed Environment:
Since 2007, the subsequent events which contributed towards the financial crisis have raised questions from investors about the promise of the hedge fund industry. Is it still possible to deliver a risk-return profile that is uncorrelated with traditional markets? At the height of the crisis, hedge funds, taken as a group, broke through the boundaries implied by their historical correlations and suffered along with the rest of the financial industry. Further complicating the situation is a fixed-income conundrum: limited income potential in a low interest-rate environment and the threat of capital losses induced by potentially rising rates. While some individual hedge funds famously prospered, only a small number of sub-strategies within the hedge fund universe outperformed during this period. One of these groups of investment programs is those which engages in the CTA, or Managed Futures, strategy.
Industry Return Correlations:
In charting the returns of the broader hedge fund industry returns (DJCS HF), it is clear that performance has become highly correlated to that of the global equity markets. During the market meltdown, CTA strategies (Stark CTA Index) offered diversification from traditional markets by posting positive returns.
Understanding CTA Strategies:
Following the aftermath of the 2007 financial crisis that exposed significant flaws in the Eurozone financial markets, CTAs have proven themselves as a sub-strategy that can not only outperform the traditional markets but also the wider hedge fund industry. This is achieved by utilizing the high volatility environment to generate higher returns and in the process fulfill their promise of portfolio protection. It is this ability of CTAs to preserve capital in the good years and to provide a portfolio protection response in the bad that makes them of interest to investors and portfolio managers alike. However, identifying and understanding which CTA strategies can adapt quickly to changing market conditions to deliver outperformance over traditional or market beta strategies, is the key factor which can potentially contribute towards reductions in risk through diversification. The effect of successfully allocating to the optimal CTA strategies in a portfolio by even a modest amount can be very significant.
Using a Multi-Strategy Process:
A multi-strategy portfolio consists of several distinct investment strategies that are managed by external investment managers, each specializing in one or more specific trading strategies. Therefore, the logic behind this approach is increased diversification, both across hedge strategies and within each strategy. Given the different characteristics of various hedging strategies, a multi-manager approach is intended to alter the risk/return dynamics.
Reduced Downside Volatility:
The ability of hedge fund strategies to help reduce downside risk was evident in the most extreme negative equity market conditions during the 20-year period ending December 2014. Among the five worst global equity market monthly downturns in the past two decades, hedge fund strategies performed comparatively well.
Hedge Fund Strategies are represented by the HFRI Fund Weighted Composite Index.
Low Correlation to Traditional Assets:
A research paper produced by The Centre for Hedge Fund Research at Imperial College London, suggested that within all hedge fund strategies, CTA investing exhibited relatively low correlations with other asset classes even during recessions. This suggests that hedge funds are unlikely to threaten the stability of the financial system, meaning that even though they exhibit exposures to systemic risk, but they do not cause or contribute to it.
CTA strategies have historically provided attractive returns over the long term when compared to traditional asset classes, keeping pace with equities over a 20-year period which included major swings in the equity markets. According to industry sources, these hedge fund strategies have at least equaled if not outperformed other asset classes at lower levels of risk over the same period.
Hedge Fund Strategies are represented by the HFRI Fund Weighted Composite Index. US Equity is represented by S&P 500 Index, with Global Equity being represented by the MSCI World Index. Finally, US Fixed Income is represented by the Barclays U.S. Aggregate Index, and Global Fixed Income being represented by the Barclays Global Aggregate Index.
Enhanced Portfolio Diversification:
The core premise of modern portfolio theory, is that risk-adjusted returns can be improved at the portfolio level by allocating to multiple strategies and asset classes that are imperfectly correlated. There are also additional benefits on risk controls during periods of market stress, because the return correlation of many hedge fund strategies with the market tends to gravitate to 1.00 during a crisis, but this is not the case with CTA strategies.
- Portfolio1: Equity and Fixed Income only
- Portfolio2: Incl. 10% allocation to Hedge Funds
- Portfolio3: Incl. 20% allocation to Hedge Funds
To measure the diversification impact on a traditional portfolio, Hedge Fund Strategies are represented by the HFRI Fund Weighted Composite Index. Global Equity is represented by the MSCI World Index with Global Fixed Income being represented by the Barclays Global Aggregate Index.
Monitoring and Evaluation:
The success of a multi-strategy portfolio involves more factors than simply the quantitative analysis behind results and performance statistics. Applying the optimal leverage and exposure to the appropriate strategy in order to generate pure alpha, requires knowledge and experience in trading a wide range of market environments. Simply put, the investment team must have skills to monitor and evaluate different strategies, processes and investment practices.
There are a number of compelling reasons for professional investors to allocate a portion of their investment portfolio to a Multi-Strategy CTA Program. The investment team managing the program must have a keen understanding of financial markets and the characteristics of the individual CTA strategies, to make any meaningful benefits and contributions to the portfolio.
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. I have no business relationship with any company whose stock is mentioned in this article.