Download PDF, Issue 26 - Swiss Futures and Options Association

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Hedge Funds 34 Risk in Alternative Investments Management, Monitoring, Biases and other Myths In the earlier article published on the last issue of the Swiss Derivatives Review, a fictional CIO described how liquidity risk and diversification would be managed at his Fund of Funds. The article pointed out how liquidity is a poorly-understood but critical driver of performance in Alternative Investments. How could the CIO describe the approach to risk management and the opportunity of getting involved in Alternative Investments? “Alternative Investments exhibit limited or no correlation with traditional asset classes and as such present attractive diversification opportunities to institutional investors. We are keen on managers who present a track record of steady returns and robust Sharpe Ratios. Last, they must be able to meet our risk requirements, namely have an in-house risk manager and provide risk information through third-party providers”. Does all of this sound too good to be true? In order to answer this major question, one has to review some of these statements carefully. Semantics play an important role in marketing the Fund-of- Funds’ supposed risk acumen and in blurring the line between perception and reality. Let me challenge the mainstream arguments above as follows: 1) Alternative Investments are far more strongly – and positively – correlated with traditional long-only paper assets than most are willing to acknowledge. One should then seriously question the whole diversification rationale for engaging in Alternative Investments. 2) Stability is a psychologically attractive feature that is prone to misuses. The frequency of positive returns – the key crude test of stability – does not necessarily translate into strong performance. Ditto for oft-quoted indicators such as Sharpe Ratios. 3) Historical volatility is by far the predominant method of risk-adjustment of returns but a very crude one to compare returns across strategies. 4) Getting risk information and knowing how to use it are by no means synonymous. This difference though is what sets risk management apart from risk monitoring. The following sections address each point in turn. Chart 1: Correlation of Returns between Hedge Fund Indices, Equities and Bonds, 2002–2004. Correlations between Alternative Investment strategies and traditional asset classes Charts 1 and 2 plot the correlation of returns between some of the most popular Alternative Investment strategies – embodied in hedge fund indices – and traditional asset classes, typically stocks and bonds. Each strategy has two correlations, plotted respectively on the vertical axis for stocks and on the horizontal axis for bonds. The S&P 500 Index and the Bloomberg/ EFFAS 7+ Treasury Index were selected as proxies for equities and bonds, respectively. To add some international flavour, the charts include the popular MSCI World Index, too. Across these two dimensions, the correlation coefficients range of course between –1 and 1. So, one may label the top right quadrant as the one with the most favourable returns for the “paper assets”. The Goldilocks economy of the second half of the 1990’s would be an example of such a phase. If the correlation argument held, one should expect strategies to be well scattered across the chart. But are they? The clustering of Hedge Fund returns in the top-right quadrant of Chart 1 above speaks for itself. The lesson is that there is some kind of pseudo-benchmarking relative to traditional “paper economy” asset classes – most notably when these display positive returns. CTAs and Short-Selling Strategies are the only notable outliers in the bottom right quadrant. You may object that there is nothing wrong with having positively-correlated returns with traditional asset classes during fair-weather phases. After all, you may add, positive absolute returns to investors are what matters. It may be that hedge fund managers display their smarts especially during bear markets. Is that true? Chart 2 plots the same correlations as above but over a 5-year period ending last May. If the diversification and lowcorrelation arguments applied, one should expect the points in the chart to be relatively scattered across the chart. SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
“These results seriously question the diversification rationale for engaging in Alternative Investments.” Hedge Funds Chart 2: Correlation of Returns between Hedge Fund Indices, Equities and Bonds, 1999–2004. Comparing Strategies A and B, one would likely be tempted to infer that a probability of positive return of about 50 bp., for instance, is higher for Strategy A than for Strategy B. Based on the frequency of returns, it is hard to dispute that point, since the returns on Strategy A have a mean of 48 bp. and a standard deviation of only 45 bp. The returns on Strategy B, on the other hand, display a standard deviation of 179 bp., or about 4 times greater. According to the transitive principle and taking this logic further, the probability of a positive return above +0.5%, say 2%, for Portfolio A should always exceed the corresponding probability for Portfolio B. 35 Again, the clustering of Hedge Fund returns in the top right quadrant does not differ much from the previous picture. Outliers are still the same as before. Similar plots emerge for returns during shorter periods between May 1999 and May 2004. What does this mean? For all the diversification benefits that hedge fund managers are supposed to bring to investors, it is simply too risky – and politically incorrect – to underperform traditional asset classes when these exhibit positive returns. Simply put, two different risk frames are at play to make investors’ perspective lop-sided in their Hedge Fund performance assessments: • during downturns, investors are biased to focus on the relative performance, i.e. they lose less than long-only strategies; any positive absolute return that they can produce is icing on the cake; • during uptrends, investors praise hedge funds’ lower risk relative to long-only strategies – which makes up for the underperformance bias of the former category vis-à-vis the latter. As risk-adjustment in Alternative Investments relies overwhelmingly on historical simulation alone (see the next point), there is no way to include in the process the significant correlations shown earlier. Frequency and probability of returns, Consider the following chart: P A(0.5%) > P B(0.5%) P A(2%) > P B(2%) and, in addition, P A(2%) and do experience discontinuities, Chart 3: Using Frequency in Drawing Probability Assessments for Trading Strategies. SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
Page 1 and 2: SWISS DERIVATIVES ISSUE 26 - NOVEMB
Page 3 and 4: Contents Contents SWISS FUTURES AND
Page 5 and 6: Dear Members and Friends of SFOA Ed
Page 7 and 8: Focus Treasury. Then came Ginnie Ma
Page 9 and 10: “This approach moves us in the di
Page 11 and 12: WHEN YOUR FIRST NAME IS “NEW,”
Page 13 and 14: Focus Union’s regulators in terms
Page 15 and 16: “There’s no rule saying banks c
Page 17 and 18: The rush of endless opportunity. Li
Page 19 and 20: Further your future: team up with a
Page 21 and 22: “Investor interest in gold was re
Page 23 and 24: A new standard in the derivatives i
Page 25 and 26: “The Stone Age didn’t end becau
Page 27 and 28: A blazing sponsor for Friday night
Page 29 and 30: CNBC Europe reporting live from Bü
Page 31 and 32: A fascinating presentation by ballo
Page 33: “Swiss taxation is very advantage
Page 37 and 38: D O W J O N E S I N D E X E S THE D
Page 39 and 40: “ ‘Carry’ strategies and even
Page 41 and 42: Education Chart 2 Overbought zone (
Page 43 and 44: Bollinger Bands Let’s briefly rev
Page 46 and 47: Emerging Markets A Perspective on E
Page 48 and 49: Profile IFRI - The International Fi
Page 50 and 51: Profile 50 Official Publication of

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