In an environment where, increasingly, risk and risk-free assets are rising or falling in concert based on government and central bank monetary policies, well-diversified Multi Strategy portfolios may be uniquely positioned to provide a hedge against tail risk when stocks and bonds together witness sharp falls.
For most institutional investors across Europe, the Middle East and Africa, 2019 was a very good year. Persistent strong performance across most asset classes meant that global equities and bonds continued their post Global Financial Crisis (GFC) decade-long bull run. This happened despite a backdrop last year of low interest rates and geopolitical uncertainties with, inter alia, the US-China trade war and mixed sentiment surrounding Brexit negotiations.
Therefore, it’s no surprise that defined benefit (DB) pension funds in Europe have revelled in the sight of improved funding levels. Trustees, sponsoring employers, and other fiduciaries, have also been able to take forward steps towards their end-game pension strategies by de-risking their portfolios.
However, valuations across both risk reducing and return-enhancing assets appear stretched, and macro and geopolitical risks are likely to continue. To make matters worse, global equity markets have been suffering a very torrid time due to the spread of the coronavirus disease, Covid-19, which emerged in China in December. The dearth of assets or investment strategies that can generate positive returns and income, to meet investors’ spending needs, represents the biggest challenge currently facing all major institutional investors.
With that backdrop, and the risk of a significantly declining stock market, we feel that now is the time to adopt a different approach to constructing return-seeking portfolios, particularly those that feature traditional single asset classes. In this paper, we postulate the case for well-constructed, diversified multi strategies (or ‘Multi Strategy portfolios’), anchored on a portfolio protection strategy, to deliver the risk-adjusted returns that investors demand.
- During stress periods, when equities fall sharply, most hedge funds have failed to provide a ‘hedge’ against large losses due to moderate-to-high correlations with equities. For that reason, we believe an explicit portfolio protection strategy is integral in diversifying Multi Strategy portfolios.
- For a Multi Strategy portfolio to generate consistent returns uncorrelated to equity markets, the underlying investments strategies must be sensible, persistent, additive, consistent and transparent.
- Investors in these portfolios may minimise netting cost and avoid the extra layer of fees associated with fund of funds.
The case for Multi-Strategies as a diversifying alternative strategy
Well-constructed Multi Strategy portfolios may address past shortcomings of hedge fund programs. The past 20 years of hedge fund investing experience has been invaluable in evaluating and designing truly diversifying strategies that also meet the return objectives of institutional investors.
Our research and investing experience indicate that sound Multi Strategy portfolios manifest the best qualities of well-diversified hedge fund programs. They invest in statistically independent and economically sensible investment opportunities, should incorporate explicit portfolio protection against large equity drawdowns, and provide diversification to the rest of a portfolio’s assets by intentionally limiting exposure to equity beta. Finally, they minimise fees and netting cost that are so prevalent in direct hedge fund programs and funds of funds.
Sensible, persistent, additive and consistent1 and transparent
Most hedge fund strategies have historically provided limited diversification benefits because they were too highly correlated with equities and with each other. And, to make the matters worse, they often provided limited or no transparency to the underlying investment strategies, even during periods of persistent underperformance.
For a Multi Strategy portfolio to generate consistent returns unrelated to equity markets, the underlying investment strategies must be sensible, persistent, and additive. By sensible and persistent, we mean there must be a good economic intuition in relation to why the investment opportunity exists today, and will persist into the future.
To be additive, we believe investment opportunities must be independent, unrelated to one another and to equity markets.
From an investor’s perspective, transparency is also important. It is unacceptable for hedge fund managers to hide behind the veil of secrecy in good times and bad.
The example of a bank risk transfer strategy (see section below) exemplifies a risk premium that we consider to be sensible, persistent, additive, consistent and transparent. This structural risk premium arose because of new banking regulations following the 2008 GFC. As long as banks are required to offload risks from structured note sales, one should expect to collect a premium by providing liquidity and risk transfer services (sensible and consistent). We expect this risk premium to persist if banks are restricted – by banking regulations – in how much risk they can hold on their balance sheets.
Finally, the source of risk premium is idiosyncratic and generally independent of other risk premia (additive).
Hedge fund correlation with equities
Correlation based on 3-Year Rolling Monthly Returns (31/1/1994 - 31/12/2019). Source: Bloomberg. Returns shown in USD
The need for explicit portfolio protection
History has shown that during stress periods, when equities fall sharply, most hedge funds fail to provide a ‘hedge’ against large losses due to moderate-to-high correlation with equities. Seemingly unrelated investment strategies become highly correlated and the associated risk premia tend to widen across the board during stress periods (Chart 1).
In the past, to minimise the cost of portfolio protection, many investors sought to mitigate equity tail risk via implicit, instead of explicit, portfolio protection. They did so to mitigate the cost of portfolio protection. Generally, this approach hasn’t worked: the track record for implicit portfolio protection strategies have been mixed, many behaving like high-deductible insurance plans that participate in losses. We believe an explicit portfolio protection strategy is integral in diversifying Multi Strategy portfolios and, to be successful, must seek to:
Generating uncorrelated positive returns in periods of sustained equity market sell-offs is one of the key objectives of diversifying strategies.
And, since “markets can remain irrational longer than you can remain solvent”, as quipped by John Maynard Keynes, it is important that Multi Strategy portfolios remain solvent and invested in other investment strategies (that may be negatively impacted by an equity sell-off). This could then capture long term positive expected returns.
Bank risk transfer:
Risk premium from European stock dividends
The divergence first emerged after the 2008 GFC when banks, shackled by a raft of new regulations such as Basel III and the US Volcker rule, scrambled to rid their balance sheet of risky assets.
At the same time, the plunge in interest rates world-wide left institutional investors yearning to earn more on their capital. They began clamouring for a strategy that would offer a higher yield than bank deposits.
To quench the burgeoning demand, banks crafted structured notes, which are typically linked to a popular index of stocks like the Euro Stoxx 50. By one account, there is about $120 billion (notional amount) of structured notes today that reference the Euro Stoxx 50 index.
To hedge the risks from note sales, banks typically buy equity forwards...banks also manage their risks by buying stocks and selling dividends.
Both moves put downward pressure on dividend prices. Based on current trading levels, Euro Stoxx 50 dividend futures are pricing in more than 3% in dividend cuts...while forecasts by analyst at Goldman Sachs expect the opposite to happen. The Goldman Sachs analysts are calling for European companies to increase their dividends...close to 5%.
This divergence is more pronounced in Europe than anywhere else in the world. In the US... dividends for S&P 500 index companies are forecast to grow at annual rate of 3.6%, according to Goldman Sachs, and S&P 500 dividend futures are pricing in growth of 2.5% per year, a far narrower gap than in Europe.
Netting cost and hedge fund fees
In multi-manager hedge fund programs and funds of funds, the results of out-performing managers are usually offset by the results of under-performing managers; however, there are no offsets between managers when it comes to incentive fees. Institutional investors pay incentive fees to the outperforming managers but do not receive an incentive fee rebate from the underperforming managers. As a result, investors may end up paying incentive fees even when the overall hedge fund program or fund of funds fail to generate excess returns above benchmark.
Earlier, we stated, “...an explicit portfolio protection strategy is integral in diversifying Multi Strategy portfolios” However, netting cost can be particularly acute for portfolio protection strategies (i.e., negative correlation strategies) because they are designed to generate positive returns in periods of sustained equity market sell-off. For that reason, in direct multi-manager programs and fund of funds, the inclusion of portfolio protection strategies can exacerbate netting cost.
By comparison, Multi Strategy portfolios avoid netting cost associated with low or negative correlation strategies because investors pay incentive fees at the aggregate Multi Strategy level, instead of at the underlying strategy level. Notwithstanding, netting cost still exists – even for Multi Strategy portfolios – at the overall portfolio level, if two or more Multi Strategy portfolios are used. For that reason, investors minimise, but do not completely eliminate, netting cost at the portfolio level.
Beyond minimising netting cost, Multi Strategy portfolios can be a superior choice for smaller DB pension funds that currently gain exposure to hedge fund strategies via a fund of funds. Ibbotson, Chen and Zhu – in “The ABCs of Hedge Funds: Alphas, Betas, & Costs” (30 March 2010) – estimate hedge fund fees at about 3.8% per year. In our estimation, the all-in fee for fund of funds investors is closer to 5.0% due to the triple layer of fees: hedge fund manager fees (3.8%), fund of fund fees (~1.0%) and consultant fees. With Multi Strategy portfolios, investors avoid a layer of fees associated with fund of funds. In the current environment, where cash is yielding zero in many parts of the world and excess returns are difficult to harvest, a fee reduction of 1.0% represents a material saving for any investor.
Our take on portfolio protection
The objective of portfolio protection is to generate positive returns in periods of sustained risk premia widening to which the rest of a Multi Strategy portfolio is normally negatively exposed.
In times of market stress, correlations tend to increase and risk premia spreads will tend to widen. Such periods are likely to present challenges to the other strategies within a Multi Strategy portfolio; albeit, potentially providing investment opportunities from the wider spreads and potential mis-valuations that result.
Portfolio protection generally has two goals during a period of stressed financial markets: eliver an uncorrelated alpha to help offset the performance drag that could be expected from the other strategies during these periods, and allow the other strategies to remain exposed to positive long term opportunities, despite the short-term stress, and potentially increase exposure at attractive levels.
Sub-strategies that we believe have a place within a portfolio protection strategy include (1) systematic option hedging, (2) systematic trend-following and (3) discretionary macro. Each sub strategy should be designed to address different market scenarios, including market sell offs and generalised risk-off environments. While no two crises are ever the same, several characteristics are salient from previous episodes.
Systematic option hedging should protect against rapid, liquidity induced, and exacerbated sell offs – such as in 1987 or mid-2008. In this type of event, volatility pricing typically soars, and underlying markets may be unable to effectively find a clearing price.
This scenario could be addressed with the use of a systematic long volatility strategy.
A systematic option hedging strategy can provide ’always on’, non-timed, long volatility exposure for the portfolio. As the name suggests, its implementation should predominantly be rules-based and manifested via a portfolio of equity index options and futures. The strategy’s purpose should be to capture substantial positive alpha in severe deep left tail scenarios such as the 2008 GFC.
However, it may not provide meaningful alpha in less severe risk-off episodes such as the 2015 China devaluation.
Systematic trend-following should protect against persistent, trending sell-off. In this instance, as existing initial hedges expire, the cost of re-hedging often becomes prohibitive. This scenario can be addressed with a time series momentum-based CTA strategy.
This element of portfolio protection is a well-documented and understood risk premium. A trend following strategy seeks to systematically capture trends in global markets and generate positive returns over the business cycle.
The convex payoff profile of a time series trend following strategy (known as the ‘CTA Smile’) has historically provided highly efficient left tail protection in periods of extended market stress.
Returns are a function of a number of factors, including volatility regimes through time (increasing or decreasing), the type of dislocations that manifest in crisis environments (i.e. a sudden shock or more extended market dislocation) and attribution from any particular sector.
Discretionary macro: Catalyst events and macro factors create potentially foreseeable opportunities to forward hedge a Multi Strategy portfolio. This scenario can be addressed by buying convexity (long option or option spread) positions across a range of asset markets where that convexity seems to be priced cheaply relative to the opportunity/risk. The strategy may at times buy outright index puts to supplement the systematic option hedging with the aim of giving portfolio protection an explicit negative beta exposure.
This element of a portfolio protection strategy is focused on owning protection when needed for the portfolio as a whole, but equally minimising the cost of protection when it is not. The strategy should only buy convexity and so, in high volatility, and declining volatility environments, the addition of positions has a higher bar.
When volatility is identified to be cheap on a forward basis and/or to the risk environment, this strategy should look for opportunities to add exposure. This is typically with a view to a macro risk event – recent examples include the Brexit vote, the Trump election – or it may be on a more generalised view of the risk environment.
While positioning in this strategy may vary in duration and asset class, it should explicitly reference the main risk premia exposures within Multi Strategy portfolios. Unlike many macro style strategies, it is important to remember this strategy should always be flat or long convexity. It should not sell convexity. Therefore, it explicitly hedges Multi Strategy portfolios from negatively convex exposures that risk premium harvesting naturally exposes them to.
We believe that, in a portfolio of mostly systematic processes, Discretionary Macro is an important, rules-based approach to eliminate some of the potential weaknesses of past portfolio construction. It allows judgment and forward-looking analysis to mitigate what we believe are often knowable or probable risks.
According to Barclays' 2019 Global Hedge Fund Industry Outlook, “...investors indicated they are looking for just over 7.0% [target of 7.4%] from their hedge fund allocations...”. A return target of 7.4% – in line with the required rate of return of institutional investors – should be achievable for well constructed Multi Strategy portfolios that target moderate level of risk.
However, it is not enough for Multi Strategy portfolios to deliver on the return target only; they should do so with returns uncorrelated to equities and with portfolio protection during periods of market stress. In an environment where, increasingly, risk and risk-free assets are rising or falling in concert based on government and central bank monetary policies, well-diversified Multi Strategy portfolios can be positioned to provide a hedge against tail-risks when stocks and bonds together witness sharp falls.
Multi Strategy portfolios based on sensible, persistent, additive, consistent and transparent investment ideas, coupled with an explicit portfolio protection strategy, should deliver to the original objectives of institutional hedge fund programs. And, as noted earlier, they may provide a more fee-efficient exposure than direct multi-manager programs or fund of funds.
Finally, with a slew of indicators showing macro and geopolitical risks are likely to continue in the future, and the need for truly diversifying alternatives, we firmly believe Multi Strategy portfolios deserve a prominent role within institutional portfolios.
1 Also referred by the acronym ‘SPAC,’ Barclays Global Investors popularised this investment concept back in the 1990s and early 2000s.
2 Anita Raghavan, “A Way to Play European Stock Dividends,” Barron’s 31 March 2019.