Our newsletter is up for this week, and this time around, we’re taking a look at some fascinating research coming from other corners of the industry. A recent research piece by Quest Partners, a systematic multi market CTA out of New York, was forwarded to us by a client (thanks Mr. S) last week, and their findings resonated so well with us that we asked permission to share their work in our newsletter.
Their research essentially showed that relying on volatility as a predictor of future drawdowns is an exercise fraught with risk, as in tests of past performance – low skew strategies saw wide variances between the expected and realized drawdowns, while high skew strategies saw less variance.
.. This is ironic as investors commonly invest in low skew strategies due to their low volatility and avoid high skew strategies due to their higher volatility. For investors, this often results in large negative surprises due to the mistaken confidence in low risk that is implied by the low volatility strategies.
Now, this isn’t groundbreaking necessarily, and one of the reasons programs have a low skew rating is because there have been negative outliers in their performance, which we would assume cause larger drawdowns. But the link with volatility is somewhat new. We usually don’t equate skew with volatility, but they do a good job of it in their piece, showing that low skew strategies (negative skews) are usually those which have low volatility of returns.
Basically, volatility indicates the degree to which a program’s performance has deviated from the average, while skew indicates the direction the bulk of that volatility has been in. Positive meaning outliers to the upside, negative meaning outliers to the downside.
The goal of Quest’s piece is, “to assist hedge fund investors evaluate the risk of disproportionate losses relative to volatility.” You can view the full piece in PDF format here.
The arguments being made are solid, so we wanted to take a moment to go through the points made. To read the full scope of our comments, click here: http://bit.ly/lPtMhj
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