We half-jokingly asked in our Managed Futures/Global Macro 2019 Outlook, “Is this asset class working for you?” following a year in which managed futures didn’t deliver the crisis period performance they’ve become known for. But a recent piece in the hedge fund journal shows it wasn’t just trend following type CTAs that under performed in 2018.
The turbulence of 2018 made it a difficult year for most systematic investment products. To the surprise of several investors, many of these quant products had been sold as market neutral. In particular, the new breed of alternative risk premia (ARP) products – that had flooded the market a few years prior to 2018 – performed exceptionally badly. For example, the composite HFR Bank Systematic Risk-premia Multi-Asset Index lost -18%, in comparison with a loss of -4% on the S&P 500 total return index. However, traditional alternative asset classes also under performed, with the flagship HFRX Global Hedge Fund Index losing -7% and the SG Trend Index losing -8%…..In the face of such losses, both investors and managers are asking how and why so many quant strategies under performed?
What’s going on here? Have systematic investment products added more long equity and short volatility exposure in response to the 2013 to 2017 period where such long equity/short vol thrived? We know first-hand that there’s more than a few which have done just that (and benefited from it, overall). Or was it just some rather bad timing in 2018 for systematic strategies, where investors shouldn’t jump to any conclusions and lump them in with alternative risk premia strategies which also under performed in 2018 as stocks sold off.
Artur Sepp and Louis Dezeruad, both of Quantica Capital, researched just this question in their latest piece in the Hedge Fund Journal, analyzing three different types of systematic strategies: hedge funds, managed futures, and alternative risk premia. They find that it’s not time to throw out managed futures with the risk premia bath water just yet following the positive correlation with down equity markets in 2018.
The article looks at alternative risk premia being highly correlated to down equity markets, despite being sold as market neutral. They aren’t making any friends in the risk premia world, finding that this positive downside correlation to equities is more of a feature than a flaw, being that alternative risk premia strategies are designed to produce returns by taking on the hidden risk of tail events in equity markets.
Managed futures on the other hand, don’t produce alpha by taking on this hidden tail risk they find. Trend following style managed futures programs produce returns by taking on the risk of non-directional volatility (false breakouts, trend reversals, etc) in exchange for the out sized returns produced by trends lasting for sustained periods. It just so happened, in 2018, that both environments surfaced – with the tail risk surfacing AND sharp reversals of trends in both February and again in October.
Here’s what that all looks like for the mathematically/graphically inclined:
And their summary of how each type of strategy find returns:
Risk-seeking strategies: the marginal bear beta is positive (increased risk in bear regime) compensated by positive risk premia alpha. Most hedge fund and ARP products are risk-seeking strategies with tail risk. We observe almost a linear relationship between risk premia alpha and marginal bear betas for the cross-section of hedge funds and ARP indices. ARP products deliver less risk premia alpha for the same level of tail risk compared to hedge funds.
Defensive strategies: the marginal bear beta is negative (reduced risk in bear regime) compensated by negative risk premia alpha. Defensive strategies diversify equity risk in bear regimes but deliver negative risk premia alpha.
Trend following CTAs: produce negative marginal bear market betas and hence strongly diversify equity risk in bear market regimes. Because their risk premia alpha is flat, trend followers can be considered as an anomaly, or as a differentiation from ARP and traditional hedge fund products.