Pictet Alternative Advisors SA
Hedge funds: the case for ‘trading strategies’
June 2018
A successful ‘trading strategy’ is able to adjust a portfolio’s risk profile rapidly to short term market conditions, regardless of long term convictions. The use of trading strategies, especially Global Macro and Commodity Trading Advisors (CTAs) funds, has been effective in achieving resilience during periods of market stress.
Contents
2 Summary
3 Trading Strategies What is a ‘trading strategy’? Which hedge fund strategies? Pioneers of trading strategies What is Global Macro? What are CTAs? What are the differences? What are the benefits and risks? When do they go wrong? When do they perform best? Why include these strategies in a traditional portfolio? How do they compare with a classic multi-strategy fund of funds?
8 Appendix: Pictet’s Mosaic Trading
Hedge funds: the case for ‘trading strategies’
1 Summary
‘… the unquenchable While no-one doubts that future financial crises, by capability of human their very nature, remain unpredictable, one thing beings when confronted is certain: there will be crises in the future. Investors with long periods of must therefore find ways of minimising the impact prosperity is to presume of unexpected financial shocks to their portfolios. that it will continue’ There are important benefits to be gained from Alan Greenspan exposure to a dynamic hedge fund strategy that has little correlation to markets during periods of stress. The best approach for investors would be to maintain an allocation to a diversity of trading strategies at all times. A successful trading strategy is able to adjust a portfolio’s risk profile rapidly to short term market conditions, regardless of long term convictions. His - torically, the use of such trading strategies has been an effective means of achieving this aim. Carefully selected hedge funds within these strat - egies, mainly Global Macro and Commodity Trading Advisors (CTAs) funds, can provide resilience to mar - ket shocks in the context of a traditional portfolio. Pictet has more than 20 years of experience investing in hedge funds for clients and for its funds of hedge funds (FoHFs). Among these fohfs, Mosaic Trading specialises in hedge funds employing trad - ing strategies.
Hedge funds: the case for ‘trading strategies’
2 Trading strategies
What does a ‘trading strategy’ The original trading mean? strategies: Global Macro and A successful trading strategy is CTAs characterised by the ability of a hedge Global Macro and CTA managers were AHL: a quantitative investment fund manager to adjust rapidly the pioneers in the hedge fund industry manager established in 1987, risk profile of a portfolio to short term with some track records dating back acquired by MAN and now their largest and most successful fund. market conditions, regardless of long to the 1980’s. The Global Macro term convictions. Such tactical moves world was populated by legendary can be made either judgementally figures such as George Soros and Paul or with a systematic approach, and Tudor Jones, while CTAs achieved may be based on a wide range of data, prominence through the success of from economic fundamentals to pure groups such as AHL or the Turtle technical indicators. Traders. Initially, Global Macro and Which hedge fund strategies CTA strategies represented the qualify? bulk of hedge fund assets under The two main trading strategies management. Today, although assets in use are Global Macro and in trading strategies continue to grow Turtle Traders: an early 1980s Commodity Trading Advisors significantly, their share of the hedge experiment led by commodities trader Richard Dennis and (CTAs), also known as ‘managed fund industry has diminished due to business partner William futures’. Opportunistically, trading the growth of other hedge fund styles Eckhardt. See Way of the Turtle – managers are also found in almost and the popularity of equity related How Ordinary People Became all other strategies, such as in Long/ strategies. Millionaire Traders, M. Hendrix Short, Emerging Markets and Fixed Income. In general, managers whose strategy can be characterised as buy- and-hold, or who invest in less liquid instruments, such as Event Driven or Distressed, generally do not qualify.
TRADING STRATEGIES – ESTIMATED GROWTH OF ASSETS VS % TOTAL HF ASSETS
Assets USD bn % of total 700 45%
600 40%
500 35% 30% 400 25% 300 20%
200 15%
10% 100 5% 0 0% 1991 1994 1997 2001 2004 2007 2011 2014 2017 1990 1992 1993 1995 1996 1998 1999 2000 2002 2003 2005 2006 2008 2009 2010 2012 2013 2015 2016 2018
Trading Strategies assets USD billion (lhs) Trading Strategies % of total hedge fund assets (rhs)
Source: Global Hedge Fund Industry Report - First Quarter 2018
Hedge funds: the case for ‘trading strategies’
3 Trend followers take advantage of What is Global Macro? value from the identified themes. long term moves across various A Global Macro approach typically Great focus is attached to expressing markets. They do not predict or forecast specific price levels, rather involves the analysis of large the trade in the most profitable way they identify a trend and ride it. quantities of macroeconomic data – in other words, to uncovering the across markets and regions. Managers financial instruments that offer the try to identify potential trends or best risk/reward profile. In this case, imbalances in the risk premium the most liquid opportunities take relating to the main asset classes, priority. such as equities or currencies. This top-down process helps them narrow down opportunities in the asset class and to find ways to extract the most
CTAS SHOW PERSISTENT OUTPERFORMANCE DURING MARKET STRESS 1994-2018
returns 40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60% Jul 98 Apr 00 Feb 01 May 01 Apr 02 Dec 02 Nov 07 Jun 08 May 10 May 11 Apr 12 ------Aug 98 Nov 00 Mar 01 Sep 01 Sep 02 Mar 03 Mar 08 Feb 09 Jun 10 Sep 11 May 12
Periods of more than 3 consecutive down months of fall of more than 9% (MSCI World Index)
MSCI Daily TR Net World USD CS Managed Futures Index
Source: Bloomberg, data as at 30.06.2018
Hedge funds: the case for ‘trading strategies’
4 12-MONTH ROLLING CORRELATIONS OF CTAS AND GLOBAL MACRO DURING BEAR MARKETS What are Commodity Trading Advisors (CTAs)? RUSSIAN TMT/DOTCOM THE GREAT EURO CRISIS CTAs have two main characteristics. CRISIS BUBBLE BURST FINANCIAL CRISIS 1 First, they only trade on the futures markets. Second, they take positions 0,8 by following systematic buy and sell signals based on sophisticated 0,6 computer models. Generally speaking, 0,4 most of the inputs are priced-based indicators, while most models are 0,2 derived from trend-following algorithms. 0 Nevertheless, over the past decade, -0,2 CTAs have invested considerably in research in order to diversify away -0,4 from classic trend-following systems. Today, managers employ a wide -0,6 range of time-frames and models. For -0,8 instance, the average holding period can range from hours to months, while -1 pattern-recognition or counter-trend
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 models are also becoming popular. CTAs have often proved resilient Credit Suisse Global Macro Hedge Fund during periods of market stress. In Credit Suisse Managed Futures Hedge Fund the following chart, in each period of more than three consecutive down Source: Bloomberg, data as at 30.06.2018 months or a fall of more than 9 per cent in global equity markets, CTAs have generally shown a positive return. This remarkable resilience can be expressed in a different way, by looking at the 12-month rolling correlations of CTAs and Global Macro during bear markets. In the following chart, correlations turn sharply negative during such periods.
Hedge funds: the case for ‘trading strategies’
5 Opportunity cost: the cost of not being invested in THE BENEFITS AND RISKS OF TRADING STRATEGY HEDGE FUNDS other hedge fund strategies Benefits Risks
‘Trading’ hedge funds tend to be managed Some ‘trading’ hedge funds are still by the most seasoned managers with long concentrated and highly leveraged with track records across all large directional bets. market cycles.
Trading managers employ financial A correct macroeconomic view can products and strategies outside the classic be expressed in an ineffective way, by stock-and-bond allocations. choosing the wrong financial instrument.
Operational risk is lower because they CTA trend-following systems may be upset mostly use financial instruments that are by certain volatility conditions that trigger liquid and exchange-traded. false signals.
Risk management is generally rule-based Because CTA returns are highly cyclical, and strictly enforced, preventing irrational too high an exposure involves an attachment to a position or theme. opportunity cost.
Source: Pictet Alternative Advisors SA
When do Global Macro and When do they perform best? CTAs go wrong? There are two specific market A Goldilocks economy is ‘neither There are two specific market conditions during which both Global too hot, nor too cold, but just conditions during which both Global Macro or CTAs may outperform. right’ Multiple references mid Macro or CTAs may underperform. First, a high and lasting volatility 1900s onwards The first is during an extremely low regime in key markets is positive for volatility environment. The best trading strategies, especially relative historic example is during the so- to other strategies and asset classes. called ‘Goldilocks’ economy. With In such circumstances, Global Macro low uncertainty, predictable central should outperform CTAs. Indeed, bank policies and synchronized their short-term tactical bias would growth worldwide, there were dominate long term views, while few opportunities to benefit from trend-following models with a longer mispricing. The second circumstance time frame would struggle. Second, is during repeated volatility spikes, clear trends in key markets, and not which are difficult to manage and necessarily in equity or credit indices
‘Once you recognise that market can hurt performance. While trading only, are particularly favourable. In moves are random you simply need managers can and do actively trade, this environment, CTAs would be to put yourself in a position where they are not day traders and can likely to outperform Global Macro you can capitalise on a move when therefore be ‘whiplashed’ if a spike in managers, because of their use of it happens’ Michael Covel, Turtle volatility triggers – through automatic trend-following models. risk management rules – a sudden deleveraging, only for the initial trend to resume. A typical example of what triggers a volatility spike would be surprise government intervention.
Hedge funds: the case for ‘trading strategies’
6 Why include these strategies DOWNSIDE RISK CONTROL IN STRESS MARKET CONDITIONS in a portfolio of traditional 0 asset classes? Based on track records back to the -10 1990s, it is clear that in times when equities fall, trading strategies -20 have tended to outperform both traditional funds and other hedge funds strategies. They even delivered -30 positive returns in many instances. Trading strategies would therefore -40 have tempered the worst effects of past market crises. Furthermore, there have -50 been many academic studies showing that an allocation to CTAs improved -60 the overall Sharpe ratio of a portfolio composed of equities and bonds. 1994 1997 2001 2004 2007 2011 2014 2017 1993 1995 1996 1998 1999 2000 2002 2003 2005 2006 2008 2009 2010 2012 2013 2015 2016
HFRI Macro (Total) Index How do these strategies differ MSCI World TR USD HFRI Fund Weighted Composite Index from a classic multi-strategy fund of hedge funds?
Source: Lipper, Hedge Fund Indices, data as 29.03.2018 Multi-strategy funds of hedge funds can invest in all the hedge fund strategies available, and they can make tactical adjustments depending TRADING STRATEGIES & GLOBAL MACRO - BETA AGAINST GLOBAL EQUITIES on the economic cycle. For example, after a credit crisis, investments in 0,7 distressed managers may be increased significantly, while long/short 0,6 managers may be favoured during an economic recovery. Overall, multi- 0,5 strategy FoHF returns should be less 0,4 cyclical than a thematic product, but they are likely to underperform a pure 0,3 trading strategy product in a period of market stress, particularly during an 0,2 equity bear market. Compared with a
0,1 pure trading product, the correlation of multi-strategy FoHFs to equity 0 indices is higher and their beta against those indices less variable, as the chart -0,1 below demonstrates.
-0,2 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
HFRI Macro (Total) Index Credit Suisse Hedge Fund USD
Source: Lipper, Hedge Fund Indices data as 29.03.2018
Hedge funds: the case for ‘trading strategies’
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