1/8 Asset Management / May 2019 For institutional investors only / not for public viewing or distribution Drawdown management strategies – preparing for the next market downturn Multi Asset Boutique – Alternatives & Multi Manager Solutions

So-called trading strategies, encom- All drawdowns are not alike – an introduction passing global macro and commodity After equity markets corrected between October and December 2018, interrupting the soon-to-be longest trading advisor (CTA) hedge funds, bull market in history, investors are increasingly looking faced stiff headwinds after an unprece- for portfolio building blocks that provide protection dented flood of global monetary stim- or a degree of diversification in drawdowns in order to mitigate the negative impact these drawdowns have ulus followed the Great Financial Crisis for investors. Drawdowns can occur in all asset classes, of 2008 and the ensuing Euro Crisis. but since equities tend to be the riskiest asset class Central bank actions frequently inter- in the portfolios of most institutional investors and thus have the biggest loss potential, we will focus on equity rupted trends and created whipsawing drawdowns hereafter. Moreover, while some investors prices. Global macro and CTAs are might already consider equity corrections in the 5 % range the only major hedge fund strategies “drawdowns,” we argue that the loss-threshold for a drawdown definition should be in the –15 % to –20 % range showing positive bear-market perfor- in order to focus on the occasional but painful events. mance, positive convexity and the ability Considering the recent Q4 2018 sell-off and the ensuing to take sizable short positions. These recovery, we also hold that the length and path of a correction are important for the drawdown definition. strategies surf capably in rough waters. The examples in Chart 1 show that the definition of a drawdown is not straightforward; individual drawdowns differ in various parameters and are not easily classifiable. Chart 1 and Table 1, which show all periods with peak- to-trough losses of more than 20 % of the S&P 500 Price Index (daily data since 1925), highlight the different shapes of drawdowns. Since the longest drawdown starting in September 1929 lasted 25 years, we limit the chart to the first four drawdown years in order to improve readability. 2/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

Chart 1: Strong dispersion of historical S&P 500 one should differentiate between longer-stretched draw- Price Index drawdowns with respect downs on the one hand, and very sharp / abrupt draw- to duration and magnitude downs on the other hand. Generally speaking, the former 0 % can be tackled by deploying medium- to longer-term – 10 % trend-following CTAs, while the latter form of drawdowns – 20 % can better be confronted with long volatility strategies. – 30 % – 40 % Trend-following CTAs as drawdown mitigators – 50 % When it comes to strategies that offer diversification – 60 % during drawdowns, people often think of trend-following Drawdown – 70 % strategies. These strategies are the biggest sub-category – 80 % of managed futures, also called CTAs (for Commodity – 90 % Trading Advisors). Pure trend-following strategies rely – 100 % only on prices and take a long position in a market when 0 100 200 300 400 500 600 700 800 900 000 the price trend goes up and a short position when the Number of trading days price trend goes down. These strategies were one of the 09.1929 10.2007 03.2000 01.1973 few that performed positively during the 2008 financial 12.1968 08.1987 12.1961 12.1980 crisis as well as during other equity drawdowns. And unlike 02.1966 08.1956 plain-vanilla hedging strategies such as buying index put options, trend-following does not come with an explicit Source: Vontobel Asset Management, Bloomberg. ex-ante cost-burden in the form of a payable option Past performance is no indication of current or future performance. premium.

Table 1: Notable S&P 500 drawdowns since 1925 For our further analysis, we use the BarclayHedge BTOP50 CTA Index as proxy for trend-following strategies. DRAWDOWN NO. MONTHS NO. MONTHS MAX. The BTOP50 Index is an equally weighted index of the START TO RECOVERY TO TROUGH DRAWDOWN largest CTA programs which represent at least 50 % of Sep 1929 301 34 – 86 % the BarclayHedge CTA universe. While there are other Nov 2007 65 16 – 53 % trend-following indices including the SG Trend Index and Sep 2000 81 25 – 46 % the HFRI Macro: Systematic Diversified Index, we use Jan 1973 91 21 – 46 % the BTOP CTA Index because it has the longest history. Dec 1968 42 19 – 33 % The chart below highlights the performance of the Sep 1987 23 3 – 30 % BTOP50 CTA Index during all S&P 500 corrections with Dec 1980 25 20 – 24 % a peak to trough performance of at least –5 % (since Jan 1962 20 6 – 23 % inception of the BTOP50 in 1987). The blue bar shows the Aug 1956 26 17 – 19 % performance of the BTOP50 CTA Index during the peak Feb 1966 15 8 – 18 % to trough period of the S&P 500, the yellow bar shows the Jun 1990 9 5 – 16 % performance of the BTOP50 CTA Index from peak until Jul 1998 5 2 – 16 % recovery of the S&P 500.

Source: Vontobel Asset Management, Bloomberg. Chart 2: BTOP50 CTA Index performance was positive Past performance is no indication of current or future performance. during the major drawdowns of S&P 500, but not necessarily during smaller corrections One striking distinction is the length of the “under-water” 100 % period. For example, while it took 25 years to recover 80 % the drawdown starting in 1929 purely in nominal terms 60 % (please note that we do not use total returns here, i.e. 40 % dividends are not reinvested), recent drawdowns had 20 % shorter durations. Another difference is the various paths 0 % of the individual drawdowns. In 1987, it took only slightly – 20 % more than three months to get from peak to a 32 % trough. – 40 % On the other hand, the drawdown starting in 1968 only – 60 % reached its trough after roughly one and a half years. Both drawdowns needed, however, a similar time to recover 07.1998 07.1999 10.2018 02.2018 01.1990 09.1991 11.2007 09.1987 06.2015 08.1997 02.1994 01.2000 06.1990 04.2000 from trough to peak. Another interesting detail is that with 09.2000 exception of the drawdowns in 1929 and 1987, the majority Drawdown start date of S&P 500 drawdowns reached –20 % only after about Max. Drawdown S&P 500 five months from peak. CTA Performance to Trough CTA Performance to Recovery As the data above shows, each drawdown has its unique features, which calls for a diversified as well as tailor-made Source: Vontobel Asset Management, Bloomberg, BarclayHedge. Past performance is no indication of current or future performance. drawdown management approach. At the very minimum, 3/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

Performance of the BTOP50 CTA Index was positive in Based on the often noticed positive performance of trend- the five major S&P 500 corrections since 1987, while following strategies during longer equity drawdowns, performance during smaller corrections (including the but also during extended upward trends, the term “CTA one starting in October 2018) was mixed. smile” has become established. We get this pattern by plotting the monthly returns of the S&P Index on the We pick the two worst drawdowns of the S&P 500 Index horizontal and the corresponding monthly returns of to show the evolution of the performance of the BTOP50 the BTOP 50 CTA Index on the vertical axis of a scatter CTA Index during the S&P drawdown. In the November chart and then fitting a second order polynomial. The 2007 drawdown, the BTOP50 CTA Index generated charts below show the “CTA smile” with data since 1987, positive performance during the initial phase of the draw- first with monthly, then with quarterly returns. down and managed to keep these gains during the recovery phase of the S&P 500 Index. Chart 5: The “CTA smile” with monthly data shows the tendency of CTAs to perform well Chart 3: In the November 2007 S&P 500 drawdown, in the most positive or negative months the BTOP50 CTA Index was positive during in equity markets the initial phase and protected its gains during 25 % 2nd order polynomial: y = 1.06x2 + 0.00x + 0.00 the recovery phase of the S&P 500 Index 20 % 80 % 15 % 60 % 10 % 40 % 5 % 20 % 0 % in same period 0 % –5 % – 20 % –10 % BTOP50 monthly CTA, return – 40 % –20 % –10 % 0 % 10 % 20 % 30 % – 60 % S&P 500, monthly return 10.2007 10.2008 10.2009 10.2010 10.2011 10.2012 S&P 500 BTOP50 CTA Source: Vontobel Asset Management, Bloomberg. Past performance is no indication of current or future performance.

Source: Vontobel Asset Management, Bloomberg, BarclayHedge. Past performance is no indication of current or future performance. Chart 6: When we use quarterly returns, the “CTA smile” becomes more pronounced In the September 2000 drawdown, the BTOP50 CTA 25 % 2nd order polynomial: y = 1.57x2 – 0.08x + 0.01 Index was not only able to generate positive performance 20 % during the initial phase of the drawdown, but actually also 15 % during the recovery phase. 10 % 5 % Chart 4: In the September 2000 drawdown, 0 %

performance of the BTOP50 CTA Index in same period –5 % increased even during the recovery phase –10 %

of the S&P 500 Index BTOP50 quarterly CTA, return –20 % –10 % 0 % 10 % 20 % 30 % 80 % S&P 500, quarterly return 60 % Source: Vontobel Asset Management, Bloomberg. 40 % Past performance is no indication of current or future performance. 20 % 0 % – 20 % The smile is more pronounced, i.e. shows a higher curva- – 40 % ture or convexity, for quarterly returns. It is worth noting – 60 % that most other hedge fund strategies show a negative 2000 2001 2002 2003 2004 2005 2006 smile or smirk with respect to equity returns. S&P 500 BTOP50 CTA The “CTA smile” highlights two features of trend-followers: Source: Vontobel Asset Management, Bloomberg, BarclayHedge. First, trend-followers increase their exposure when trends Past performance is no indication of current or future performance. extend, i.e. let the winners run, and cut losing positions quickly, be it on the long or the short side. In mathematical The reasons why trend-following performance was not finance jargon we would say that they are long gamma. equally strong in the above examples are manifold and may Second, trend-followers need the trends to last a certain be due to factors such as different trend opportunities in time in order to build their profits. We consider the follow- asset classes beyond equities (fixed income, currencies ing factors important when assessing a trend-follower’s and commodities), the initial positioning of the index funds, reaction to a drawdown: holding time, positioning at the the composition of the index and strategy changes in onset of a drawdown, and asset allocation. the index funds. 4/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

The holding time measures the reaction time or speed of This contrasts with many other active strategies as well a trend-follower. This varies between individuals from as equities which exhibit fat left tails, i.e. negative skewness. 40 to 120 days for the majority. This indicates that trend- The chart below shows the historical evolution of the roll- followers generally do not profit from drawdowns that ing 36-month skewness of the BTOP50 CTA Index. After are brief. In recent years, initial signs of equity draw- being positive for a long time, it turned negative in February downs have often resulted in central bank actions and 2018, and overall we notice a downtrend in skewness. rhetoric that stopped the drawdowns and generated “whipsaw” price behavior. This environment was detri- Chart 7: The rolling 36-month skewness of the mental to trend-following performance; the shorter the BTOP50 CTA Index was mostly positive holding period and more reactive the strategy, the higher in the past, but a downtrend is noticeable the risk of being “whipsawed” by repeatedly sharp price 1.5 reversals. Not surprisingly, some trend-followers have 1.0 therefore increased the holding-period of their programs, 0.5 thus slowing the reaction time and reducing the risk of 0.0

being whipsawed. These trend-followers’ reduced trading Skew (absolute) – 0.5 speeds, however, come at the expense of higher market beta and reduced convexity since they take longer to 12.2017 12.2011 12.2015 12.2013 12.1991 12.1997 12.1989 12.1995 12.1993 12.2001 12.1999 12.2007 12.2005 12.2003 adapt to emerging trends. 12.2009

The positioning at the onset of drawdowns is another Source: Vontobel Asset Management, Bloomberg, BarclayHedge. Past performance is no indication of current or future performance. factor to consider when looking at the behavior of trend- followers in a drawdown. If a drawdown follows just on the back of a long-lasting, smooth uptrend, trend-followers While the trend-follower features were widely acknowl- will have built up substantial long equity positions. In the edged in the past, the recent period of muted trend- first phase of the equity correction, trend-followers will follower performance has caused much discussion about therefore suffer losses on their equity allocation which the return potential for trend-following going forward. can, absent of profit-generating trends in other classes, The main points of criticism are: lead to initial losses in parallel with equities. The period –– The strategy’s presumed simplicity makes it easy to January / February 2018 exemplified such an environment replicate. This has led to big inflows and an over- and highlighted the path-dependency of trend-followers’ crowding in the space. positioning and correlation to equity markets. –– Markets have become more efficient, hence the behavioral inefficiencies that trend-followers rely on Finally, an important part of trend-followers’ edge comes to make profits have diminished. from allocating across asset classes, i.e. including fixed –– The unprecedented liquidity flood and increased income, commodities and currencies. The number of market control and coordination of central banks futures contracts invested in can range from 50 to 150 has interrupted emerging trends, especially on the across the globe, and the individual allocations are broadly downside, and generated whipsaws which have diversified across contracts, so profitable trends may led to losses for trend-followers. arise from various sources. Consequently, historical trend- following contributions during equity drawdowns came With regards to the first point, a September 2018 analysis not only from short positions in equities, but also from by AQR1 concluded that while trend-following assets other asset classes. For example, a substantial part of peaked in 2008 at USD 211 billion, they have since the 2008 trend-following performance came from fixed decreased and were running at USD 124 billion by mid- income and commodities. The allocation to the asset 2018. classes and individual contracts is highly dependent on the portfolio construction process of the individual Chart 8: Estimated Managed Futures AUM managers. As a result, the performance dispersion January 2004 – June 2018 of trend-followers is significant, although the strategy 230 $211 B seems relatively homogeneous at first glance. This favors 210 investing in a diversified portfolio of high-quality trend- 190 followers rather than a single CTA, in order to optimize 170 overall risk-reward. 150 130

Trend-following: Recent pro and con debates 110 $124 B AUM ($ Billions) AUM ($ Returning to the CTA smile, it also shows evidence of 90 positive skewness, a feature of trend-followers which is 70 highly sought-after for protecting against equity draw- 50 downs and complementing negatively skewed strategies. 2004 2006 2008 2010 2012 2014 2016 2018 This means that compared to a normal distribution, Source: AQR the return distribution of trend-followers has more pro- nounced positive returns than negative ones, mainly an effect of the “let winners run, cut losers quickly” rule. 1 AQR (2018), “Trend Following in Focus” 5/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

At the same time, AQR points out that futures markets Trend-followers tend to generate substantial profits unex- have increased in size over the same period. pectedly in a short time after long drought periods, for which the first quarter of 2019 may serve as an example. Chart 9: Futures Markets Open Interest Timing is therefore nearly impossible and there is a risk January 2004 – June 2018 of leaving the strategy just before another performance 24 boost, which happened to quite a few investors losing faith in trend-following just prior to the 2014 performance 2 3 20 spike. Managers like AQR or CFM found that trend- following has been working for over one hundred years, 16 hence the recent period may just be an interim period.

12 Not all trend-following CTAs are created equal It should, however, be taken into account that trend- 8 following managers face a dilemma: Available futures data enable extensive back-tests. Ideally, managers

(Number of contracts, in millions) 4 should not over-fit the optimization parameters, in order Rolling 3-Month Median Open Interest to avoid that a strategy with a brilliant back-test does not 0 underperform with new data going forward. A tolerance 2004 2006 2008 2010 2012 2014 2016 2018 for some underperforming phases where strategies do Commodities Equities not work is therefore a logical consequence, and all long- Fixed Income Interest Rates standing trend-following managers have incurred some longer and pronounced drawdowns – which could be (ForSource: both AQR Chart 8 and Chart 9) eVestment Managed Futures Category, AQR, Bloomberg. As of June 30, 2018. For Chart 9: The above open interest, per asset class, is based on called a “pain premium” paid for the positive convexity a hypothetical basket of aggregated open interest for individual futures markets across of the strategy. With respect to the more recent past, equities, fixed income, interest rates, and commodities. Open interest is computed using the rolling 3-month median on the aggregated open interest for each asset class. the question therefore arises whether the results are still Hypothetical data has inherent limitations some of which are disclosed herein. For within the statistical norm or whether an adaptation Illustrative purposes only and not representative of any strategy that AQR currently manages. of the strategy may be justified. Managers have opined divergently: While some trend-followers change as little Source: AQR as necessary, others have added some non-trend compo- nents or long biases which may increase the Sharpe ratio AQR thus concludes that the slice of trend-followers in but come at the cost of reduced skewness and convexity. the futures markets has decreased and there is there­- Winton, a renowned manager, has drastically reduced fore little evidence that the trend-following space is over- the allocation to trend-following in its flagship product. crowded. The risk, however, is that the more a manager adapts his strategy to a less-trendy environment, the less he may With respect to diminishing profit opportunities for trend- profit in an eventual large drawdown. followers, some studies conclude that risk-adjusted returns (Sharpe ratios) for trend-following strategies have So where does this lead in the context of drawdown decreased in recent years. This could be an effect of management? The paragraphs above have outlined that higher market efficiency. Some managers have therefore each drawdown has its own individual evolution. While expanded into so-called exotic markets (interest rate trend-following is a strategy that may provide diversifica- swaps, credit indices, power markets, exotic commodities, tion in drawdowns, the diversification benefit depends etc.), where Sharpe ratios are still higher but liquidity is on the shape, duration and extent of the drawdown less ample. While the applied algorithms are similar, liquidity itself and on the characteristics of the respective trend- management and trade execution quality are crucial, and followers such as trading speed, purity of the trend- the required operational efforts are significantly higher. following approach, portfolio management and asset allocation as well as positioning at the start of the draw- Considering the convexity of trend-following strategies, down. To cope with a broad set of environments, a blend the sometimes heard statement that trend-following of trend-following managers providing diversification has stopped working should be taken with a grain of salt. across these parameters is necessary, but not sufficient. The increased interventions by central banks in the past Due to their systematic “backward-looking” approach, few years have created a new environment with lower trend-following strategies will struggle in certain types market volatility and fewer trends, but it seems danger- of drawdowns where a more forward-looking and ous to extrapolate the recent past into the future. discretionary approach may excel – as is the case for global macro as well as several long volatility strategies.

2 Hurst B., Ooi Y. H., Pedersen L. H. (2017), “A Century of Evidence on Trend-Following Investing”

3 Capital Fund Management (2015), “Trend Following: A Persistent Market Anomaly“ 6/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

Global macro strategies: A good complement to CTAs for There is no “hard and fast” definition of global macro building a holistic drawdown management portfolio strategies. The main common denominator of global Global macro strategies tend to share a few characteristics macro managers is their forward-looking focus on broader with CTAs which are crucial for drawdown management economic, regional and asset class shifts. Other than purposes: Positive convexity/skew as well as the ability to that, the global macro scene is extremely diverse, as illus- go net short entire asset classes in size. trated in the table below. This also explains why global macro indices are of rather limited use when assessing On the other hand, global macro strategies differ from global macro’s suitability as drawdown management (trend-following) CTAs in important ways, making them a strategy. Rather than looking at global macro from an valuable complement for drawdown management pur- extremely heterogeneous (and thus diluted) index level, poses. The main differences to trend-following CTAs are it seems more fruitful to look at individual styles (and global macro’s discretionary (non-systematic) use of fun- managers): Some of them prove rather valuable as draw- damental information to trade a generally broader suite of down mitigators, while others might even turn out counter- instruments (often options) in a forward-looking manner. productive.

Table 2: Global macro strategies vary widely in approach and are not always preferable for drawdown management

DESCRIPTION PREFERENCE FOR DRAWDOWN MANAGEMENT PURPOSES Directionality Ranging from completely directional to overwhelmingly Prefer trading markets more directionally, with real macro relative value (incl. some micro RV) relevance /sensitivity and relatively lower gross leverage

Linear vs. Ranging from completely linear expressions (e.g. futures, Mix of linear and options-based implementations (crucially Non-linear forwards) to completely options-based implementations only long options), with a bias to options- and options-like (i.e. long gamma) trading styles

Amount of Ranging from strongly positive net vega to moderately Prefer positive vega portfolios net vega negative vega portfolios

Geography Ranging from truly global approaches to regional focuses Build portfolio of regionally diversified approaches, (e.g. emerging or developed markets) with sufficient emphasis on major markets

Asset Class(es) Ranging from truly multi-asset class (incl. equities, Mix across asset classes, conditional on good liquidity commodities, credit) to more rates- or FX-focused also during stress scenarios approaches. Ranging from purely intra-asset class to overwhelmingly cross-asset class expressions

Trading speed Ranging from very strategic 1-2 year trading horizons Mix of time horizons, with a tilt to relatively faster trading to very tactical, even intra-day approaches speeds – even more so, when medium to long-term trend-following CTAs are already deployed in the portfolio

Sources of Ranging from purely fundamental data-driven to over- Mix between price and non-price input data information whelmingly technical approaches.

Originality of Ranging from mainstream/equilibrium views to more Tilt to managers with relatively less mainstream, more views “long shot” (i.e. less probable, less priced-in) variant views (given convincing arguments and sufficient investment ideas risk controls)

Risk bias Ranging from significantly long-biased (balanced portfolio) Avoid long-biased managers, in all their explicit and implicit approaches to moderately short-biased styles forms. We prefer a mix between unbiased and (tactically) short-biased managers/strategies

Degree of Ranging from one theme / trade to dozens of themes / trades Mix of diversification degrees. This is conditional on the diversification more concentrated managers / strategies being sufficiently robust /convex to withstand adverse market moves

Momentum vs. Ranging from mainly momentum / break-out driven to Prefer momentum and momentum-like strategies (i.e. mean-reversion largely mean-reversion / value-oriented approaches positive gamma), for which disciplined risk management is a key feature

Degree of Ranging from overwhelmingly intuitive (synergistic) Mix of information processing approaches. Avoiding overly intuition approaches to analytically refined, more quantitative optimized/fragile approaches, which might be overly approaches reliant on the more recent past. Preference for “skeptics” as well as risk-conscious and nimble traders

Number of Ranging from single-risk taker model to dozens Tend to avoid overly diversified multi-PM strategies, as their risk-takers of risk-takers portfolios often tend to be somewhat diluted, for the sake of higher performance-stability 7/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

Global macro style selection: Separating drawdown market, so-called straddle and strangle option strategies. management “wheat from chaff” Although this simple strategy literally guarantees positive First of all, one has to avoid falling into an overly narrow, convexity, it unfortunately comes with a hefty price tag: myopic and backward-looking bias often associated with Substantial premium time decay on the options acquired. crisis-protection strategies. This tendency of “fighting Hence, this approach to creating convexity only tends to the last war” led many investors to flock to conventional be sensible if the market prices for volatility (implied vola- tail-protection strategies (e.g. buying short-dated equity tility) are very cheap and / or the timing of an anticipated volatility) right on the back of the Great Financial Crisis larger price move is spot-on, thus losing less time value. 2008. Buying the kind of “protection” which worked best during the last crisis often turned out to be the most Trading strategies, on the other hand, tend to spend a expensive protection. Just as important, both market relatively small amount of capital on directly buying participants’ as well as regulators’ various reactions to a options. Depending on their specific trading styles, they past crisis often render a crisis in the same “spot” (e.g. deploy various means to generate positive convexity market or country) less likely. There are some similarities in less expensive ways: to the situation after a plane crash occurred: Risk aware- ness and mitigation measures often lead to the post- Disciplined risk management crash risks actually decreasing rather than increasing – Most global macro managers use pre-defined stop- while consumers’ (behavioral) reaction goes the other way. losses on both the portfolio as well as on a position / theme level, and most CTAs have systematically built-in A key aspect when investing in global macro strategies sliding stop-losses as well. This key feature of most trading for drawdown management purposes is to look at each strategies of adding to winners and cutting losers is a manager and style individually, given their high heteroge- crucial source of convexity, coming at the cost of being neity. For example, the January 15, 2015 Swiss Franc “whipsawed” every once in a while, when market prices de-peg from the Euro saw some macro managers score oscillating in a range lead to the trading strategy getting big, while others suffered significant losses. If the losers stopped out repeatedly at the (in hindsight) wrong spots. and winners among macro managers during this particu- lar episode had been randomly distributed, there would Selectively investing in fundamentally be no point in trying to select specific managers. How- asymmetric market constellations ever, the outcome for specific macro managers (and their An extreme example of this was going long credit-default related style of macro trading) was anything but random: swaps protection around 2006 / 07, due to their being There was a clear tendency of managers with long con- very cheap, i.e. only having priced a minimal likelihood of vexity profiles to score big, in some instances in the order a credit meltdown. Similarly, shorting the Euro against of +30 %. These managers’ positive convexity was cre- the Swiss franc ahead of the January 2015 peg break ated mostly by being long options and positioned for a also offered a strongly asymmetric opportunity; as the divergence of the Euro-Swiss Franc trading range, as well exchange rate came ever closer to the 1.20 floor, the as by being skeptical about the Swiss National Bank’s Swiss National Bank got nervous, and the positioning of stamina (and willingness) to stay their course and “walk investors was crowded in the belief of the status quo their talk.” holding.

Opportunities for global macro during drawdowns Balanced portfolio construction More recently, the following short-biased macro and The ability to go both long and short different markets long-volatility themes have been observed repeatedly: and the general absence of either a long or short bias –– Short corporate credit (incl. HY) and EM credit. Also enables a trading strategy to run during various market includes short-selling of credit exchange-traded regimes. For instance, trading strategies tend to be about funds (e.g. high yield, bank loans), which might be the only major investment strategies with the ability to vulnerable to a liquidity mismatch in the face of go (materially) short during market downturns. The ability potentially large investor outflows, and thus offer to survive can be crucial in the event of major market asymmetric short opportunities. regime shifts, enabling the trading strategy to capitalize –– Long (medium-term) volatility across equity indices, on the dislocation rather than falling prey to it. rates and currencies. More recently also in certain precious metals (e.g. gold). The above-listed techniques for generating convexity are –– Risk-off spread-wideners (e.g. basis wideners and essential elements not only for weathering, but usually asset swaps) which tend to profit during liquidity capitalizing in a changing, higher-volatility market envi- squeezes and flight-to-quality episodes. ronment. The goal of investing in high-quality trading –– Targeting currency devaluations, i.e. selectively short- strategies is twofold: First, minimize the cost of positive ing emerging market currencies (e.g. in Eastern convexity by finding clever ways to generate it. Second, Europe and Middle East) vulnerable to a devaluation investing in a diversified, complementary array of trading against the USD or EUR. strategies buffers a portfolio well for various forms of “higher-volatility” or market “downturn” environment. Positive convexity comes with varying price tags In brief: Not all volatilities are created equal, nor are all In principle, positive convexity can be created by simply market downturns created equal. buying put and call options on the desired underlying 8/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel For institutional investors only / not for public viewing or distribution

Conclusion However, a differentiated and selective approach to Drawdowns take many forms, varying by the market(s) selecting CTAs and global macro strategies is warranted affected, length, severity as well as price path. This when constructing drawdown management portfolios: necessitates a clear understanding of which drawdowns Global macro strategies are rather heterogeneous and to prioritize when designing drawdown management CTA programs also evolved in recent years – marking strategies. Given the defined drawdown scenarios to pro- some of them suitable and others unsuitable for draw- tect against, the most suitable drawdown management down mitigation purposes. strategies (such as different CTAs and global macro programs) can then be combined to maximize protection Not unlike insurance, one could do without drawdown effectiveness while keeping the costs associated with management strategies like CTAs and global macro and achieving positive convexity low. ostensibly “save” money as long as no “accident” occurs. Only time will tell whether this “goldilocks” regime will More specifically, trend-following CTAs have a long history continue or make way to a more turbulent environment. of positive contributions during equity market drawdowns. Their positive convexity (“smile” on the return scatter plot) To borrow again from surfing, catching and riding up­- is rather pronounced. This valuable positive convexity coming big waves means having the strategies to is also exhibited by many global macro strategies (unlike dynamically navigate different scenarios. Drawdown most other hedge fund strategies), also rendering them management strategies repeatedly proved their value an appealing drawdown management strategy. CTAs and in times of stress – this time is (usually) not different. global macro complement each other well, as the latter tends to trade more options and use fundamental infor- mation in a forward-looking manner.

Ilario Scasascia, CAIA Daniel Germann Florian Albrecht, CFA Head of Alternatives & Senior Portfolio Manager Senior Portfolio Manager Multi Manager Solutions Director Director Executive Director

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