Unhedged Commentary

Tuesday, September 29, 2015

Unhedged Commentary: Clearing Up Confusion Around Risk Parity and Market Sell-Offs

   Peter Hecht, Evanston Capital Management

It seems as though just about everyone in the investment community has pontificated on the role that risk parity strategies play in market sell-offs like the one in August. Unfortunately, many of the views are coming from possibly uninformed or biased parties, creating confusion and the need for clarification. I’d like to move the debate forward by focusing on the key risk parity portfolio construction technique possibly contributing to market sell-offs: volatility targeting. To understand the recent debate in the media, you need to understand volatility targeting and how it is used by risk parity managers.

Let’s get this important topic out of the way upfront: Why listen to me? Besides being a Eugene Fama–trained University of Chicago finance Ph.D. and ex–Harvard finance professor, I have a lot of practical experience with risk parity products through my prior work, which included managing large, complex institutional investment portfolios. More importantly, neither I nor my employer has anything to gain or lose by promoting or criticizing risk parity. In other words, while we all have personal biases, at least it’s hard to argue that I’m talking my own book.

So what role does volatility targeting play in risk parity? In general, risk parity tries to set portfolio weights that (1) equalize the risk contribution across the various asset classes and (2) achieve some total portfolio risk (volatility) level. For example, in the simple case of a 10 percent volatility product where only stocks and bonds are available, the portfolio weights are chosen such that the stock and bond risk contributions are equalized (e.g., 20 percent stocks and 80 percent bonds equates to a 50-50 risk allocation) and add up to a total portfolio risk of 10 percent (e.g., the stock-bond allocation has to be levered 2-to-1 in order to achieve a 10 percent total volatility, leaving you with 40 percent stocks and 160 percent bonds).

All else equal, if stock volatility is higher, a risk parity manager will hold fewer stocks for both reasons 1 and 2 outlined above. To equalize risk, fewer stocks will be held relative to bonds (reason 1). Additionally, less leverage will be needed to achieve the 10 percent total volatility target (reason 2).

So far I’ve left out a critical piece of information: Is the manager using short-term volatility or long-term volatility when implementing reasons 1 and 2? Understanding this is critical to clearing up the confusion around all of the recent risk parity chatter.

What if a manager uses short-term volatility? If short-term stock volatility increases, as it did in August, a risk parity manager will need to sell stocks to maintain the equal risk allocation and total portfolio volatility, as explained above. Whether there are enough risk parity managers using short-term volatility to move the markets is a different question — and one I’ll leave others to answer — but at least there’s a rationale for short-term, volatility-focused risk parity managers to sell stocks in a month like August.

What if a manager uses long-term volatility? There was nothing special about August. Period. By definition, long-term volatility numbers are not affected by one particular month. Whether in a low or high short-term volatility environment, a long-term, volatility-focused risk parity manager is trying to maintain the same portfolio weights — the set of weights that (1) equalize the long-term risk contribution across the various asset classes and (2) achieve some long-term total portfolio risk (volatility) level. So what happens in a month like August, when stocks drop in value relative to bonds? The long-term, volatility-focused risk parity manager needs to buy stocks to bring the portfolio weights back in line with objectives 1 and 2. In other words, in a month like August, long-term, volatility-focused risk parity managers were providing stability to the equity markets. Does this make the long-term approach better? Not necessarily. It’s just different.

The bottom line is that risk parity managers come in different flavors when it comes to their use of volatility. Some use short-term volatility. Some use long-term volatility. Short-term volatility users were likely selling stocks in August, while long-term volatility users were doing the opposite. Was the entire risk parity market net buyers or sellers of stocks in August, and is this net effect big enough to move markets? I’m not sure, but my gut says risk parity managers were probably net sellers in August, and that net amount is minuscule relative to the markets they trade. But this last statement is all speculation. Let’s focus on the facts: Not all risk parity managers were selling stocks in August. In fact, a material amount of the risk parity market were buyers of stocks.

Take the time to understand the risk parity manager’s portfolio construction process. Is he allocating based on short- or long-term volatility? It’s not only critical to understanding the strategy, it’s critical to navigating through what the talking heads say about risk parity anytime markets experience volatility.

Peter Hecht, Ph.D., is managing director and senior investment strategist at Evanston Capital Management. The information contained herein does not constitute an offer to sell or a solicitation of an offer to purchase any securities and is not intended to provide investment advice. Before investing in any investment product you should consult with your financial, tax and/or legal advisers.

Tuesday, August 25, 2015

Unhedged Commentary: What China Could Learn from Japan

   Jeffrey Saret, Two Sigma

Many investors hold a long position on China, whether they know it or not. Developed-market equities have exposure to Chinese consumers, Chinese growth fuels commodity markets, and China holds approximately 20 percent of U.S. Treasuries.

In light of this, the 30 percent-­plus decline in China’s equity market from June to early July, and the nearly 9 percent decline during the last week of July, raise concerns but should not inspire panic. As of mid-August, Chinese equity prices remained some 70 percent higher than a year ago. However, the Chinese government’s response — lending money to brokerages to buy stocks, forbidding large shareholders from selling, allowing companies to suspend trading of their shares and devaluing the yuan — is more worrying. Investors have experience managing the fallout from equity bubble pops, but rarely do governments directly intervene in stock markets.

Three historical case studies — Hong Kong in August 1998, Japan in August 1992 and Japan in October 1987 — outline a range of potential outcomes from China’s unconventional intervention.

In 1997–’98, Hong Kong’s equity market abruptly turned from bullish to bearish during a foreign currency crisis. Thailand’s baht devaluation triggered a yearlong, 50 percent decline in the Hang Sang Index. To reverse the slide, the Hong Kong government purchased HK$118 billion ($15 billion) of domestic equities. Some empirical evidence suggests the intervention lifted share prices in the short term. In the longer term the Hang Sang reached a new high in 2001, and the Hong Kong economy returned to growth.

The similarities between today’s China and 1990s Japan run deeper. During those respective periods both countries enjoyed two decades of fast economic growth that relied on manufacturing exports. Their demographics shifted as their populations urbanized and aged. Real estate and equity prices rapidly increased.

When it became apparent in the early 1990s that Japan’s growth trend had stalled, the government responded to the plummeting Nikkei index by adopting the Price Keeping Operation in August 1992. The goal was to sustain the index above the psychologically important level of 17,000. The government restricted some stock sales, purchased equities and limited the release of state-owned shares. By most measures, the intervention proved unsuccessful. Equity prices stabilized, but Japan’s economy still has not recovered — annual per capita real GDP is lower today than in 1994.

Further back, Japan offers another case study of government intervention. Between January 1982 and October 1987, Japanese stocks gained nearly 350 percent while the country enjoyed 4 percent real annual GDP growth. The good times threatened to end in the week of October 14, 1987, when the Nikkei fell 18 percent. To avert panic, Japan’s Ministry of Finance “advised” brokers and fund managers to avoid selling. The Bank of Japan promised sufficient funds to satisfy liquidity needs. The Nikkei recovered within five months, and economic growth continued at more than 4 percent annually for the rest of the decade.

Significant differences exist between today’s China and the first two case studies. Unlike the laissez-faire reputation Hong Kong enjoyed, China struggles to shed its dirigiste image. The government’s intervention threatens to undermine investors’ confidence that market forces will play a decisive role going forward.

Unlike Japan in the 1990s, where per capita real GDP exceeded U.S. levels, China can still enjoy strong growth as it converges with more-developed markets. China’s strategy may rest on the belief that medium-term growth will justify current equity valuations and that all China need do to avoid a more significant drawdown is buy time and maintain political stability.

Japan in 1987 offers the most apt comparison. China’s intervention may seem unorthodox, but its debt and inflation remain manageable. However, Japan’s intervention in October 1987 likely contributed to the bubble in the country’s real estate and equity markets by inflating overly exuberant expectations. China can only hope that its current intervention similarly maintains steady economic growth and wealth accumulation — preferably without inflating a bubble.

Unfortunately, asset allocators do not enjoy the option of waiting for the outcome of the Chinese government’s intervention to manifest. If China’s intervention ends poorly, few investors will find their multi-asset-class portfolios well hedged to the Chinese economy.

Jeffrey Saret is head of thematic research at New York–based hedge fund firm Two Sigma. Opinions are the author’s only. TS may have views and market positions that differ.

Tuesday, May 26, 2015

How an Inefficient Hedge Fund Market Works for Investors

There has been a lot of talk in the financial media about hedge funds recently. The discussion has not been characterized by glowing optimism. The media’s primary complaint — that average hedge funds don’t add enough value to justify their fees — is legitimate. We’ve been saying this for years. But it’s not true for the reasons that most media critics give. And it’s not universally true: Sophisticated and careful investors can create portfolios of hedge funds that add substantial value.

Much of the criticism stems from a comparison of nominal hedge fund returns with equity market returns. This misses the point. Nobody buys ten-year U.S. government bonds with 2 percent yields because they love the expected returns; they buy them to diversify their portfolios. For this reason, bond investors aren’t criticized for failing to keep up with equity markets. Similarly, hedge fund investments make sense only if they add value to a broader portfolio. Sophisticated hedge fund investors call that added value alpha: skill-based returns that don’t depend on passive market exposures to other asset classes.

Why are hedge funds subjected to this odd comparison with equities? Mostly because benchmarking them isn’t easy. Individual hedge funds differ widely, and the industry just isn’t that tightly correlated with any single asset class.

Luckily, introductory finance classes offer students a basic tool for finding a more reasonable benchmark for hedge funds. Using a linear regression, an investor can measure the passive return a fund achieves from persistent exposures to equities, credit and fixed income (or whatever mix of risks seems sensible for a given track record). The difference between a fund’s return and the return of this customized benchmark can be thought of as the return attributable to manager skill. A simple approach like this really isn’t enough. It ignores all kinds of information about current market opportunities, manager differentiation and nonlinear risk exposures. But it’s a good start.

When we evaluate hedge funds this way, we learn a couple of things. First, hedge funds as a class aren’t underperforming that much. Second, recent results for average funds still aren’t great. Their alpha has steadily declined over the past decade. Although the average alpha for the HFRI Fund Weighted Composite Index of hedge fund performance was about 5 percent from 2003 to 2007, it has been zero for the past five years. This shouldn’t shock anyone. Alpha is a negative-sum game after fees, frictions and financing. Over the past couple of decades, we’ve seen the development of a much more sophisticated professional investment community and the flow of a lot more money into hedge funds. A more competitive and efficient market is good for the world, but it’s a tougher environment in which to add value as an investment manager.

So should we all just pack up our tents and head back to the land of the 60-40 portfolio? Probably not — or at least, not all of us. Though the average investor will (by definition) buy average hedge funds, more-careful investors can do better. Why? Because the market for hedge funds is still not efficient.

The Efficient Market Hypothesis has various flavors, but the basic idea is that under certain conditions investor decisions will result in efficient prices and the expected return on expertise will be zero. For this mechanism to work properly, the market needs lots of well-informed investors making frequent decisions.

The hedge fund marketplace has relatively few investors, limited and variable access to information, and modest liquidity. Accordingly, expert investors should be able to add substantial value.

How? Smart hedge fund investing requires access to an investment team with the skills, resources and experience to identify attractive opportunities across a wide array of complex strategies, to differentiate among managers with varying levels of skill and to evaluate risk management in normal and shock scenarios. More generally, it requires an organizational culture of accountability for measuring outcomes with sensible benchmarks.

Doing this well is hard, but it’s not impossible, and it is important. The payoff from adding alpha to a portfolio can be very substantial: Raising a portfolio’s annual returns by just 1 percent a year can materially improve ultimate outcomes. To achieve this, investors need to be disciplined about selecting only the best managers. As the data shows, average is no longer good enough.

Benjamin Appen and James Hall are founding partners of New York–based Magnitude Capital. Readers interested in exploring this idea further can do so at www.betterbenchmarking.org, a website developed by Magnitude Capital.

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