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Tactical Asset Allocation Implemented by Hedge Funds

Tactical Asset Allocation Implemented by Hedge Funds. Patrik Säfvenblad. Disclaimer. Do not invest in hedge funds! At least not without professional advice! At least not your own money! Trading yourself is risky, and you are sure to underperform professional investors!. $3,000. $2,500.

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Tactical Asset Allocation Implemented by Hedge Funds

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  1. Tactical Asset AllocationImplemented by Hedge Funds Patrik Säfvenblad Tactical Asset Allocation

  2. Disclaimer • Do not invest in hedge funds! • At least not without professional advice! • At least not your own money! • Trading yourself is risky, and you are sure to underperform professional investors! Tactical Asset Allocation

  3. $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 9312 9406 9412 9506 9512 9606 9612 9706 9712 9806 9812 A Fund With Risk Control? Tactical Asset Allocation

  4. $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 9312 9406 9412 9506 9512 9606 9612 9706 9712 9806 9812 …Or Without? Tactical Asset Allocation

  5. Purpose • Discuss some asset allocation hedge fund styles • Systematic Global Macro • Discretionary Global Macro • Trend Following • Show • how tactical asset allocation is used in practice by hedge fund managers • How trade timing is the key issue • Various solutions to trade timing • Discuss trend following as a pure timing strategy Tactical Asset Allocation

  6. My Background • Used to be Assistant Professor at SSE • Now VP Business Development at RPM Risk and Portfolio Management AB • Most of my time goes to • Evaluating trading strategies and managers • Building and evaluating hedge fund portfolios • E-mail: finpsa@hhs.se RPM • Allocates capital to hedge funds (currently 750 MUSD, 20 managers) • Measures and manages risk in hedge fund based products (Currently > 5bn USD) • Mostly futures trading strategies and other asset allocation strategies • 22 employees. Tactical Asset Allocation

  7. What is a Hedge Fund? • US • Hedge funds are private unregistered investment pools for wealthy individuals or institutional investors. • Hedge funds invest in a variety of securities and use return enhancing tools such as leverage, derivatives and arbitrage • Legally structured as a private investment limited partnership (LP) or a limited liability corporation (LLC) • Typically charges a management fee (1-3%) and an incentive fee (15-25%) • Europe • A fund management firm that charges an incentive fee. • Looks to create absolute returns, I.e. returns in excess of those predicted by CAPM or other asset pricing models. Tactical Asset Allocation

  8. Key Differences Between Hedge Funds and (Usual) Funds • Absolute return objective (10% to 25% per year) versus relative returns (out-performance of an index) • Often clearly stated risk objective, e.g. 20% p.a. • Market volatility presents opportunities since hedge funds can trade from both the long and short of the market • Managers compensation is primarily based on performance, not based on the size of the assets under management (better aligning interests of managers with investors) • Many funds are closed or give an explicit size at which they will close • Limited capacity for most strategies, managers try to grow by steps, e.g. 100 MUSD, 400 MUSD, 1000 MUSD in order to avoid failure • Moore returned 3bn to investors in 2001 Tactical Asset Allocation

  9. Hedge Fund Fees • The fee structure is homogenous: • A management fee of a 1-3% p.a. and, • An incentive fee of 10%-30% of profits • Often a reference rate must be met before incentive fees are paid, e.g. 3 month T-bill + 200 bp. • Incentive fee gives incentive and protects from ``earnings dilution'' due to size constraints of a particular strategy • High watermark • The manager only receives the incentive fee on new ``high-highs'‘, typically calculated monthly or quarterly. • Reduces risk taking incentives of managers • Locks in investors when the fund is in ``drawdown’’ (100% participation in first profits) • Gives managers a downside Tactical Asset Allocation

  10. Hedge Fund Market Growth Tactical Asset Allocation

  11. Hedge Fund Styles by Assets Source: Tass Research Tactical Asset Allocation

  12. The Strategy Universe 40% Aggressive Growth Market Timing 35% Opportunistic 30% S&P 500 25% Macro Event Driven Market Neutral 20% Fund of Funds MSCI World Equity Distressed 15% Equity Arbitrage Securities Income Convertible Arbitrage Emerging Markets 10% Average Bond Mutual Fund 5% Short Selling 0% -5% -10% 0% 5% 10% 15% 20% 25% 30% Source: Van Money Manager Research Tactical Asset Allocation

  13. Not a very popular style recently Capital Flows to Global Macro Tactical Asset Allocation

  14. It took returns of Global Macro sector 3 years to return to the April 1998 level. (CSFB index) For good reasons? Tactical Asset Allocation

  15. Sources of Returns in Financial Markets • Taking a priced risk • Equity risk, Term premium, Liquidity premium • Does not disappear if spotted by investors • Easy - Can often be captured using passive, or systematic trading methods • Exploiting a price inefficiency • Pure arbitrage, Statistical arbitrage, Risky arbitrage • Hard to capture, often very information intensive • Exploit superior information • Know the impact of events before other investors • Disappears when spotted by investors • Hard to capture, often very information intensive Tactical Asset Allocation

  16. Information Based Strategies Tries to identify mispricing using analytical work Long/Short equity Discretionary trading Aggressive growth/market timing Technical Strategies Tries to discover Mispricing and Risk premia using technical analysis of price patterns Trend following Statistical arbitrage Model Based Strategies Tries to discover mispricing or risk premia using relative value models Convertible arbitrage Merger arbitrage Relative valuation models Macro based market timing models Strategy Types Tactical Asset Allocation

  17. Return generator Market Investment style Currencies Directional Equity Indices Diversified Information Commodities Hedged Model-based Bonds Intraday trading Technical Equity & options Long only Target and Bidder equity Global Macro Strategies ü ü ü ü ü ü ü ü Tactical Asset Allocation

  18. Possible Trading Styles, Again Return generator Market Investment style Currencies Using Manager Skill Directional Equities Information Diversified Commodities Capturing Risk Premia Hedged Equity & convertibles Model-based Intraday trading Equity & options Technical Long only Target and Bidder equity Tactical Asset Allocation

  19. The Dilemma of Macro Trading "Markets can remain irrational longer than you can remain solvent.” J.M. Keynes Tactical Asset Allocation

  20. The Danger of Fundamentals:Nasdaq versus S&P 500 Tactical Asset Allocation

  21. Yahoo Stock Price Tactical Asset Allocation

  22. Yahoo Stock Price and My Sell Recommendations Tactical Asset Allocation

  23. Fundamental trading • Trading on fundamentals is one of the most common ways to profit in financial markets • Market prices can diverge from fundamentals • for several years. • by orders of magnitude • Fundamentally based (arbitrage) trading is therefore very risky and requires very explicit risk controls. • In addition to direct losses there is also opportunity cost • Lower risk for short term strategies than for long term strategies • We address the risk by finding ways to trade selectively. • Technical indicators, multiple time frames, options Tactical Asset Allocation

  24. Conclusion Yahoo • The stock price of Yahoo was not related to fundamentals • Therefore trading on fundamentals is very very risky • Wait for an indication of normality before trading on fundamentals • It might make very good sense to trade on technical indicators Tactical Asset Allocation

  25. Not Only a Theoretical Problem • In March 2000, Julian Robertson announced the closing of the Tiger funds blaming “irrational markets” for the fund’s poor performance. His statement was: “Earnings and price considerations take a back seat to mouse clicks and momentum”. • At the same time George Soros cut back his $8.5 billion Quantum Fund after having faced huge double-digit losses. Evidently the two largest Macro players were unable to cope with “irrational markets” during the second half of 1999 and first quarter of 2000. [Lars Jaeger]. Tactical Asset Allocation

  26. Information Based: Global/Macro • Aims to profit from changes in global economies • Leveraged directional bets tend to make the largest impact on performance • Participates in all major markets: equities, bonds, currencies and commodities. • Typically employ an opportunistic top-down approach • Dynamic ``global asset allocation'' style with rapid rotation. • Examples: Soros, Tiger, Moore Tactical Asset Allocation

  27. Profiles and methods vary from manager to manager Mostly information based Often use technical indicators In spite of this, performance is closely linked to volatility. Information Based: Discretionary Trading 20% 20% 15% 15% 10% 10% 5% 5% 0% 0% -5% -5% -10% -10% -15% -15% -20% 95 96 97 98 99 00 01 -20% 95 96 97 98 99 00 01 Tactical Asset Allocation

  28. Markets Matter for Global Macro • For both fundamental and technical trading, price volatility is necessary in order to generate profits. • Too high short term volatility triggers stop losses and reduces position size and potential profits. Tactical Asset Allocation

  29. A costly false start • September 11 led to a sharp appreciation of the JPY. • This was very costly for ’Carry trades’, i.e. Borrowing JPY to invest in EUR or USD. • The manager below lost significant amounts on the spike and could not participate fully in the later Yen depreciation. Tactical Asset Allocation

  30. Solution 1: Using a scoring model A scoring model can help a fundamenatl analyst cover and trade more markets, thus diversifying the overall portfolio. Tactical Asset Allocation

  31. Solution 2: ‘Asymmetric’ Analysis • Although it is ’easy’ to see where the market is going, it is hard to predict when. • A solution to this dilemma is to try to predict where the market is not going. • That view is often implemented using options – if the analysis is correct, profits will come sooner or later while cost is limited. Tactical Asset Allocation

  32. Example of Asymmetric Analysis ``The next chart is merely an enlargement again of this ratio. It shows the Yen at the strongest level versus the Share Index since 1996. The point here is that if traders are buying Yen because of the recent strength of the Index, they may sadly be misjudging the situation. […] The implication is clear: the Index can rally a great deal with a constant Yen to get this ratio back to “normalized” levels. This assumes of course that the Index is about to enter into a bull market. The jury is definitely out on this one. There are strong fundamental reasons to suggest that the banks are not yet fixed. More likely the Index will either fade or begin to range trade. In that case, the Yen would have to weaken on the order of 25-35% to return this ratio to “normal” levels. Of course, there is no way of knowing if the direct correlation will hold up over time. However, there is no reason for me to believe that it is in the process of inverting right now.The point is that buying Yen for the reasons mentioned […] may not be very well thought out.’’ Note negative conclusion! Tactical Asset Allocation

  33. Example of Asymmetric Analysis: Graph Tactical Asset Allocation

  34. Example of Asymmetric Analysis: Result • In this case the trader made profits from the analysis with approximately a 3 month lag. • September 11 triggered smaller losses than in our first example. Analysis Macro Trader 150 Result 125 110 100 2000 2002 Tactical Asset Allocation

  35. Solution 3: Combining Time Frames • By trading with different time horizons some diversification can be achieved. • Use both short-term and longer-term indicators. Returns Trading at Different Frequencies 109 107 105 103 101 99 Tactical Asset Allocation

  36. Example: Six Distinct Trading Frequencies US Bonds Trading signals are generated at six distinct trading frequencies. The slowest frequency system trades approximately once a year on average, the fastest once a week. Red=Sell Blue=Buy TF6 TF5 TF4 TF3 Signals : TF2 TF1 Tactical Asset Allocation

  37. Solution 4: Combining Fundamental and Technical Analysis • Combining time-frames implies betting more when all indicators are aligned. • Combining with fundamental with technical indicators adds an additional level of filtering. Tactical Asset Allocation

  38. Combining Technical and Fundamental Signals Value versus Price Combine Value and Momentum Momentum versus Price • At market extremes position risk is reduced Tactical Asset Allocation

  39. Combining Technical and Fundamental: USD/JPY Value versus Price Combine Value and Momentum Momentum versus Price Tactical Asset Allocation

  40. Momentum trading • Seeks to profits from large moves (trends) in financial markets. • Typically ‘gives back’ 20-40% of profits when a trend ends • Suffers so called ‘whip-saw’ losses when markets trade in a range. Large Profit Large Loss (Give-back) Small (Whipsaw) Losses Small Profit Small Loss Tactical Asset Allocation

  41. Large Loss Large Profit No Position Large Profit Neutral Fundamental Trading • Uses fundamental and relative price analysis to forecast future prices • Profits from large price moves, but loses from ‘overextended trends’. Tactical Asset Allocation

  42. As a result • Momentum trades • capture part of the upside of fundamental trading • avoid (negative capture) the losses of momentum trades. • Fundamental trades • capture part of the upside of momentum trading • avoid (negative capture) the losses of momentum trades. Tactical Asset Allocation

  43. If Timing is so Important, Why Bother about Fundamentals?Trend Following as Rational Response Tactical Asset Allocation

  44. Trend following • It is hard to time the market • Therefore there is room for specialists only timing the market. • These traders are typically called trend followers • Seeks capital appreciation from movements in the value of futures contracts or other exchange traded securities • Participates in all major commodities markets (equities, fixed income, currencies, metals, energies and agricultural) • Often uses high leverage to accentuate the impact of market moves • Examples: John Henry, Dunn, Eckhardt, Campbell, … Tactical Asset Allocation

  45. Diversified directional bets on futures markets. Similar to buying a straddle on each market. Often up to 100 positions at any one time A Trend Following CTA 20% 15% 250 10% 200 5% 0% 150 -5% -10% 100 -15% -20% 95 96 97 98 99 00 01 95 96 97 98 99 00 01 Tactical Asset Allocation

  46. Some straddle examples, Nat Gas and Crude Tactical Asset Allocation

  47. A portfolio of 10 straddles • OMX, Crude, Natural Gas, Cotton, S&P, Cattle, Lumber • Sharpe 0.25. Tactical Asset Allocation

  48. Sector Positions Trend followers wait for large moves in markets. In this case, the trader profited from a bond market rally, a stock market fall and a yen depreciation. Other markets mostly showed small losses. Tactical Asset Allocation

  49. Actual JPY position, beginning 2002 • As the JPY trend ends, short positions are gradually reduced. Price JPY Position P&L Tactical Asset Allocation

  50. Diversification • Definition: Take on several independent elements of risk • The risk is reduced by approximately 1/sqrt(n) • Diversification can reduce risk to zero if there are many assets • Often diversification is only available across correlated assets. • A diversified stock portfolio never escapes the stock market risk • Statistical trading rules are often triggered in several markets at the same time • But many statistical systems may only have a small fraction of possible positions open at any one time. • Technical Analysis is easy to apply on many markets, fundamental analysis is not Tactical Asset Allocation

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