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

Tactical Asset Allocation1

Tactical Asset AllocationTactical Asset AllocationImplemented by Hedge FundsImplemented by Hedge Funds

Patrik Säfvenblad


DisclaimerDisclaimer

• 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!


A Fund With Risk Control?A Fund With Risk Control?

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

9312 9406 9412 9506 9512 9606 9612 9706 9712 9806 9812


……Or Without?Or Without?

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

9312 9406 9412 9506 9512 9606 9612 9706 9712 9806 9812


Purpose 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


My BackgroundMy 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: [email protected]

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.

mailto:[email protected]


What is a Hedge Fund?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.


Key Differences Between Hedge Funds and Key Differences Between Hedge Funds and (Usual) Funds(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


Hedge Fund FeesHedge 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


Hedge Fund Market GrowthHedge Fund Market Growth


Hedge Fund Styles by AssetsHedge Fund Styles by Assets

Long/short equity40%

Managed futures14%

Event-driven15%

Global Macro14%

Fixed income arb.7%

Convertible arb4%

Other6%

Sourc

e:

Tass

Rese

arc

hSourc

e:

Tass

Rese

arc

h


The Strategy UniverseThe Strategy Universe

Income

Opportunistic

Convertible Arbitrage

MSCI World Equity

Market Timing Aggressive Growth

Event Driven Macro

Distressed Securities

Fund of Funds

Market Neutral

Average Bond Mutual Fund

Short Selling

S&P 500

Emerging Markets

Equity Arbitrage

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

0% 5% 10% 15% 20% 25% 30%

Source: Van Money Manager Research


Capital Flows to Global MacroCapital Flows to Global Macro

• Not a very popular style recently


For good reasons?For good reasons?

Global Macro

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96

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98

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00

Apr-0

0

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-00

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01

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Jul-0

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-01

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02

• It took returns of Global Macro sector 3 years to return to the April 1998 level. (CSFB index)


Sources of Returns in Financial MarketsSources of Returns in Financial Markets

1. 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

2. Exploiting a price inefficiency– Pure arbitrage, Statistical arbitrage, Risky arbitrage– Hard to capture, often very information intensive

3. Exploit superior information• Know the impact of events before other investors– Disappears when spotted by investors– Hard to capture, often very information intensive


Strategy TypesStrategy Types

• 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


Global Macro StrategiesGlobal Macro Strategies

Model-based

Information

Technical

Commodities

Equity Indices

Bonds

Diversified

Directional

Hedged

Intraday trading

Equity &options

Target and Bidder equity

Currencies

Investment styleMarketReturn generator

Long only


Possible Trading Styles, Possible Trading Styles, AgainAgain

Model-based

Information

Technical

Commodities

Equities

Equity &convertibles

Diversified

Directional

Hedged

Intraday trading

Equity &options

Target and Bidder equity

Currencies

Investment styleMarketReturn generator

Long only

Capturing Risk Capturing Risk PremiaPremia

Using Using Manager SkillManager Skill


The Dilemma of Macro TradingThe Dilemma of Macro Trading

"Markets can remain irrational longer than you can remain

solvent.” J.M. Keynes


The Danger of Fundamentals:The Danger of Fundamentals: Nasdaq versus S&P 500Nasdaq versus S&P 500


Yahoo Stock PriceYahoo Stock Price


Yahoo Stock Price and My Sell RecommendationsYahoo Stock Price and My Sell Recommendations


Fundamental tradingFundamental 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


Conclusion YahooConclusion 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


Not Only a Theoretical ProblemNot 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].


Information Based: Global/MacroInformation 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

1986 1988 1990 1992 1994 1996 1998 2000 2002

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Quantum

1986 1988 1990 1992 1994 1996 1998 2000 2002-0.4

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Information Based: Discretionary TradingInformation Based: Discretionary Trading

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• 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.


Markets Matter for Global MacroMarkets 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.


A costly false startA 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.

1997 1998 1999 2000 2001 2002

200

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Long-Term Currency Strategy

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar4200

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Solution 1: Using a scoring modelSolution 1: Using a scoring model

A scoring model can A scoring model can help a fundamenatl help a fundamenatl analyst cover and trade analyst cover and trade more markets, thus more markets, thus diversifying the overall diversifying the overall portfolio.portfolio.


Solution 2: ‘Asymmetric’ AnalysisSolution 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.


Example of Asymmetric AnalysisExample 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!Note negative conclusion!


Example of Asymmetric Analysis: GraphExample of Asymmetric Analysis: Graph


Example of Asymmetric Analysis: ResultExample 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.


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2000 2002

100

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150Macro Trader

Analysis

Result


Solution 3: Combining Time FramesSolution 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

99

101

103

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107

109


Example: Six Distinct Trading FrequenciesExample: Six Distinct Trading Frequencies

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.94

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J an/01 Mar/01 May/01 J ul/01 Sep/01

US Bonds

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: B

lue=

Bu

yR

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=S

ell

TF6

TF5

TF4

TF3

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TF1


Solution 4: Combining Fundamental and Solution 4: Combining Fundamental and Technical Analysis 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.


-2

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• At market extremes position risk is reduced

Value versus Price

Momentum versus Price

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Combining Technical and Fundamental SignalsCombining Technical and Fundamental Signals


Value versus Price

Momentum versus Price

Combine Value and Momentum

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J an 95 Feb 95 Mar 95 Apr 95 May 95

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Combining Technical and Fundamental: USD/JPYCombining Technical and Fundamental: USD/JPY


Momentum tradingMomentum 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.

Larg

e Pro

fit

Small Loss

Small Profit

Small (Whipsaw) Losses

Large Loss (Give-back)


Fundamental TradingFundamental Trading

• Uses fundamental and relative price analysis to forecast future prices

• Profits from large price moves, but loses from ‘overextended trends’.

Larg

e Pro

fit

Neutral

Large LossLarge Profit

No Position


As a resultAs 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.


If Timing is so Important, If Timing is so Important, Why Bother about Fundamentals?Why Bother about Fundamentals?

Trend Following as Rational ResponseTrend Following as Rational Response


Trend followingTrend 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, …


A Trend Following CTAA Trend Following CTA

95 96 97 98 99 00 01

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• Diversified directional bets on futures markets. Similar to buying a straddle on each market.

• Often up to 100 positions at any one time


Some straddle examples, Nat Gas and CrudeSome straddle examples, Nat Gas and Crude


A portfolio of 10 straddlesA portfolio of 10 straddles

• OMX, Crude, Natural Gas, Cotton, S&P, Cattle, Lumber• Sharpe 0.25.


Sector PositionsSector Positions

Trend followers Trend followers wait for large wait for large moves in markets. moves in markets.

In this case, the In this case, the trader profited trader profited from a bond from a bond market rally, a market rally, a stock market fall stock market fall and a yen and a yen depreciation.depreciation.

Other markets Other markets mostly showed mostly showed small losses.small losses.


Actual JPY position, beginning 2002Actual JPY position, beginning 2002

74

74.5

75

75.5

76

76.5

77

77.5Transtrend - position imm j-yen

-400

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12/23 12/30 01/06 01/13 01/20 01/27 02/03 02/10 02/17 02/24-5000

0

5000

• As the JPY trend ends, short positions are gradually reduced.


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Price

Position

P&L

JPY


DiversificationDiversification

• 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


Diversification across MarketsDiversification across Markets

Commodity10%

Currency17%

Energy9%

Interest Rates31%

Metals8%

Stock indices88%

Stock indices25%

A Fundamental Trader

A Technical Trader

Fundamental Fundamental traders tend to be traders tend to be specialists, while specialists, while technical traders technical traders are generalists.are generalists.


The Value of DiversificationThe Value of Diversification

• With diversification, Stop Loss is less necessary, meaning that future returns can be captured

• This is illustrated below where A is a more focused trader with stop loss, while B uses diversification for risk control.

AA B


ConclusionConclusion


What Did We Learn?What Did We Learn?

• The main problem in tactical asset allocation is timing– Risk of direct losses– Opportunity cost, I.e. missing out on other opportunities.– Risk of being stopped out from profitable trades

• Ways to reduce this problem include– Trade filters such as technical filters, multiple time frames, scoring

models.– Asymmetric exposure, e.g. options.

• Global Macro often suffers from a lack of diversification– Analysts are specialists by definition

• Pure trade timing, Trend following, is less precise than fundamental analysis, but provides better diversification.


Patrik Sä[email protected]+46-8-4403644

RPM Risk & Portfolio Management ABStureplan 15SE-111 45 Stockholm

Thanks to Lars Jaeger, Richard Conyers, Warren Naphtal, Owen Brown. Thanks to Lars Jaeger, Richard Conyers, Warren Naphtal, Owen Brown.

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

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