Tactical Asset Allocation
Implemented by Hedge Funds
Patrik Säfvenblad
Tactical Asset Allocation
1
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
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A Fund With Risk Control?
$3,000
$2,500
$2,000
$1,500
$1,000
$500
$0
9312
9406
9412
9506
9512
9606
9612
Tactical Asset Allocation
9706
9712
9806
9812
3
…Or Without?
$3,000
$2,500
$2,000
$1,500
$1,000
$500
$0
9312
9406
9412
9506
9512
9606
9612
Tactical Asset Allocation
9706
9712
9806
9812
4
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
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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.
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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.
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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
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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 ``highhighs'‘, 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
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Hedge Fund Market Growth
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Hedge Fund Styles by Assets
Long/short
equity
40%
Other
6%
Convertible
arb
4%
Fixed income
7%
Managed
futures
14%
Global Macro
14%
Event-driven
15%
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Source: Tass Research
arb.
11
The Strategy Universe
40%
Aggressive Growth
Market Timing
35%
Opportunistic
S&P 500
30%
25%
Market Neutral
Macro
Event Driven
20%
Fund of Funds
Distressed
Securities Income
Convertible Arbitrage
15%
MSCI World Equity
Equity Arbitrage
10%
Emerging Markets
Average Bond
Mutual Fund
5%
Short Selling
0%
-5%
-10%
0%
5%
10%
15%
20%
25%
30%
Source: Van Money Manager Research
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Capital Flows to Global Macro
• Not a very popular style recently
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Ja
n9
Ap 4
r-9
4
Ju
l -9
4
O
ct
-9
Ja 4
n9
Ap 5
r-9
5
Ju
l -9
O 5
ct
-9
Ja 5
n9
Ap 6
r-9
6
Ju
l -9
O 6
ct
-9
Ja 6
n9
Ap 7
r-9
7
Ju
l -9
7
O
ct
-9
Ja 7
n9
Ap 8
r-9
8
Ju
l -9
8
O
ct
-9
Ja 8
n9
Ap 9
r-9
9
Ju
l -9
9
O
ct
-9
Ja 9
n0
Ap 0
r-0
0
Ju
l -0
O 0
ct
-0
Ja 0
n0
Ap 1
r-0
1
Ju
l -0
O 1
ct
-0
Ja 1
n02
For good reasons?
• It took returns of Global Macro sector 3 years to return to the
April 1998 level. (CSFB index)
Global Macro
350
300
250
200
150
100
50
0
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Sources 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
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Strategy 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
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Global Macro Strategies
Return generator
Market
Investment style


Currencies
Directional
Equity Indices
Information


Diversified
Commodities
Model-based
Technical

Bonds



Hedged
Intraday trading
Equity &
options
Long only
Target and
Bidder equity
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Possible Trading Styles, Again
Return generator
Market
Using
Manager Skill
Currencies
Information
Investment style
Directional
Equities
Diversified
Commodities
Capturing Risk
Premia
Hedged
Equity &
convertibles
Model-based
Intraday trading
Equity &
options
Technical
Long only
Target and
Bidder equity
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The Dilemma of Macro Trading
"Markets can remain irrational
longer than you can remain
solvent.”
J.M. Keynes
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The Danger of Fundamentals:
Nasdaq versus S&P 500
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Yahoo Stock Price
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Yahoo Stock Price and My Sell Recommendations
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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
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23
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
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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].
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Information Based: Global/Macro
Quantum
4000
•
•
•
•
•
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.
3000
2000
1500
1000
500
200
100
1986
1988
1990
1992
1994
1996
1998
2000
2002
0.4
0.3
0.2
0.1
0
-0.1
-0.2
•
Examples: Soros, Tiger, Moore
-0.3
-0.4
1986
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1988
1990
1992
1994
1996
1998
2000
2002
26
Information Based: Discretionary Trading
• 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.
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
-10%
-15%
-20%
-15%
95
96
97
98
99
00
01
-20%
95
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96
97
98
99
00
01
27
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
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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.
Long-Term Currency Strategy
5600
close
5400
400
5200
5000
300
4800
250
4600
200
4400
4200
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
1997
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1998
1999
2000
2001
2002
29
Solution 1: Using a scoring model
A scoring model can help
a fundamenatl analyst
cover and trade more
markets, thus
diversifying the overall
portfolio.
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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.
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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!
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Example of Asymmetric Analysis: Graph
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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
5600
Macro Trader
close
150
Result
5400
5200
125
5000
4800
110
4600
100
4400
2000
4200
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
2002
Mar
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Solution 3: Combining Time Frames
• By trading with different time horizons some diversification
can be achieved.
• Use both short-term and longer-term indicators.
109
Returns Trading at Different Frequencies
107
105
103
101
99
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Example: Six Distinct Trading Frequencies
US Bonds
Trading signals
are generated
at six distinct
trading
frequencies.
Signals : Blue=Buy Red=Sell
112
110
108
106
104
TF6
102
TF5
100
TF4
98
TF3
TF2
96
94
Jan/01
TF1
Mar/01
May/01
Jul/01
Sep/01
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The slowest
frequency
system trades
approximately
once a year on
average, the
fastest once a
week.
36
Solution 4: Combining
Technical Analysis
Fundamental
and
• Combining time-frames implies betting more when all
indicators are aligned.
• Combining with fundamental with technical indicators adds an
additional level of filtering.
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Combining Technical and Fundamental Signals
Value versus Price
2
105
1
Combine Value and Momentum
95
0
2
90
Value + Momentum Position
Value Position
100
85
-1
80
-2
75
Momentum versus Price
Momentum Position
2
105
100
100
1
95
0
90
85
-1
1
95
0
105
90
-2
80
75
85
-1
-2
80
•
At market extremes position risk is reduced
75
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Combining Technical and Fundamental: USD/JPY
Value versus Price
105
Signal
1
95
Price
2
Combine Value and Momentum
2
0
105
-2
Jan 95
Signal
1
75
Feb 95
Mar 95
Apr 95
May 95
95
Price
85
-1
0
Momentum versus Price
2
105
85
-1
Signal
1
95
0
90
Price
100
-2
Jan 95
75
Feb 95
Mar 95
Apr 95
May 95
85
-1
80
-2
Jan 95
75
Feb 95
Mar 95
Apr 95
May 95
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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 Loss (Give-back)
Small (Whipsaw) Losses
Small Loss
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Fundamental Trading
• Uses fundamental and relative price analysis to forecast future
prices
• Profits from large price moves, but loses from ‘overextended
trends’.
Large Loss
Large Profit
No Position
Neutral
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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.
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If Timing is so Important,
Why Bother about Fundamentals?
Trend Following as Rational Response
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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, …
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A Trend Following CTA
• Diversified directional bets on futures markets. Similar to
buying a straddle on each market.
• Often up to 100 positions at any one time
20%
15%
250
10%
200
5%
0%
150
-5%
-10%
100
-15%
95
96
97
98
99
00
01
-20%
95
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96
97
98
99
00
01
45
Some straddle examples, Nat Gas and Crude
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A portfolio of 10 straddles
• OMX, Crude, Natural Gas, Cotton, S&P, Cattle, Lumber
• Sharpe 0.25.
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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.
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Actual JPY position, beginning 2002
• As the JPY trend ends, short positions are gradually reduced.
5600
Transtrend - position imm j-yen
close
77.5
5400
5200
77
Price
5000
4800
76.5
JPY
4600
4400
76
4200
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
75.5
75
74.5
Position
74
0
-200
-400
5000
P&L
0
-5000
12/23
12/30
01/06
01/13
01/20
01/27
02/03
02/10
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02/17
02/24
49
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
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Diversification across Markets
A Technical
Trader
Commodity
10%
Stock indices
25%
Currency
17%
Fundamental
traders tend to be
specialists, while
technical traders
are generalists.
A Fundamental
Trader
Metals
8%
Energy
9%
Stock indices
88%
Interest Rates
31%
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The 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.
A
B
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Conclusion
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53
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.
Tactical Asset Allocation
54
Patrik Säfvenblad
finpsa@hhs.se
+46-8-4403644
RPM Risk & Portfolio Management AB
Stureplan 15
SE-111 45 Stockholm
Thanks to Lars Jaeger, Richard Conyers, Warren Naphtal, Owen Brown.
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