Minimizing Risk

Investors who wish to gain exposure to commodities can do so directly through futures, options and other derivatives; or indirectly, and perhaps unintentionally, through the currencies of commodity exporting nations. The Australian dollar (AUD), Canadian dollar (CAD), Brazilian real (BRL), Mexican peso (MXN), Russian ruble (RUB) and the South African rand (ZAR) demonstrate positive and, at times, reasonably strong correlations to a large basket of commodities (Fig.1).

These correlations offer opportunities for investors who have exposure to either currencies or commodities. For example, one could take a position in a commodity and potentially reduce portfolio risk by taking an opposite position in a positively-correlated currency (Fig.2–5).

Remarks at the Economic Club of New York

Thank you, Terry [Lundgren], for that kind introduction. I am delighted to speak to you here at the Economic Club of New York. The Club has established itself as an esteemed, non-partisan forum for economic discourse. It is an ideal place to discuss policy of the U.S. Securities and Exchange Commission (“SEC” or “the Commission” or “the agency”) and its effects on the U.S. economy and the American people. I intend to do just that in this, my first public speech as Chairman of the SEC.1

Nearly six months ago, my predecessor Mary Jo White gave her last public address as SEC Chair in this same forum. In her remarks, she stated “I am confident in reporting that the agency is today a stronger protector of investors than ever before and much better equipped to meet the challenges of the fast-paced, complex, and interconnected securities markets of 2017.”2 I am pleased — and thankful — to say that I agree with Chair White. When I arrived at the Commission, I made it a priority to meet with staff across the agency. With each meeting, I became more impressed by the breadth of issues my 4,600 colleagues cover, and even more, by their dedication.

The Dodd-Frank Act of 20103 required the SEC to complete an unprecedented array of congressionally mandated rulemakings — all on top of the agency’s usual work. Under Chair White’s leadership, the Commission made great strides, adopting a number of the rules with which it was charged. Admittedly, there are still Dodd-Frank mandates to be completed. But I have inherited an agency with considerably more discretion over its agenda.

MiFID II In Focus

The Dechert speakers were:

Mikhaelle Schiappacasse, Senior Associate (MS)
Matthew Duxbury, Associate (MD)
Dick Frase, Partner (DF)

MS Good morning everyone and welcome to this new session on MiFID In Focus, Unlocking Organisational Requirements. I’m joined by my colleague, Matt Duxbury. I’m Mikhaelle Schiappacasse, and we’re both associates here in the financial services group in London.

We will be joined later by our colleague Dick Frase who will be speaking about product development, and provide some additional updates since the last seminar that covered that topic.

So, without further ado, I’ll hand it over to Matt to start us off.

Man FRM Early View

Conversations about volatility sometimes feel like conversations about gold. There are people who seem to have a bottomless pit full of opaque, conspiratorial and technical knowledge out of which they cook up a witches’ brew of the most terrifying forecasts which infect the imagination and wake you up at night. They aren’t often right, so it is easy to resent the loss of sleep, and they are making a lot of noise right now.

Calls for higher volatility were commonplace in the annual outlook documents at the beginning of the year. Back then, politics and the end to a decade of flooded liquidity were the triggers. With perfect foresight on these issues, we doubt many of these pundits would have changed their volatility forecasts. But they all seem to have been wrong so far and at the half way mark, short volatility strategies are performing well.

Growth numbers are better than we might have expected; global and solid, without being worryingly strong in our view. And the weaker dollar – historically a benign influence on global liquidity – seems to have surprised many. And any good news out of European politics (Macron and the French election) has been beneficial. This has made it possible to listen to the Central Bankers’ warnings about the end of the party in a state of preternatural calm.

Editor’s Letter - Issue 125

The global hedge fund industry has made new highs in assets and performance, as have several of the managers profiled in this issue. HFR and Evestment both place industry assets at $3.1 trillion while Preqin put the figure at $3.3 trillion and BarclayHedge is in the middle at $3.2 trillion. Performance in 2017 to July ranges between about 4.5% to 7.5% depending on index providers and strategies. Equity and event-driven managers are generally performing best, and there is a wide spread of performance within the relative value, CTA and macro spaces.

The asset split by strategy varies much more than do assets and performance, according to how managers are defined and categorised by themselves (and/or by database providers). For instance, relative value is largest at $827 billion per HFR whereas Preqin’s relative value tally is just $341 billion. Preqin ranks macro biggest at $955 billion while HFR’s macro total is $579 billion.

Newer and smaller managers are punching above their weight. The fact that HFR’s equal-weighted indices are outperforming its asset-weighted indices shows smaller managers outperforming, in absolute terms. Some 1,006 new funds launched in 2016, according to Preqin. And in terms of numbers, the industry is dominated by smaller funds. Nearly half of hedge funds (and fund of funds) – or close to 5,000 of them – run below $100 million.

What’s New In Washington

On June 30, Congress gaveled out for the July 4 recess after postponing a critical vote to begin debate on an Affordable Care Act (ACA) repeal-and-replace bill. Senate Majority Leader Mitch McConnell (R-KY) and the GOP caucus have worked for the last two months in countless hours of behind-the-scenes meetings on what many believe to be a long-shot effort to unite 50 of the 52 Republican senators.Senators from both sides of the aisle have taken issue with the manner in which the bill has been written and the lack of opportunities to voice concerns and offer amendments through the traditional committee markup process. GOP leadership has countered by noting that the upcoming Senate floor debate will allow several dozen bipartisan amendments to be offered and voted upon.

Substantive concerns have been expressed by a handful of moderate Republican senators over cuts to Medicaid, while more conservative Republican senators have voiced their concern that the legislation does not go far enough in the direction of a complete repeal. The debate on this issue will continue when the Senate gavels back in on July 10, and it awaits a new score from the Congressional Budget Office on a revised bill. In the meantime, calls to cancel or shorten Congress’ annual August recess have begun to grow louder. After celebrating the Independence Day holiday in Washington, D.C., President Trump headed to Poland and then Germany for the G-20 summit. Mr. Trump is expected to meet some critics who are concerned with his administration’s maneuvering on the international stage so early into his presidency. A topic of conversation among the world leaders: steel and aluminum trade.

Here are some things that we believe are worth focusing on since our last article:

Man FRM Early View

As John F. Kennedy said in his state of the union address in 1962, “The time to repair the roof is when the sun is shining”. With eight years of quantitative easing still compressing yields and inflating valuations, the sun still seems to be shining on pretty much all asset classes. In the first half of the year passive exposure to equities and government bonds returned 7.1%1 and 4.5%2 respectively. But confidence among asset managers in the sustainability of this move in risk assets appears stretched. The recent 20% peak-to-trough decline in the oil price has reopened the cracks in the high yield market, undermining expectations in credit more generally, but the government bond move speaks of a deeper unease. US 2yr notes are close to the highs in yield on the year, while the long end has rallied, flattening the curve by some 50bps since March.

In the very big picture, we believe forward returns on traditional assets simply do not square with the needs of ageing populations, but there are also concerns in the shorter term. A notable and rising proportion of our clients are thinking about ways to help protect against future volatility (the vogue terms are ‘Crisis Risk Offset’, ‘Tail Risk Protection’ or ‘Crisis Alpha’). We believe that this kind of fixing the roof deserves closer attention.

Rethinking Equity Long/Short Allocations For Retail Investors

The model for allocating to equity long/short funds is broken. The mentality of most allocators is to chase the “hot dot” – that is, invest with a fund that performed well recently and hope the hot streak continues. This approach is based on the discredited assumption that allocators can easily identify which funds will perform well going forward. In addition, the risk inherent in individual equity long/short funds is widely misunderstood – the equivalent of conflating the risk of a single stock with a diversified index. The net result is a decade of disappointment among clients who expected.

The alternative (and, we argue, superior) approach is to reframe investing in equity long/short as a “category” allocation – akin to investing in a passive, diversified index at low cost rather than making concentrated bets on high fee, volatile individual constituents. In fact, the actual, live performance of a simple, factor-based replication portfolio we’ve managed since 2012 has outperformed 80-90% of individual funds on a risk-adjusted basis with low fees, daily liquidity and transparency – a package that, overall, should be far more compelling to any allocator seeking to include equity long/short strategies within a diversified portfolio.

The factor-based replication approach that we advocate is the culmination of ten years of research and provides a data-driven solution to the pitfalls experienced post-crisis by many investors in liquid alternatives products.

Why invest in equity long/short strategies?
Why invest in equity long/short in the first place? The simple reason is that an allocation to equity long/short can improve the risk-adjusted returns of a diversified portfolio. Since January 2000, ELS hedge funds outperformed global equities with far less risk (see Fig.1).

The Hunt for Alpha Lies in the Short-Term

Quantitative or systematic investing is more competitive than ever. Cheap computation power, infinite storage capabilities, the proliferation of low-cost but state-of-the-art data analysis tools, online data scientist communities, combined with the progressive commoditization of well-known quant factors through the “smart beta” tag, undoubtedly raises questions about the value-add of a systematic managers in such an environment. If one hasn’t resigned oneself to the belief that all alpha has become beta, where is this alpha now to be found?

What are the elements that quant managers still can offer today to deliver differentiating results? A prominent factor of any systematic asset manager is ultimately to generate a distinctive return stream, which cannot be replicated by a simple combination of standardized, cheaply available financial products. Hence the objective should be to deliver independent and non-replicable return streams. It seems that in the current environment, this objective has become a much more challenging task than in the past.

To highlight where the value proposition of a systematic asset manager lies today, it helps to first understand the underlying drivers of a quant manager’s capacity to generate alpha or differentiated performance. The “Fundamental Law Of Active Management” introduced in 1995 by Grinold and Kahn states that an active manager’s value-add, which can be expressed by the Information Ratio (IR) is the product of his Information Coefficient (IC) and his Breadth (N):


The Science of Investor Communications

Old-school salespeople may rely on gut instinct when sussing out prospects, but we now live in a big world where it is not always practical for a small team (or even one individual) to keep up a rapport with thousands of potential clients. “Many hedge funds do not think enough about their communications strategy but there is a whole science behind building long term relationships,” says Alok Misra, CEO at Navatar, the investor relations platform used by alternative asset managers. Marketing and investor relations teams need to categorise contacts into an investor intelligence centre; use targeted segmentation to prioritise schedules for making contact; keep abreast of allocator news, changing staff and strategy preferences, and use all of this and historical allocation patterns to inform outreach, while also maintaining controls on the security of confidential data and documents. They may need to do all of this ‘24/7’, anywhere on the planet.

Categorising investors: How to build your very own LP intelligence centre
KAP Group co-founder and CEO, Jennifer Aleman Hutter, advises fund managers on communications and marketing, and was a placement agent in her former job at Credit Suisse. “It is not cost effective for all managers to build an internal IR team right away. Outsourcing the IR function can free up time for the team to focus on investing,” says Hutter. That said, many KAP clients do have an in-house IR function that dovetails with support from KAP Group.


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