Commodity Trading Advisors: Risk, Performance Analysis, and Selection Chapter 11 ppt

CHAPTER 11220 CHAPTER 11 Managing Downside Risk in Return Distributions Using Hedge Funds, Managed Futures, and Commodity Indices Mark Anson This chapter examines how alternative invest

CHAPTER 11

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CHAPTER 11 Managing Downside Risk in Return Distributions Using Hedge

Funds, Managed Futures, and

Commodity Indices

Mark Anson

This chapter examines how alternative investments can provide downside return protection in a portfolio composed of U.S stocks and bonds Adding active, “skill-based” strategies such as hedge funds or managed futures to the portfolio leads to important improvements in downside returns, Sharpe ratio, and cumulative performance improvement, often without reducing upside expected returns In some cases, the same benefits can be realized by adding passive commodity futures indices instead of skill-based strategies

INTRODUCTION

Every investor is concerned with downside risk management This is why diversification is a uniform portfolio tool The better diversified an invest-ment portfolio, presumably, the less the portfolio is exposed to months where the return is negative

Yet it is an unfortunate fact of life that when things hit the fan, they tend to do it all at the same time For example, a number of studies have examined the correlation of the U.S domestic and international equity markets during periods of market stress or decline The conclusion is that the equity markets around the world tend to be more highly correlated during periods of economic stress (See Erb, Harvey, and Viskanta 1994;

Sinquefield 1996.) Therefore, international equity diversification may not provide the requisite diversification when a U.S domestic investor needs it most—during periods of economic turmoil or decline

The equity markets have become a single, global asset class for four reasons

1 Policymakers from major industrial nations regularly attend economic

summits where they attempt to synchronize fiscal and monetary policy The Maastricht Treaty and the birth of “Euroland” is an example

2 Corporations are expanding their operations and revenue streams

beyond the site of their domestic incorporation

3 The increased volume of international capital flows suggests economic

shocks will be felt globally as opposed to locally

4 Nations such as Japan have undergone a “big bang” episode where

domestic investors have greater access to international investments This provides for an even greater flow of capital across international boundaries As a result, distinctions between international and domes-tic stocks are beginning to fade

This diversification vacuum is one reason why “skill-based” investing has become so popular with investors Hedge funds and managed futures and other skill-based strategies might be expected to provide greater diver-sification than international equity investing because the returns are dependent on the special skill of the manager rather than any broad macro-economic events or trends However, diversification need not rely solely on active skill-based strategies Diversification benefits also can be achieved from the passive addition of a new asset class such as commodity futures This chapter examines the downside portion of the return distribution for a diversified portfolio of stocks and bonds We then blend in hedge funds, managed futures, and commodity futures to see how the distribution changes when these alternative asset classes are added

DESCRIBING DOWNSIDE RISK

The greatest concern for any investor is downside risk If equity and bond markets are indeed becoming increasingly synchronized, international diversification may not offer the protection sought by investors The ability

to protect the value of an investment portfolio in hostile or turbulent mar-kets is the key to the value of any macroeconomic diversification

Within this framework, investment strategies and asset classes distinct from financial assets have the potential to diversify and protect an

invest-Managing Downside Risk in Return Distributions 221

1 We argue that hedge funds represent alternative investment strategies within exist-ing asset classes rather than a distinct asset class.

0 5 10 15 20 25

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FIGURE 11.1 Frequency Distribution, Portfolio with 60/40 Stocks/Bonds

ment portfolio from hostile markets.1 Hedge funds, managed futures, and commodity futures are a good choice for downside risk protection

To demonstrate this downside risk protection, we start with a standard portfolio of stocks and bonds We begin with a portfolio that is 60 percent the Standard & Poor’s (S&P) 500 and 40 percent U.S treasury bonds In Figure 11.1 we provide a frequency distribution of the monthly returns to this portfolio over the time period 1990 to 2000

Our concern is the shaded part of the return distribution, which shows both the size and the frequency with which the combined portfolio of 60 percent S&P 500 plus 40 percent U.S treasury bonds earned a negative return in a particular month It is this part of the return distribution that corresponds to downside risk and that investors attempt to avoid or limit (See Strongin and Petsch 1996.)

We measure downside risk two ways: First we take the average return

in the shaded part of the return distribution presented in the figure Second

we examine the number of months of negative returns associated with the distribution of returns for the stock/bond portfolio

Table 11.1 shows that the average monthly return to a 60/40 stock/bond portfolio in the shaded part of the distribution is −2.07 per-cent In other words, when the standard stock/bond portfolio earned a negative return in any given month, on average the magnitude of that return was −2.07 percent These negative returns are exactly the downside

risk that investors want to reduce through diversification In addition, the number of months of negative returns is 42 out of 132, a frequency of 31.8 percent

To demonstrate the synchronization of the global equity markets, we blend in a 10 percent allocation to international stocks to our 60/40 U.S stock/U.S bond portfolio The exact allocation is 55 percent S&P 500, 35 percent U.S treasury bonds, and 10 percent EAFE.2 We then calculate the return distribution for this new portfolio in the same manner by which we produced the return distribution for the 60/40 U.S stock/U.S bond portfolio Table 11.1 provides the statistics regarding the return distribution for the 55/35/10 U.S stock/U.S bond/international stock portfolio Again, we concentrate on the downside portion of the distribution The average monthly return to the downside portion of this distribution is −2.11 percent

That is, a 10 percent allocation to international stocks provided an

Therefore, over this time period, an allocation to international stocks did not diversify an investment portfolio comprised of domestic stocks and bonds In fact, a 10 percent allocation to international stocks increased the exposure to downside risk Also, the number of months with negative returns increased to 44 (a 33.3 percent frequency) for the 55/35/10 U.S stock/U.S bond/international stock portfolio from 42 months for our ini-tial 60/40 U.S stock/U.S bond portfolio

Managing Downside Risk in Return Distributions 223

TABLE 11.1 Downside Risk Exposure with Stocks and Bonds

Expected Standard Sharpe Average Portfolio Composition Return Deviation Ratio Downside

60/40 US Stocks/US Bonds 0.91% 2.60% 0.177 −2.07% 55/35/10 Stocks/Bonds/EAFE 0.86% 2.66% 0.155 −2.11%

Number of Cumulative Cumulative Cumulative Downside Downside Return Performance Portfolio Composition Months Protection Potential Improvement

60/40 US Stocks/US Bonds 42 N/A N/A N/A 55/35/10 Stocks/Bonds/EAFE 44 −5.90% −6.60% −12.50%

2 Europe, Asia, and the Far East (EAFE) is an international stock index developed and maintained by Morgan Stanley Capital International.

Finally, the addition of international equities to the standard 60/40 stock and bond portfolio resulted in a decline of the expected monthly return down to 0.86 percent, a reduction in average monthly return of

5 basis points, with a commensurate decline in the associated Sharpe ratio Unfortunately, this is an example where international equity diversification did not provide downside risk protection

MANAGING DOWNSIDE RISK WITH HEDGE FUNDS

We have described and demonstrated the risk that investors attempt to avoid through diversification The question we now address is whether hedge funds can help investors manage this risk There has been some spec-ulation as to whether hedge funds, in fact, can hedge an investment portfo-lio (See Asness, Krail, and Liew 2001.)

We use data on hedge funds from Hedge Fund Research Inc (HFRI), and include several categories of hedge funds in our portfolio mix to determine how each style changed the return distribution for the blended portfolio We begin with funds of funds (FOF) Using the HFRI FOF index, we construct a portfolio of 55 percent U.S stocks, 35 percent U.S treasury bonds, and 10 percent FOF We build the same frequency distri-bution as presented in the exhibit and focus on the downside portion of the return distribution

For hedge FOF, we find that the average downside return was −1.90 percent This indicates that, on average, the addition of hedge FOF to the standard stock/bond portfolio provided 27 basis points of downside risk protection The number of downside months was the same at 42 Table 11.2 presents the results of the blended portfolios of 55 percent U.S stocks, 35 percent U.S treasury bonds, and 10 percent hedge funds, for each category of hedge fund

We also consider what trade-off might be necessary to achieve this level

of downside protection It is possible some upside potential was sacrificed

to provide the downside protection In Table 11.1 we saw that the average monthly return to our initial U.S stock/U.S treasury bond portfolio was 0.91 percent In Table 11.2 we see that the average monthly return when hedge fund of funds is added is 0.92 percent Therefore, no upside return potential was sacrificed to achieve the downside risk protection Last, the Sharpe ratio increased for the portfolio with hedge FOF

We can calculate the cumulative performance improvement to the stock/bond/hedge fund of funds portfolio from downside risk protection and upside return enhancement by:

(−1.90% × 42 months) − (−2.07 × 42 months) + [(0.92% − 0.91%)

× 132 months] = 8.46%

TABLE 11.2

60/40 US Stocks/ US Bonds

55/35/10 Stocks/ Bonds/FOF

55/35/10 Stocks/ Bonds/Equity L/S

55/35/10 Stocks/Bonds/ Convertible Arb

55/35/10 Stocks/Bonds/ Market Neutral

55/35/10 Stocks/Bonds/ Distressed Debt

55/35/10 Stocks/Bonds/ Event Driven

55/35/10 Stocks/Bonds/ Fixed Income Arb

55/35/10 Stocks/Bonds/ Global Macro

55/35/10 Stocks/Bonds/ Market T

55/35/10 Stocks/Bonds/ Merger Arbitrage

55/35/10 Stocks/Bonds/ Short Selling

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The cumulative performance improvement of 8.46 percent may be split into two parts, the cumulative return earned from downside risk pro-tection (7.14 percent) and the amount earned from upside return potential (1.32 percent)

Table 11.2 presents several interesting results In every case, the down-side risk was reduced The cumulative downdown-side protection for each hedge fund strategy is positive Average monthly downside risk ranged from −1.63 percent for short sellers to −2.04 percent for global macro hedge funds It

is not surprising that global macro hedge funds offered the least in down-side protection because these funds tend to take significant market risk the same as stocks and bonds (See Anson 2000.) Also, it is not surprising that short sellers offered the best downside risk protection because the very nature of this strategy is to profit in months when the stock and bond mar-kets perform poorly

In every case but two (short sellers and fixed income arbitrage), the average monthly return of the whole return distribution increased when hedge fund strategies were added to the initial stock/bond portfolio More important, for every hedge fund strategy, the cumulative performance improvement is positive Also, Sharpe ratios improved uniformly for all hedge fund strategies Last, in only one strategy, distressed debt, did the number of downside months increase (by one, to 43), but the average downside return was much lower (−1.84 percent) compared to the stock/ bond portfolio

In conclusion, we found that hedge funds uniformly offered downside risk protection, and in many cases, this protection was considerable Also,

in only two cases did this downside risk protection come at the sacrifice

of upside return potential (for short sellers and fixed income arbitrage), but the cumulative downside protection received was sufficient to offset the reduction of cumulative return potential In every other instance,

downside risk protection was achieved in combination with increased

return potential

Managing Downside Risk with Managed Futures

Managed futures refers to the active trading of futures contracts and for-ward contracts on physical commodities, financial assets, and currencies The purpose of the managed futures industry is to enable investors to profit from changes in futures prices This industry is another skill-based style of investing Investment managers attempt to use their special knowledge and insight in buying and selling futures and forward contracts to extract a pos-itive return These futures managers tend to argue that their superior skill

is the key ingredient to derive profitable returns from the futures markets

Within this framework, an asset class distinct from financial assets has the potential to diversify and protect an investment portfolio from hostile markets It is possible that skill-based strategies such as managed futures investing can provide the diversification that investors seek Managed futures strategies might provide diversification for a stock and bond port-folio because the returns are dependent on the special skill of the commod-ity trading advisor (CTA) rather than any macroeconomic policy decisions made by central bankers or government regimes (See, e.g., McCarthy, Schneeweis, and Spurgin 1996; Schneeweis, Spurgin, and Potter 1997; and Edwards and Park 1996.)

To analyze the impact of managed futures on the distribution of returns

in a diversified portfolio, we use the Barclay CTA managed futures indices There are four actively traded strategies: CTAs that actively trade in agri-cultural commodity futures, CTAs that actively trade in currency futures, CTAs that actively trade in financial and metal futures, and CTAs that actively trade in energy futures If managed futures can provide downside protection, we would expect the average monthly downside return to be smaller than that observed for our initial stock/bond portfolio

Once again, we build a blended portfolio of 55 percent U.S stocks, 35 percent U.S treasury bonds, and 10 percent CTA strategy We then develop a frequency distribution of monthly returns over the period 1990 to 2000 In Table 11.3 we present the results from the return distribution generated by this CTA-blended portfolio for each CTA strategy For example, for CTA agriculture, the average downside return is −1.81 percent This is an improve-ment of 26 basis points over the average downside return observed with the stock/bond portfolio The number of downside months with CTA agriculture managed futures added to the portfolio increased by one month to 43 Unfortunately, some upside potential was sacrificed, as the expected monthly return of the investment portfolio declined from 0.91 percent to 0.88 percent when CTA agriculture managed futures are added Still, even with the decrease in expected return for the portfolio, the reduction in downside risk would have added 5.15 percent of cumulative performance improvement to the portfolio over this time period:

[(−1.81% × 43 months) − (−2.07% × 42 months)]

+ [(0.88% − 0.91%) × 132 months] = 5.15%

Table 11.3 indicates that the 5.15 percent of cumulative performance improvement can be split into 9.11 percent of cumulative downside protec-tion and −3.96 percent of cumulative return potential The table also pres-ents results for the other CTA managed futures strategies In every case,

Managing Downside Risk in Return Distributions 227

TABLE 11.3

60/40 US Stocks/ US Bonds

55/35/10 Stocks/Bonds/ CT

55/35/10 Stocks/ Bonds/CT

55/35/10 Stocks/Bonds/ CT

55/35/10 Stocks/Bonds/ CT

aThe downside protection and cumulative performance improvement for CT

228

downside risk protection is observed However, with respect to CTA energy managed futures, this downside risk protection came at the expense of sig-nificant upside return potential; the cumulative Performance Improvement

is−4.56 percent.3

These results highlight the concept that managed futures products should not be analyzed on a stand-alone basis The downside risk protec-tion demonstrated by managed futures products is consistent with the research of Scheeweis, Spurgin, and Potter (1996) Their true value is best achieved in a portfolio context

MANAGING DOWNSIDE RISK WITH COMMODITY

FUTURES

Hedge funds and managed futures fall into the category of skill-based investing That is, the returns derived from these strategies are dependent

on the active skill of the individual hedge fund or managed futures manager However, downside risk protection may be achieved without active man-agement To demonstrate, we blend passive commodity futures into the ini-tial stock and bond portfolio

A commodity futures index represents the total return that would be earned from holding only long positions in an unleveraged basket of com-modity futures Comcom-modity futures indices are constructed to be unlev-eraged The face value of the futures contracts are fully supported (collateralized) either by cash or by treasury bills Futures contracts are pur-chased to provide economic exposure to commodities equal to the amount

of cash dollars invested in the index Therefore, every dollar of exposure to

a commodity futures index represents one dollar of commodity price risk

We consider four commodity futures indices: the Goldman Sachs Com-modity Index (GSCI), the Dow-Jones/AIG ComCom-modity Index (DJ-AIGCI), the Chase Physical Commodity Index (CPCI), and the Mount Lucas Man-agement Index (MLMI).4The GSCI, DJ-AIGCI, and the CPCI are unlever-aged indices of long-only positions on physical commodities The MLMI

Managing Downside Risk in Return Distributions 229

3 Data for the CTA energy managed futures index is available only through 1998 Therefore, the data are not strictly comparable to the other managed futures indices, particularly with respect to the number of downside months However, in Table 11.3, the cumulative downside protection, cumulative return potential, and the cumulative performance improvement have been adjusted to reflect the different time period examined for this trading strategy.

4 More details regarding these indices can be found in Anson (2001).