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 11.2Downside Risk Protection Using Hedge Funds Number ofCumulativeCumulativeCumulative ExpectedStandardSharpeAverageDownsideDownsideUpsidePerformance Portfolio CompositionReturnDeviationRatioDownsideMonthsProtectionPotentialImprovement 60/40 US Stocks/ US Bonds0.91%2.60%0.177−2.07%42N/AN/AN/A 55/35/10 Stocks/ Bonds/FOF0.92%2.45%0.191−1.90%427.14%1.32%8.46% 55/35/10 Stocks/ Bonds/Equity L/S1.00%2.54%0.215−2.03%405.74%13.88%19.62% 55/35/10 Stocks/Bonds/ Convertible Arb0.93%2.42%0.197−1.88%419.86%3.57%13.43% 55/35/10 Stocks/Bonds/ Market Neutral0.92%2.40%0.195−1.83%4210.08%1.32%11.40% 55/35/10 Stocks/Bonds/ Distressed Debt0.95%2.45%0.204−1.84%438.25%4.37%12.62% 55/35/10 Stocks/Bonds/ Event Driven0.95%2.49%0.201−1.91%426.72%5.28%12.00% 55/35/10 Stocks/Bonds/ Fixed Income Arb0.90%2.36%0.189−1.86%4110.68%−1.32%9.36% 55/35/10 Stocks/Bonds/ Global Macro0.97%2.51%0.207−2.04%405.34%9.86%15.20% 55/35/10 Stocks/Bonds/ Market Timing0.95%2.50%0.198−2.03%405.74%7.18%12.92% 55/35/10 Stocks/Bonds/ Merger Arbitrage0.93%2.43%0.196−1.90%419.04%3.57%12.61% 55/35/10 Stocks/Bonds/ Short Selling0.85%2.02%0.198−1.63%3726.63%−7.92%18.71%
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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 downside 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 11.3Downside Risk Protection Using Managed Futures Number ofCumulativeCumulativeCumulative ExpectedStandardSharpeAverageDownsideDownsideReturn Performance Portfolio CompositionReturnDeviationRatioDownsideMonthsProtectionPotentialImprovement 60/40 US Stocks/ US Bonds0.91%2.60%0.177−2.07%42N/AN/AN/A 55/35/10 Stocks/Bonds/ CTA Agriculture0.88%2.37%0.182−1.81%439.11%−3.96%5.15% 55/35/10 Stocks/ Bonds/CTA Currency0.90%2.39%0.190−1.96%3910.50%1.38%11.88% 55/35/10 Stocks/Bonds/ CTA Financial & Metals0.89%2.39%0.182−1.95%408.94%−0.86%8.08% 55/35/10 Stocks/Bonds/ CTA Energya0.92%2.38%0.197−1.86%316.24%−10.80%−4.56% aThe downside protection and cumulative performance improvement for CTA energy is adjusted to reflect data ending in 1998.
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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.