Global Head of Multi-Asset Class Solutions - Citi Investment Management
April 6, 2016
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Certain hedge funds’ returns often have low or negative correlation to traditional asset classes, which can potentially make them a valuable addition to portfolios in turbulent times.
Financial markets have endured a turbulent start to 2016.
The S&P 500 Index fell both in January and February, while high yield credit in both corporate and emerging markets also came under pressure. Although the month of March has brought some relief, we see a risk of ongoing volatility ahead. Greater volatility often hits during the late stages of an economic recovery. And that is where we believe we are now in the cycle.
What can investors do when faced with increased volatility? We see potential ways of mitigating volatility’s impact on portfolios and even exploiting it. One possibility is to include a certain kind of hedge fund within our allocations, which Citi Private Bank has classified as ‘Diversifiers’. Diversifiers* are hedge funds that try to take advantage of large and unusual movements in the markets. They can go long or short in many different securities and assets. Their returns can often have low – or even negative – correlation with traditional asset classes.
Diversifier hedge funds can follow three different styles. Here’s an example of one them, Commodity Trading Advisor (CTA) managers. CTAs trade in and out of markets based on computerized ‘buy’ and ‘sell’ signals. Their computer programs can often scan more than 100 different futures and forwards markets, searching for trends to follow or trying to spot new trends in the making. Because their strategies are automated, human emotions are taken out of the equation, helping to make more objective decisions during times of stress.
Source: Bloomberg, as of 21 Mar 2016. Past performance is no guarantee of future results. The indices are unmanaged and not investible. Barclays Trader CTA Index: The composite performance of established programs (Commodity Trading Advisors) with more than four years of performance history.
The accompanying table highlights a potential benefit of investing in CTA managers, using the Barclay CTA Index as a proxy. It shows how the Barclay CTA Index has performed during the ten worst calendar quarters for the S&P 500 Index between mid-1988 and the end of 2015. These included the depths of the 2007-09 global financial crisis and the bursting of the technology bubble in 2002. In eight of these ten episodes, overall Barclay CTA performance was positive. The Barclay CTA Index’s average gain was 5.1% compared to an average loss in the S&P of 13.9%.
Despite their often-negative correlation with other asset classes, Diversifiers also come with risks. For example, their performance can struggle when markets go sideways or change direction abruptly. The computer programs behind them can sometimes get caught out by volatility that triggers repeated false signals. And there are also times when they are unable to trade owing to a sudden drought of liquidity in the markets and occasionally because of a software issue.
Given our Global Investment Committee’s market outlook, we believe that now may be a favorable time to allocate to Diversifiers. This type of hedge fund could potentially enhance the risk-adjusted returns of a portfolio made up of several asset classes. That said, we’d also stress that not all Diversifiers are created equal or appropriate for all investors. Getting appropriate exposure requires careful selection. Our manager research analysts therefore scour a universe of thousands of hedge funds and do rigorous due diligence reviews on potential candidates. We then work with you and within your investment objectives to help select appropriate managers, given your risk, return and liquidity goals.
Alternative investments are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk.
Asset allocation does not assure a profit or protect against a loss in declining financial markets.
* Diversifier, Return Enhancer and Volatility Dampener are internal descriptors based on a fund’s strategy and objective that HedgeForum Research Management ("HFRM") has developed and uses to categorize hedge funds. Such descriptors have not been approved by the relevant portfolio managers. The internal classification noted above is subject to change without notice to investors. Many portfolio managers offer multiple products that could have a different objective or classification from that of the fund identified herein. Diversification does not ensure against loss of principal invested.