Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

From Pensions & Investments magazine: 

Value-at-Risk and other popular risk measurements are typically effective during calm markets but often times are quite ineffective during challenging periods such as market shocks. More predictive models need to be used now that market volatility is high.

... normality ignores the higher moments of asymmetry and fat tails. Since volatility is simply ... not accounting for fat tails and return asymmetry . The volatile market events of 2008 ..... distributions that account for fat-tails and asymmetry.

Read it all at: Pensions & Investments: Standard Risk Measurement Not Enough: Eurozone Crisis Deconstructed

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The topic of selecting an investment manager is an important one. Many investors, including professional financial planners and advisors admit they have little skill at selecting asset managers. In fact, some admit they do such a poor job at it they don't even try. But if you understand the value in alternative investment strategies from private equity to absolute return focused investment programs, then you need to know what to look for in an investment manager. These alternative investment strategies are most often offered privately in a private hedge fund format and sometimes offered as a separate managed account (SMA). Whether you are a private individual investor, an allocator for a family office or institution, or a portfolio manager, the video below is an outstanding example of how a sophisticated investor analyzes a money manager. It’s an interview with the Chief Investment Officer of a family office. He explains why a family who sold a large business may be interested in alternative investments or alternative investment strategies rather than conventional public investments and investment programs like mutual funds.  His family office has allocated 80% to alternative investment managers (like hedge funds and the Asymmetry Investment Program™). He offers some insight about:

• Why family offices (and other wealthy investors) are attracted to alternative investment strategies commonly offered as a private hedge fund.
• What they specifically look for in selecting a portfolio manager.
• How allocators filter managers post crisis:  What exactly did you do in 2008?
• Are they looking at younger emerging hedge fund/money managers?

Click below to view:

On how they select hedge funds:  (begins around 4:07/9:57)

We are looking for opportunities with managers were we can get comfortable as to their strategy and what will generate returns for them and what the risks might be? We haven’t been very active with emerging or start-up managers. I think a lot of that has to do with where we are in terms of time.

2008 was an awesome and an awful market experience it's helpful to look at managers who actually were in existence during that period of time to gain some understanding of how they manage their portfolios are the most difficult. Someone doesn't have a 08 track record is much harder to get a sense of how they're going to do a difficult markets. 09 was a pretty easy market to make money if you were long.

How are you evaluating the 2008 period what are you looking at specifically, the drawdown?

We obviously start with performance but  I also want to see exposure in the portfolio. How did the manager navigate those markets? Did he keep his portfolio fully invested in a market environment for his strategy was not allowing it to make money was actually causing losses? Did he trim exposure? When did he put exposure back into the market place?  is something that we look at it. It's really it's a number of different factors we try and I can understand how the manager managed during that period of time and try to gain some insight on his style. Conviction doesn't automatically mean that you stay fully invested at all times. Although we certainly saw a number of managers who waited FAR too long to trim their exposure. So,  it's a combination of all those factors we try and consider. But I would say one of the things that are most important to me is trying to follow a managers gross and net exposures during that period trying to understand. That leads to conversations of what the manager was thinking at the time.

He goes on to say: 

I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what's ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I've heard people who've lost as much is 25% of investor capital argue that they preserved capital… but I don't believe you can claim that. Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it's a it's a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.

As a portfolio manager of an alternative investment program I can tell you he's spot on. Those whose jobs are that of the asset allocator, who allocates capital to investment programs, often rely too much on Modern Portfolio Theory statistics and not enough on looking very closely under the hood. As a quantitative trading system developer and operator, we are focusing on far different things and I can tell you: it's the things that matter. It's critical that the investor or allocator take a close look at the downside: how was their drawdown from peak to trough? What were the actual holdings during that time? Like he said: do they stay in the market even when it's not working for them? Or, do they reduce their exposure to the possibility of loss (risk management) by selling positions or dynamic hedging?

I also agree with his comments about experience. After such a radical waterfall occurred in 2008 - 2009, more investors and professionals have now figured out the state of the market. In a secular bear market, such waterfalls occur and it can happen again. After the fact, many investment professionals have scrambled to come up with solutions and naturally they'll be attracted to what actually worked in the past: like some forms of Global Tactical Asset Allocation, Trend Following, and other so-called "alternative" investment strategies like we run. We now have new people interested in active portfolio management that seek an absolute return, rather than a relative return. But like he said: they lack the actual experience. You really don't know how they'll react in the heat of the battle. But you can be assured of this: back-testing a system is one thing, executing is another.

Eugene Fama and Kenneth French are known for "Efficient Market Hypothesis". Many investment advisors and financial planners who take a passive approach often anchor to the hypothesis that the market reflects information too quickly for them to exploit, so they may as well buy and hold a group of index funds. Supporters of EMH continue to change the definition of what makes a market efficient, making it difficult to falsify. However, since the first EMH study was released nearly forty years ago, new knowledge has falsified the hypothesis that markets efficiently reflect new information (news). There is at least one anomaly they admit is pervasive: Momentum. Momentum can mean many things and certainly is applied in different ways by different investors, but it basically means buying stocks that have recently gone up (over the past 3 - 12 months) and selling (or at least avoiding) those that are going down. That may sound familiar, since it is a strategy used by Shell Capital Management to achieve the results you see in our separate managed account program, the Asymmetry Investment Program. We, of course, agree that momentum is a return anomaly and its robustness is at least one factor in creating the results you see in our Performance Composite. However, it takes more than just a price momentum ranking system to create those kind of results. Absolute returns and an asymmetric risk/reward profile seen in our investment program cannot be achieved by relative price strength or price momentum alone; it requires great skill at portfolio management and that involves an edge in risk control. With that disclaimer out of the way, we share some of the comments from "Dissecting Anomalies" a paper by Fama and French that studies some of the anomalies like Momentum.

The following quotes are taken from: Fama, Eugene F. and French, Kenneth R., Dissecting Anomalies (June 2007). CRSP Working Paper No. 610.

From the abstract:

 "...momentum is pervasive".

Page 1:

"The premier anomaly is momentum (Jegadeesh and Titman (1993)): stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns. Like the patterns in average returns associated with net stock issues, accruals, profitability, and asset growth, return momentum is left unexplained by the three-factor model of Fama and French (1993) as well as by the CAPM."

“…return momentum is left unexplained by the three-factor model of Fama and French (1993) as well as by the CAPM.”

Page 3:

 “We find that, at least in the extremes, net stock issues, accruals, and momentum produce strong abnormal returns for microcaps, small stocks, and big stocks. For net stock issues and accruals, however, there are chinks in the armor.”

Page 4:

"The two clear winners, in terms of strong average regression slopes for all size groups, are net stock issues and momentum."

"We also argue that the observed relations between average returns and the anomaly variables (positive for momentum and profitability, negative for net stock issues, accruals, and asset growth) are at least roughly in line with the valuation equation."

Page 9:

"Which anomalies produce strong average hedge returns for all three (micro, small, and big) size groups? The clear winners in Table II are net stock issues, accruals, and momentum."

"Finally, momentum sorts produce strong positive average VW and EW hedge returns for all size groups."

"Our momentum results complement those in Hong, Stein, and Lim (2000)."

"Since stock issues, accruals, and momentum produce large average EW and VW abnormal hedge returns in all size groups, at least in terms of hedge returns, these three anomalies are pervasive."

Page 11:

"Which anomalies are present in all size groups and produce returns that vary systematically from the low to the high ends of the sorts? Momentum satisfies both criteria. Abnormal VW momentum returns are strongest for microcaps and weakest for big stocks, but they are impressive in all size groups, and they increase rather systematically from strongly negative for extreme losers to strongly positive for extreme winners. EW momentum returns in all size groups also vary smoothly from losers to winners."

page 16:

 "...among the remaining variables, only net stock issues and momentum show strong marginal explanatory power in all size groups in the regressions...."

Source: Fama, Eugene F. and French, Kenneth R., Dissecting Anomalies (June 2007). CRSP Working Paper No. 610. Available at SSRN: http://ssrn.com/abstract=911960