Investors in 2016 endured lapses of price turbulence alongside growing uncertainty. Striking a balance between riding the bull market and safeguarding for the future was, and continues to be, top of mind. With the bull market going into its eighth year and traders betting big on future volatility, now is the time for investors to review their risk management approach.
Drawdown containment underpins a solid approach to risk management. It is a key objective of managing risk: the bigger the loss, the bigger the gain required to recoup the loss. A market decline of 20 percent, for example, requires a subsequent gain of 25 percent just to break even. The required gain jumps to 100 percent at a 50 percent market decline.
Containing drawdowns at the portfolio level means integrating uncorrelated streams of risk and return before the market drawdown occurs.
Recent volatility propelled some investors towards “crisis alpha” as a risk management strategy that seeks to limit (or contain) drawdowns. The term, which simply refers to strategies that perform well when the equity markets decline, will no doubt continue to be a key talking point for portfolio allocation and risk management. There are many persisting risk factors which could trigger a potential drawdown in the equity markets. Crisis alpha provides a natural remedy for such a situation.
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What’s your strategy? A challenge with crisis alpha is finding the right strategy. For example, a bear market strategy will generally perform well in a market decline. However, bear market strategies exhibit negative correlation to equities and thus tend to produce negative returns during normal market conditions. If the equity markets continue higher, such a strategy will not flourish. Instead, a strategy that seeks positive returns in various market environments, thus potentially benefiting the overall portfolio in both up and down markets, is needed.
Managed futures is a strategy that is increasingly being recognized as a compelling source of crisis alpha. Unlike some crisis alpha strategies, like those mentioned previously, managed futures strategies have the possibility of achieving alpha in both a bull and bear market.
This strategy, which is typically overseen by a commodities trading advisor, provides returns uncorrelated to the equity market through investments in futures contracts. Since the returns are uncorrelated, traditional market movements have a limited impact on the strategy’s performance. It is this fact that denotes managed futures as an option for crisis alpha: the ability to perform in times of crises as well as contribute during normal market environments.
Historical data supports this point. Since 1980, managed futures have delivered stable returns through a wide range of market environments. During the worst three drawdown periods of the Standard & Poor’s 500 index since 1987, these strategies achieved positive performance. When the S&P dropped more than 30 percent following Black Monday, managed futures, represented by the Barclay BTOP50 index, returned more than 8 percent.
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Similarly, when the S&P dropped more than 44 percent when the tech bubble burst and more than 50 percent during the financial crisis, managed futures returned more than 38 percent and 14 percent, respectively. During these large equity market declines, managed futures investors offset the declines from their equity allocations, containing the drawdown and better positioning themselves for their long-term objectives.
Finding the right managed futures strategy requires a review of historical performance, correlation and risk-adjusted returns, in addition to reviewing the strategy’s positioning and objectives. Furthermore, investors should review the managed futures strategy in relationship to their entire portfolio. An investor with a balanced portfolio may find it advantageous to implement a managed futures strategy that has historically provided more stable returns. On the other hand, an investor with significant equity exposure may benefit from a managed futures strategy that has historically delivered significant upside during a down market without exhibiting inverse correlation over full market cycles.
Comprehension is the key. The idea of crisis alpha will continue to gain spotlight as market uncertainty persists. The options to fulfill this role come in all shapes in sizes. And while attempting to provide an uncorrelated return stream and also reduce the impact of drawdowns is a strong strategy, it requires informed implementation. Comprehension is the key: know the strategy and understand how the strategy’s expected performance relates to your current portfolio positioning.
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Doing so will best position you for drawdown containment, and maximize the impact of a crisis alpha strategy.
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Crisis Alpha and the Importance of Risk Management originally appeared on usnews.com
