Table 4.1 presents the results of a risk–return analysis for AIS strategy sectors from January 1990 to January 2002 based on monthly data. Returns were calculated as geometric averages (cumulative returns) of the log-differences of consecutive prices. The risk calculation is based on the standard deviation of returns. One can observe that the risk–return properties of Hedge fund strategies are very heteroge- neous. Additionally, in Figures 4.1 and 4.2 these performance numbers are displayed graphically in a risk–return plot. I intentionally did not choose to plot the perform- ance properties of individual strategies as risk–return coordinate points, but instead show representative areas of return and risk (namely one standard deviation along the main two axes of each performance ‘cluster’) to express the variability of man- ager performance within each sector.
8409 Chapter 4 p111-135 11/4/02 1:13 PM Page 113
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
TABLE 4.1■Risk and return of AIS
Return Volatility Max. Drawdown Sharpe Ratio Kurtosis
Distressed Securities
HFR 15.10% 6.38% –10.78% 1.58 6.53
Long/Short Equity
HFR 20.22% 9.21% –9.29% 1.65 1.22
Tremont 13.15% 11.88% –14.21% 0.69 2.69
Equity Market Neutral
HFR 11.11% 3.24% –2.72% 1.88 0.35
Tremont 10.86% 3.17% –3.55% 1.85 0.05
Event Driven
HFR 15.90% 6.67% –10.78% 1.63 6.75
Tremont 11.87% 6.42% –16.04% 1.07 28.30
Macro
HFR 17.50% 8.82% –10.70% 1.42 0.25
Tremont 14.26% 13.28% –26.78% 0.70 1.33
Market Timing
HFR 14.49% 6.92% –5.50% 1.37 –0.61
Regulation D
HFR* 23.02% 7.18% –11.99% 2.51 2.04
Relative Value
HFR 13.58% 4.14% –6.55% 2.07 8.44
Convertible Arbitrage (HFR) 11.90% 3.39% –4.84% 2.03 3.61
Convertible Arbitrage (Tremont) 11.06% 4.82% –12.04% 1.26 5.20 Fixed Income Arbitrage (HFR) 8.59% 4.79% –14.42% 0.75 9.09 Fixed Income Arbitrage (Tremont) 7.57% 4.76% –12.47% 0.54 15.22 Short Selling
HFR 1.43% 22.73% –53.36% –0.16 1.44
Tremont –1.04% 18.27% –43.64% –0.33 1.35
Fund of Funds
HFR 10.97% 6.05% –13.08% 0.99 4.16
Composite
HFR 15.83% 7.27% –11.42% 1.49 3.44
Tremont 11.80% 9.21% –13.81% 0.74 1.15
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TABLE 4.1(Continued)
Return Volatility Max. Drawdown Sharpe Ratio Kurtosis
Managed Futures
Tremont 4.69% 11.59% –17.74% –0.03 1.34
MAR Systematic Active** 6.62% 11.05% –15.64% 0.15 0.78
MAR Discretionary Active 12.47% 6.87% –5.60% 1.09 1.13
MAR Trendfollowing 10.29% 16.14% –20.11% 0.33 1.39
Passive (sGFII) 13.16% 10.02% –9.09% 0.81 1.19
Currency Trading
Parker Index 11.11% 9.73% –8.86% 0.63 3.90
Equity
MSCI EU (incl. dividends) 8.79% 15.33% –33.03% 0.25 0.60
MSCI World (incl. dividends) 6.79% 14.65% –35.32% 0.12 0.63 S&P 500 (incl. dividends) 12.03% 14.52% –31.41% 0.48 1.13 Bonds
SSB World (10) Gov’t Bonds 6.60% 6.13% –5.92% 0.26 0.40
Commodities
Goldmann Sachs Index 3.10% 17.96% –48.25% –0.11 1.91
Source: Partners Group
Data:HFR (01.90–10.02), Tremont (01.94–01.02), MAR (01.90–01.02),
*01.96–01.02; **01.92–01.02
Focusing on Global Macro and Long/Short Equity strategies, one can clearly observe that: (1) high returns came at the expense of high risk; and (2) there are significant differences between the HFR and the Tremont benchmarks. For the 12-year study period, HFR show an average annual return for Global Macro funds of 17.5% per annum. Along with these impressive returns came a relatively high level of risk. With 8.9% standard deviation, Global Macro investments ranked among the more volatile in the Hedge funds industry. The strategy has a Sharpe ratio of 1.42 according to HFR. In contrast, the eight-year CSFB Tremont Index for Global Macro shows an average annual return of 14.3%, a volatility of 13.3% and a Sharpe ratio of 0.7. Long/Short Equity strategies showed 20.2%
annualized returns, 9.2% volatility and a Sharpe ratio of 1.65 (Tremont: 13.2%
returns, 11.9% volatility, 0.69 Sharpe ratio). The kurtosis numbers for Long/Short Equity strategies are slightly higher than those for Global Macro. One reason for
4 ■Empirical Properties of Alternative Investment Strategies 8409 Chapter 4 p111-135 11/4/02 1:13 PM Page 115
the deviation between the two indices for Macro and Long/Short Equity strategies is that they had strong returns during the years 1990–94, a time period not entirely reflected by the Tremont Index, which began coverage in 1994.
It is important to note the large deviation in the drawdown figures between the HFR and Tremont databases for Global Macro, Long/Short Equity, Convertible Arbitrage and Event Driven strategies, for which the different time periods cannot be an explanation. While the ten-year equal-weighted HFR Macro Index shows the most severe drawdown during the period to be –10.7%, the asset-weighted Tremont Index (covering a shorter time period) shows a substantially worse –26.8%. The deviations for Long/Short Equity and Event Driven strategies are less remarkable, but also noteworthy (–9.3% HFR and –14.2% Tremont, –10.8% HFR and –16.0%
Tremont respectively). For Convertible Arbitrage, HFR displays the worst draw-
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
2% 4% 6% 10% 12% 14% 16%
5%
10%
15%
20%
25%
30%
35%
40%
8%
Short Seller Global
Macro
Equity Hedge
Equity Mkt. Tim.
Relative Value
Distress Security
Event Driven
Convert
Deb. Arb S&P500
Return
FIGURE 4.1■Risk and Return for Hedge fund strategies (01.90–01.02)
Source: Partners Group Data: HFR, MAR
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down of –4.9% in comparison to a value of –12.0% for the CSFB/Tremont Index.
The wide differences between the two databases for this very important statistic fur- ther illustrate the value of understanding the way data is collected and what the information truly represents. My assessment is that the Tremont numbers in most circumstances provide a better understanding of past performance characteristics than the HFR indices. The Tremont data is asset weighted which provides better insights into the performance for the average investor.
Providing slightly lower returns on average, but better stability on the risk side are Market Timing, Relative Value, Distressed Securities and Event Driven strate- gies. While Market Timing and Relative Value experienced single worst drawdowns of –5.5% and –6.6% (HFR data) respectively, Event Driven and Distressed Securities exhibited drawdowns of about double these amounts.
Looking further at kurtosis provides another view on risk: Market Timing (HFR):
4 ■Empirical Properties of Alternative Investment Strategies
2% 4% 6% 10% 12% 14% 16%
5%
10%
15%
20%
25%
30%
35%
40%
8%
System.
Passive
Discret.
Active
System.
Active S&P500
Return
FIGURE 4.2■Risk and Return for Managed Futures strategies (01.90–01.02)
Source: Partners Group Data: HFR, MAR
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–0.6, Relative Value (HFR): 8.4, Distressed Securities (HFR): 6.5, Event Driven:
6.75 (HFR) and 28.3 (CSFB/Tremont). The large kurtosis for Fixed Income Arbitrage (HFR: 9.1, CSFB/Tremont: 15.2), and for Relative Value in general, was largely caused by the events in the fall of 1998.
The worst performing sector during the period is clearly Short Selling.
Suffering during a decade of bullish equity markets, short sellers returned an aver- age of 1.4% with a volatility of 22.7% (HFR). The worst drawdown figure of –53.4% sheds further light on the difficulties faced by this sector during the time period considered here. Similar results are reflected by the Tremont Index. It is not surprising, however, that in the 18-month period from April 2000 to September 2001, short sellers were among the best performers in the industry (but they lost significantly again between 10/01 and 01/02).
Equity Market Neutral strategies demonstrated impressive risk-adjusted performance according to both the HFR and Tremont databases. With returns of 11.1% and low volatility of 3.2%, the strategies show a very impressive Sharpe ratio of 1.88 and 1.85 (HFR and Tremont respectively). This strategy has the lowest drawdown overall (–3.55% for Tremont and –2.72% for HFR). The kurtosis for the strategies is zero, indicating low tail risk.
Convertible Debenture Arbitrage (‘Regulation D’) strategies showed average annual returns of 23.0% and volatility of 7.2%, which gives a Sharpe ratio of 2.51. The worst drawdown stands at –12.0%. An important factor to consider here is the lack of liquidity. The presented volatility is partly the effect of the absence of mark to market pricing. With frequent changes in pricing absent, volatility appears artificially low. The high returns partly represent a liquidity pre- mium the investor receives for accepting a relatively long lock-up period.
The Managed Futures side of the AIS Universe is more homogenous than Hedge funds. The standalone return to risk ratios of Managed Futures strategies are gener- ally not as impressive when compared to Hedge fund strategies. Their main value lies in their correlation attributes and diversification capacities within an overall portfolio. Interesting because of their attractive return and risk properties (and their usually lower fee structure) are Systematic Passive Futures strategies (as represented by the sGFI)9 with 13.2% return and 10.0% volatility (Sharpe ratio: 0.81). The maximal drawdown of this strategy is –9.1%. Active Discretionary Futures strategies
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES 8409 Chapter 4 p111-135 11/4/02 1:13 PM Page 118
show a 12.5% return, 6.9% volatility and a –5.6% maximal drawdown. Systematic Active strategies demonstrate 6.6% returns and 11.1% standard deviation, with a –15.6% maximal drawdown. The pure trendfollowing strategies show a return of 10.3%, a volatility of 16.4% and a maximal drawdown of –20.1%. For complete- ness, the Commodity Long Only strategy, as represented by the Goldmann Sachs Commodity Index, is also displayed. This Long Only approach does not take advan- tage of large swings on the downside and therefore demonstrates only 3.1% returns and a very large 18.0% standard deviation. The worst drawdown of –48.35% is a staggering number that further illustrates the benefits of having the flexibility to go short in the Futures market.