Substituting Liquid Alternative Funds
March 1, 2016
All Weather Portfolio
A recent cover story in Barron’s features liquid alternative funds from AQR. According to the article
The liquid-alt pitch is that individuals can access the same types of investments as university endowments and other big institutions, to diversify equity-heavy portfolios, typically with a 10% to 20% allocation to liquid alts… The advantage of the [AQR Managed Futures] strategy […] is that it is uncorrelated with other asset classes, and “has the most consistently strong performance in equity bear markets.” That is when diversification matters most, as was the case in the third quarter of last year and the early part of this year.
Ideally, returns of a liquid-alt fund should not only be uncorrelated with those of both stocks and bonds but also significantly positive over a long evaluation period. Let’s take a look at the performance of three AQR funds with a sufficiently long history.
The following chart shows rolling return correlation of the AQR Managed Futures Strategy Fund (AQMIX) with the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total Bond Market ETF (BND):
Please note that AQMIX had the first full month of returns in February 2010. Consequently, the first rolling 36-month return became available at the end of January 2013. As could be expected, the fund had lower correlation to stocks than to fixed income, although both coefficients were quite low (generally, correlation below 0.6 provides diversification benefits).
Here is a similar chart with related statistics for the AQR Multi-Strategy Alternative Fund (ASAIX):
Compared to AQMIX, this strategy had a higher correlation to bonds.
Here is a similar chart with statistics for the AQR Diversified Arbitrage Fund (ADAIX):
In contrast to AQMIX and ASAIX, this strategy had a higher correlation to equities than bonds; however, both coefficients were still pretty low.
The problem with any of these strategies is the lack of accessibility for most individual investors:
AQR’s approach can be hard to understand. Because of this—and to deter hot money—the firm sells its liquid-alt funds almost entirely through financial advisors. Retail buyers can access the funds directly through fund supermarkets like Fidelity, but direct investments involve a minimum of $1 million. Investments through advisors and 401(k) plans have no minimum.
Is there a way to substitute these liquid-alt funds with readily available ETFs? Let’s explore this possibility using Alpholio™’s patent-based analysis service for mutual funds. One variant of this methodology constructs a reference portfolio of ETFs with fixed both membership and weights. Here is the resulting cumulative RealAlpha™ chart for the AQR Managed Futures Strategy Fund (to learn more about this and other performance measures, please visit our FAQ):
As the statistics section below the chart shows, since its inception the fund had a smaller return and a much higher volatility (measured by standard deviation) than those of the reference portfolio. The following chart illustrates the constant composition of the reference ETF portfolio in this analysis:
The major positions in the reference portfolio were the PowerShares DB US Dollar Index Bullish Fund (UUP; fixed weight of 38.1%), iShares 20+ Year Treasury Bond ETF (TLT; 22.9%), iShares MSCI Netherlands ETF (EWN; 9.3%), Guggenheim CurrencyShares® Swiss Franc Trust (FXF; 6.0%), Consumer Staples Select Sector SPDR® Fund (XLP; 5.5%), and Utilities Select Sector SPDR® Fund (XLU; 4.7%). The Other component in the chart collectively represents addition five ETFs with smaller fixed weights.
The return correlation of the reference ETF portfolio over the entire evaluation period was 0.16 with VTI and 0.58 with BND. Given that these figures for AQMIX were approximately -0.07 and 0.21, respectively, the reference portfolio was not as good a diversifier for stocks and bonds as the fund was. However, the reference portfolio only had long positions in non-leveraged ETFs. It also returned about 8% more than the fund on a cumulative basis and with a 59% lower volatility. Similar analyses can be conducted for ASAIX and ADAIX. In the end, it is up to the investor to weigh the pros and cons of using reference ETF portfolios as substitutes for these funds in the context of the overall portfolio.
We hope that our Investment Toolkit™ will provide useful services for investors who want to construct well-diversified portfolios. If you would like to use it, please register on our website.
November 18, 2014
Hedge Fund Stats
Today’s post on Yahoo Finance discusses an “all weather” portfolio recommended by one of the most famous hedge fund managers. The portfolio strives to achieve an equal distribution of risk across macro periods of inflation, deflation, high and low economic growth.
The portfolio consists of:
- 30% stocks
- 15% intermediate-term government bonds
- 40% long-term bonds
- 7.5% gold
- 7.5% commodities
The portfolio has a large fixed-income component relative to equities to get close to a risk parity (yet, it does not use bond derivatives). The portfolio should be rebalanced at least annually.
Let’s use the Portfolio Service of the Alpholio™ App for Android to analyze this all weather portfolio. To do so, let’s construct a portfolio of ETFs that represent the above asset classes:
These ETFs were selected to have the earliest possible inception dates and lowest sponsor fees (expense ratios). The time span of the analysis is limited by the inception date of DBC. An alternative commodity ETF, the iShares S&P GSCI Commodity-Indexed Trust (GSG), became available about five months after DBC, therefore the latter was chosen. Since about 8% of DBC tracks gold, the weight of IAU is lower than that of DBC by one percentage point (due to the limitation of setting widgets, the app only accepts whole percentage weights).
Here is the setup for the analysis (the Dates, Return Frequency and Rebalance Frequency sections can be expanded by tapping their respective headers):
Here are the analysis results for the above portfolio with monthly returns and quarterly rebalancing:
With semi-annual (i.e. every six months) rebalancing, the all weather portfolio performed slightly better in terms of the higher annualized return and Sharpe ratio as well as smaller maximum drawdown:
Annual rebalancing yielded no further improvement in the annualized return or Sharpe ratio, but reduced the maximum drawdown to 12.1% and lowered the beta to 0.20.
For reference, here are the results for a traditional balanced portfolio, comprised of 60% SPY and 40% of iShares Core U.S. Aggregate Bond ETF (AGG), with monthly returns and semi-annual rebalancing in the same analysis period:
Compared to the traditional balanced portfolio, the all weather portfolio had all the desirable characteristics: a higher annualized return and Sharpe ratio, coupled with a significantly lower beta and maximum drawdown. However, the above analysis covered a prolonged period of decreasing and historically low interest rates that drove the returns of intermediate- and long-term bonds, the dominant positions in the portfolio. In an environment of rising interest rates (generally expected to begin next year) and falling commodity prices (already taking place), a risk-parity oriented portfolio, even with no bond leverage, may suffer.
October 31, 2013
An article in Barron’s points out a disconnect between assets and returns of hedge funds:
As of Sept. 30, the industry managed a record $2.51 trillion in assets, according to the analysts at Hedge Fund Research. That’s also a huge recovery from the depths of the financial crisis, when the funds’ $1.87 trillion in assets fell by $400 billion.
The HFRI Fund Weighted Composite Index, which covers a wide range of strategies, was up only 5.5% from Jan. 1 to Sept. 30, while the S&P 500 rose 19.79%. The poor showing was no better than during the 10 years ended on Sept. 30, when the index, compiled by Hedge Fund Research, was up only 5.92% on an annualized basis.
Annualized returns for other periods to September 30 compiled by Hedge Fund Research (HFR) are also unimpressive:
|HFRI Fund Weighted Composite Index
|HFRI Equity Hedge [EH] (Total) Index
|HFRI Event-Driven (Total) Index
|HFRI Macro (Total) Index
|HFRI Relative Value [RV] (Total) Index
|HFRI Emerging Markets (Total) Index
|HFRI Fund of Funds Composite Index
|HFRI EH: Short Bias Index [lowest]
|HFRI RV: Fixed Income-Asset Backed Index [highest]
Not surprisingly, in the environment of low interest rates and modest economic recovery, the short-biased funds had the worst and the fixed income funds had the best performance in the past five years.
Meanwhile, the compensation of hedge fund personnel increased more in line with assets under management rather than performance. Per a Barron’s blog post, the 2014 Glocap Hedge Fund Compensation Report states the following figures:
A new study contends an entry-level analyst at a middling large hedge fund is taking home $353,000 this year. The figure, which includes salary and bonus, rises to $2.2 million for the average portfolio manager of a large fund. Overall, average compensation in the industry gained between 5% and 10% for the year.
This surely contributed to the huge increase in the number of hedge funds: from 2,392 in 1996 to 8,201 at present (567 more than before the financial crisis).
The influx of money into hedge funds is caused by institutional investors that, according to the 2013 Glocap Report, account for 77% of capital compared to only 12% contributed by high-net-worth individuals and family offices. The main reason is that after the financial crisis institutions want to minimize losses during market downturns, while sacrificing the upside during market rebounds (in 2008, the HFRI composite index fell 19.03%, while the S&P 500® lost 37.0%).
Also, hedge fund returns are supposed to exhibit low correlation with those of the market, which leads to improvement of return-to-risk characteristics of the investment portfolio. However, as the following chart from the HFR presentation to the US Dept. of Labor shows, historical correlation of the HFRI composite index to the S&P 500® has been quite high:
Furthermore, the correlation of the equity hedge fund index to the S&P 500® has been on the rise for a long time, which makes it very difficult for such funds to beat that benchmark:
In sum, while some, especially smaller, hedge funds have attractive characteristics, performance of the overall industry leaves a lot to be desired.