CHW Vol 15 Isu 7 July Quarterly EHP Funds v1
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Transcript of CHW Vol 15 Isu 7 July Quarterly EHP Funds v1
QUART ER LY R E V I EW O F H EDGE F UNDS & A LT E RNAT I V E I N V E S T I NG JULY 2015 VOLUME 15 ISSUE 7
AIMA CANADA SEMINAR SERIES CREATES ROADMAPFOR NEW AND EMERGING HEDGE FUND MANAGERS
2015 QUARTERLY PERFORMANCE NUMBERS
ADDING VALUE INMANAGING RISK
@RadiusFE
Volume 15 Issue 7 - July 2015 7
In a paper by Mebane Faber of Cambria Investment Management (foundhere: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461),the author uses a simple tactical trend approach to achieve equity-likereturns with bond-like drawdowns. In the paper he notes, “All of the G7countries have experienced at least one period where stocks lost 75%of their value. The unfortunate mathematics of a 75% decline require aninvestor to realize a 300% gain just to get back to even – the equivalentof compounding at 10% for 15 years!” This is without a doubt a strongargument in favour of managing one’s drawdown!
The approach examined in the paper is to hold an investment in stocks(in this case the S&P 500) only if it is trading above its 10-month simplemoving average (which is approximately equivalent to the 200-daymoving average that readers may be familiar with). If stocks are tradingbelow the 10-month average, then cash is held instead. This basic “risk-on / risk-off” model does a decent job of missing most market meltdownsand reduces drawdown and volatility without harming long-term returns,suggesting that there is merit in a tactical approach (all figures Faber’s):
www.canadianhedgewatch.com6
Can a trend-based
approach to managing
risk add value?
Jason MannPortfolio Manager,
EHP Advantage Fund
Adding Value inManaging Risk
When portfolio managers or their clients use the term “risk”, they can be referring to a number ofdifferent things. “Risk” is typically defined by academics as how volatile an investment is or hasbeen (its volatility or standard deviation). “Risk” for an investor might refer to the likelihood that theydon’t achieve their financial goals though the investments they hold. “Risk” for an investmentadvisor might be defined as the probability that their client abandons them because the investmentseither don’t keep pace with return expectations, or alternatively that returns are bad enough in theshort-run to cause the client to fire them. At EdgeHill, we view the primary risk of our investmentsas the chance of incurring a permanent loss of capital, and the secondary and equally importantrisk of “drawdown” or the temporary peak to trough decline in the Fund. Buy-and-hold investorsmight argue that “drawdown” is not a relevant measure of risk since it is by definition temporary,and that as long as the investment doesn’t incur a permanent loss then simple waiting and ignoringthe short term volatility is the best course of action. This argument ignores one key factor: humanemotions and the destructive behaviours that can result. “Buy and Hold” is only effective if onedoes in fact buy and HOLD. In reality, the majority of investors, when faced with large temporarylosses, act irrationally and lock in those losses, turning their drawdown into a permanent loss. Onthe flip side of the coin, the majority of investors also tend to chase performance, meaning thatthey typically buy investments after they have already had good returns. Dalbar’s QuantitativeAnalysis of Investor Behaviour tracks this ebb and flow of investor behaviour and finds that theaverage equity investor underperformed the index by 4.32% over the past 20 years because of this“sell low, buy high” bias.
So, we view drawdown as a critical risk that must be managed in order to succeed for our clients.Managing drawdowns is good for clients in that it helps prevent the scenario where their actionsmay cause harm to their investment returns, and it is good for us as a manager as we prefer not tobe fired by our clients!
There are numerous approaches to managing drawdown, including building a diversified portfolioof uncorrelated assets (like the traditional 60/40 bond and equity portfolio), having both long andshort positions that offset each other to some degree, or using “stop losses” or pre-defined levelswhere an investment will be sold to prevent further losses. We utilize these approaches and othersat EdgeHill and each is worthy of lengthy discussion and research, but for this article we wanted tofocus on a simple approach of using a trend-based approach to managing drawdowns. Trend-following or momentum strategies are not new, and have been extensively discussed and debatedby the investment community. Numerous managers and funds use trend or momentum as a partof their stock selection process (whether they admit it or not, and whether they use terms like“technicals, trend or momentum”). What is less commonly implemented is a methodology to usemomentum as an overall portfolio risk tool, where fund exposures are tactically increased ordecreased at the portfolio level based on some indicator of trend.
F
F
S&P 500 Total Returns vs. Timing Total Returns (1901-2012)
S&P 500 Total Returns vs. Timing Total Returns (1901-2012)
S&P 500 Ten Worst Years vs. Timing, 1900-2012
S&P 500 TIMING(43.86%)(36.77%)(36.26%)(29.61%)(26.47%)(25.26%)(25.26%)(22.10%)(19.69%)(14.69%)
1.41%1.33%(7.65%)(0.09%)8.16%(3.02%)2.51%(4.62%)(4.80%)(15.36%)
1931200819371907197419171930200219201973
9.32%
17.87%
0.32%
-83.46%
61.58%
$2,163,361
3.11%
– – – – – – – – – – – – – – – – – – – – – –
10.18%
11.97%
0.55%
-50.29%
75.80%
$5,205,587
3.11%
Returns
Volatility
Sharpe
MaxDD
% Posative Months
$100 becomes
Inflation CAGR
S&P 500 TIMING
–– TIMING–– S&P 500
6,553,600 –
3,276,800 –
1,638,400 –
819,200 –
409,600 –
204,800 –
102,400 –
51,200 –
25,600 –
12,800 –
6,400 –
3,200 –
1,600 –
800 –
400 –
200 –
100 –
50 –
19011906191119161921192619311936194119461951195619611966197119761981198619911996200120062011
Volume 15 Issue 7 - July 2015 9
We can see that this simple model has modified our returns in a numberof ways:• Our annualized return has actually improved from 7.1% to 9.1%• We’ve cut our volatility by more than a third• Our worst drawdown has been reduced from 52.6% to 14.5%• We’ve doubled our sharpe ratio (a measure of risk-adjusted returns), and reduced our beta to the market to only 0.40
A look at the chart shows that we’ve accomplished this not by beingcorrect every time we make a risk-on / risk-off decision (in fact we are“right” only about 42% of the time). Rather, we have sacrificed someupside gains in strong bull markets to avoid the very large losses that canoccur during bad bear markets and crashes. Importantly, we’ve achievedour objective of managing our drawdown risk and providing a returnstream to our clients that helps prevent them from locking in losses atthe bottom. In our view, there is clear merit in using simple trend-basedmodels to manage portfolio-level risk.
At EdgeHill, we don’t actually trade our funds in the exact mannerdescribed above. But we do use our EHP Fear Index to guide our overallportfolio risk, and we act accordingly in stressed markets by systematicallyreducing longs, increasing shorts, and rotating to more defensivestrategies and asset classes. We are big believers that risk levels shouldbe determined in advance of risk events and that emotion should neverplay a role. In other words, have a plan, and execute that plan.
Jason Mann is CIO and Portfolio Manager of the EHP Advantage Fund. Priorto co-founding EdgeHill, Jason Mann was Managing Director, Co-Head of theAbsolute Return/Arbitrage Group at Scotia Capital. Jason holds an HonoursBachelor degree in Business Administration from Wilfrid Laurier University anda CFA designation.
Founded in 2010, EdgeHill Partners is a multi-fund alternative asset managerfor accredited investors. EdgeHill manages the flagship EHP Advantage Fundas well as a number of other funds and mandates. Find out more atwww.ehpfunds.com
Introducing the EHP Fear IndexIn our funds, we extend this simple timing mechanism to include a fewother intuitive predictors of market stress to create our own “EHP FearIndex”. Our goal in our flagship Advantage Fund is to have no greaterthan a 10% drawdown, and we expect that this is the amount of riskrequired to achieve our return objective of 10-12% per year over fullcycles. The EHP Fear Index is a part of our risk control process, and itguides our portfolio-level tactical risk allocation. Our Fear Index uses acombination of three factors to determine the level of “risk-on / risk-off”:
1. Broad market indices trading below their respective 100-day moving averages (in the case of our Advantage Fund the S&P 500 and the S&P TSX Composite)
2. Volatility as measured by the VIX moving from a stable to a rising state (as measured by the 10-day moving average crossing above the 50-day)
3. High Yield bonds trading below their 100-day moving average (on a total return basis)
The 100-day moving average is not a magical number by the way, and infact is not the “best” value looking backwards and is unlikely to be the“best” value going forward. The point is not to perfectly optimize a riskcontrol process, but rather to have one in the first place and to use it asa part of a methodology that is followed in a disciplined fashion. We wouldalso suggest that simple and robust is generally better thancomplex andobscure. There are undoubtedly dozens of possible indicators that couldbe added to this indicator, but again, we prefer a simple, intuitive processthat is used consistently to an overly complex one that implies a level ofaccuracy that may not exist. Here is our fear index mapped out over timeversus the S&P 500, with the grayed-out areas representing periodswhere the indicator is “risk-off”:
www.canadianhedgewatch.com8
500
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$50,000
$500,000
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2015
Growth of $100,000 S&P 500 vs EHP Fear Index Model
EHP Fear Index Model S&P 500
$50,000
$500,000
1987
1988
1989
1990
1991
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Growth of $100,000 S&P 500 vs EHP Fear Index Model
EHP Fear Index Model S&P 500
Risk/Reward Analysis*EHP Fear Index S&P 500
Annualized Compound ROR 9.1% 7.1%Annualized Std Deviation 9.3% 15.0%Winning Months 69.6% 62.8%Average Monthly Gain 2.0% 3.2%Average Monthly Loss -2.0% -3.6%Largest Drawdown -14.5% -52.6%Sharpe Ratio (1.5%) 0.98 0.48Correlation 0.65Beta 0.40
350
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Looking at some historical market events, we can see that the indicator does a good job of avoiding the major bear markets and crashes:
Another way to test the indicator is to use it as a stand-alone trading system to see what returns would have looked like if we held stocks only whenthe fear index was in a “risk on” position and moved to cash when it is “risk off”. The results: