A new research paper from Edhec shows how the alpha benefits of using fixed-income derivatives can be successfully transported to a core investor portfolio.
The paper 'From Delivering to the Packaging of Alpha', is based on research recently carried out by Lionel Martellini, Philippe Malaise and Noël Amenc of the Edhec Risk and Asset Management Research Centre. The research was supported by Eurex.
The paper emphasises the need for the hedge fund industry to adopt a consumer (investor)-driven approach, as opposed to the current producer (manager) perspective. The authors say this requirement is going to lead to the emergence of new types of offering with characteristics better suited to the expectations of institutional investors.
As an example, the authors present a series of illustrations in a fixed-income environment suggesting that futures and options could be employed towards the design of products, allowing for the transformation of raw alpha into portable alpha, which can be used within the context of a modern core-satellite approach.
A dynamic, non-linear version of this approach is also highlighted as it enables institutional investors to benefit from a dissymmetric control of tracking error risk and greater access to the potential advantages of abnormal returns generated by hedge funds without some of their associated risks.
In particular, the authors outline the benefits of bond maturity rotation strategies for European fixed-income investors. Using data for two European broad-based bond futures, the Euro Bund and Euro Schatz futures, they show how significant out-performance can be generated from systematic maturity rotation strategies.
They also demonstrate that the abnormal performance generated from maturity rotation strategies can be transported to a core portfolio invested in a broad-based index (possibly through a derivatives position) such as a medium-term bond index.
In other words, the alpha benefits can be successfully transported to a core portfolio reflecting the strategic asset allocation of the investor.
The report's Executive Summary follows:
Although the existing literature seems to concur on the usefulness of hedge funds as valuable investment alternatives, there are still, due to the opacity and lack of transparency of their strategies, large numbers of institutional investors who wonder whether they should invest in hedge funds and how they should do it. The classic argument of hedge fund providers for investing in such structures, which is the claim that they provide investors with access to skilled managers, does not necessarily shed much light on how these products actually fit investors' needs with respect to their preferences and liability constraints.
In this paper, the authors emphasize the need for the hedge fund industry to adopt a consumer (investor)-driven approach, as opposed to the current producer (manager) perspective, and call for the emergence of new types of offering with characteristics better suited to the needs of institutional investors. Using active bond portfolio management as an example, they present evidence that derivatives can be employed by hedge fund managers not only for generating and delivering abnormal performance (alpha benefits), but also for packaging such performance in a way that is consistent with the modern core-satellite approach to institutional portfolio management.
They also introduce a dynamic extension to this approach, which leads to a nonlinear, dissymmetric control of tracking error risk, which is in essence a convenient way to allow investors to benefit from an option written on hedge fund managers' skills.
Bond Timing Rotation Strategies
In the bond universe, it is common knowledge that different maturity indices perform somewhat differently in different times and economic conditions, and there is evidence of predictability in these patterns. Using multi-factor models for the return on bond indices, where the factors are chosen to measure the many dimensions of financial risks (market, volatility, credit and liquidity risks), one may be able to implement a strategy that generates abnormal return from timing between different maturity sub-indices.
In an example, the authors calculate the profit generated by investing 100% at the beginning of each month in the bond futures contract (Euro Bund or Euro Schatz futures) with the highest return expected in the following month. Assuming that a realistic performance for a successful style timer is consistent with a hit ratio of around 70 per cent, they repeated the experiment 100 times by drawing the successful months randomly, while maintaining a 70 per cent hit ratio level, to demonstrate that the resulting excess return was not a mere artifact of a particular choice of the winning months in the sample. The distribution of out-performance obtained through this experiment underlines the robustness of the abnormal performance that can be generated by a realistic timing strategy.
Not only can maturity rotation strategies be implemented in a long-only context, but they can also be used to generate absolute return benefits. Whatever the level of leverage, the results obtained in the paper suggest that the benefits of maturity rotation strategies can be implemented an absolute return approach, with a substantial potential for out-performance with respect to the EONIA rate. It should be noted that such out-performance is generated with very little volatility.
Finally, the authors show that using an option overlay portfolio can also serve a return enhancement purpose in trendless periods of the market cycle, which are typically difficult market environments for timing strategies.
Portable Alpha Benefits
An absolute return version of the bond maturity timing strategy is perfectly suited for investors who attempt to use hedge funds to add portable alpha benefits to their long-only portfolio without modifying their passive exposure to a reference index, as it allows for a separate control on the tracking error of the satellite and core portfolios, so as to ensure that the overall portfolio is consistent with a target level of deviation with respect to the chosen benchmark.
The authors perform several experiments with an allocation to the satellite portfolio ranging from 10 per cent to 30 per cent. The results obtained through these experiments demonstrate that the alpha benefits can be successfully transported to a core portfolio reflecting the investor's strategic asset allocation.
Dynamic Core-Satellite Approach
The dynamic core-satellite approach employed by the authors allows for dissymmetric management of tracking error, ensuring that the underperformance of the portfolio with respect to the benchmark will be limited to a given level, while letting the investor gain fuller access to excess returns potentially generated by the active portfolio. This dynamic approach could not be achieved using traditional active managers, because an institutional investor cannot easily and economically terminate, increase or decrease the size of positions in a given manager.
On the other hand, this can easily be done with futures. Another major benefit of futures in the context of dynamic asset allocation decisions is liquidity. Whenever institutional investors need to change the allocation to the core versus the satellite, they can do so very easily.
In this paper, the authors present a series of illustrations in a fixed-income environment suggesting that futures and options can be employed towards the design of products, which can be used within the context of a modern core-satellite approach to portfolio management. Institutional investors may find a dynamic, non-linear version of this approach particularly appealing as it allows them to benefit from a dissymmetric control of tracking error risk and higher access to the potential benefits of abnormal returns generated by hedge funds without all the associated risks.
As the hedge fund industry is preparing to welcome the wave of institutional money management, it will have to develop different products designed to meet different investors' needs on the basis of a given alpha generation process.
This research has been sponsored by Eurex. The paper follows a previous one entitled "Using Index Options to Improve the Performance of Dynamic Asset Allocation Strategies" on the use of derivatives in the equity universe and more specifically in the case of Long/Short Equity funds.