Lyxor Asset Management’s latest Research White Paper analyses the risk/return profile of dynamic investment strategies, specifically those implemented by hedge funds.
The paper seeks to answer the questions: how is it possible for funds that have performed consistently to tumble in just a few months? Are these brutal reversals only attributable to market factors or are certain investment behaviours also to blame? Note that so-called extreme risks refer to the possibility of infrequent but important losses.
Lyxor’s research shows that strategies that bet against the market are generally exposed to extreme risks, whereas strategies that follow market trends offer a more contained risk profile. To illustrate this, the White Paper looks at the mechanisms by which such widespread investment strategies as Dollar Cost Averaging (DCA) or the systematic search for Entry Points may lead to bankruptcy if associated risks are not identified and contained.
Lyxor conducted a systematic analysis of investment strategies as applied to a single underlying asset. Dynamic strategies were classified as either trend-following or contrarian. The results revealed the extent to which these groups have opposite risk characteristics. Contrarian strategies (e.g. purchasing assets when prices are going down) do have the potential for high profits, but are, in return, exposed to extreme risks in an adverse market scenario. To mitigate this, it is necessary to set strict stop loss limits or other mechanisms to reduce positions once a given loss level is reached. Conversely, our research shows that strategies that following market trends may offer more moderate profit potential, but also more limited exposure to extreme risk. In practice, trend-following strategies such as those used by CTA (Commodity Trading Advisor) funds reacted remarkably well to the 2008 crisis.