Tell Me What You Want, What You Really, Really Want

Tell Me What You Want, What You Really, Really Want

By Tristam Lett, Managing Director and Portfolio Manager, Integra Capital Limited

Pension sponsors can become their own hedge funds without the undesirable characteristics of illiquidity, opacity, high fees and risky selection activities. The advent of new option-based, dynamic trading strategies—first developed by Professor Harry Kat, and copied by others-- allow investors to specify the characteristics of their preferred return distributions and their correlation to a target portfolio.

Ask the question, “what is the property of hedge funds that is so valuable?, and it’s clear that it is their lack of correlation to other assets and strategies. However, generating pure alpha is not without some undesirable characteristics. In particular, the distribution of alpha has a mean of zero, making it a zero sum game. This means that investors who actually are able to earn alpha must take it from other investors. This adds up to substantial risk for the investor-- they must be able to select those hedge fund managers who frequently inhabit the right side of the return distribution, a non-trivial task indeed!

Dr. Martin Leibowitz recently said that “lack of correlation in a portfolio is gold”. Plan sponsors become risk managers once they know and utilize this property in a portfolio.

A New Set of Opportunities

Rather than using alpha as this capricious source of zero correlation--as it does have a nasty property of disappearing when you most need it in a market crisis-- is there another way to do this? The Kat/Palaro process accomplishes this through correlation targeting. Investors can specify the desired higher moments of a distribution of returns and the distribution’s correlation with a target portfolio. This target portfolio could be a plan sponsor’s total fund benchmark. If a plan sponsor wished to hedge its benchmark, it could do so with a 50% allocation, as an overlay, to a synthesized portfolio that has the same variance, skew and kurtosis of the benchmark but with no correlation to it. The benefits are obvious as risk is reduced. This gives the plan sponsor a new set of opportunities in the risk/reward domain ranging from reducing risk, increasing return or some combination of both.

What makes this process more interesting than looking to hire pure alpha managers that could achieve the same objective? First, the exposures used to create the synthetic hedging portfolio are futures on highly liquid markets, such as S&P 500, Russell 2000, Libor, 5 year Treasury Bonds, 10 year Treasury Bonds, USD, YEN, EUR, GSCI and the like. A synthetic portfolio is created that tracks the daily returns of the target portfolio and adjusts itself through dynamic trading to create the desired return properties.

This portfolio is created through exposure to assets which have risk premia associated with them; in other words their distributions have positive means, unlike the alpha distribution. These exposures are incredibly cheap to implement. They can be liquidated in a day. Management fees are low. There is no selection risk, no lock ups, no style drift, no due diligence, etc. All of this means that the important criteria that a fiduciary seeks are met. In addition, from a portfolio management point of view, the diversification benefits are unlikely to evaporate the first time a market crisis hits. These synthetic portfolios are operated with simultaneous long and short positions in different markets creating a very diverse set of exposures.

In short, investors can become their own hedge fund managers without much of the baggage that accompanies them.




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