In part five of our equity risk management strategies series we discussed how to protect a portfolio from market drawdowns. In this, the last instalment of the series, we focus on the role alternative asset classes can play to manage equity market tail risks.
Hedge funds could be a useful addition to a portfolio
Besides implementing any of the strategies discussed earlier in this series, investors could also make use of alternative asset classes to reduce tail risks. This is because, in theory, these alternative asset classes are designed to exploit – and profit from - traditional market inefficiencies. However, in reality, it is not an easy task to find strategies that are uncorrelated to traditional asset classes like equity and bonds. In fact, many of the so-called alternative asset classes, like private equity and hedge funds, are sometimes highly correlated to stock markets, which defeat the purpose of using them to manage equity market risk.
Even when you find the right strategies, you might run into additional problems. For example, diversified managers and strategies, such as global macro, equity market neutral, and statistical arbitrage, have showed historically low correlation to traditional asset classes. However, the issue for most investors - particularly retail – is one of lack of access. Even ETFs, which are routinely highlighted as great facilitators of access to all sort of markets and strategies, don’t offer adequate access to these alternative asset classes and should therefore be used with caution.
As well as the lack of access, investors should also be aware that alternative strategies are not a homogeneous group. Each hedge fund is different. And so are the main hedge fund indices. Indeed, each hedge fund index comprises heterogeneous strategies with different weightings. For example, equity hedge strategies invest in long and short positions, usually in stocks and derivatives, either covering the entire market or focusing on individual sectors. Managers of event-driven strategies invest in companies which might be in the process of merging, restructuring, buying back their own stock or acquiring another company. Relative value strategies try to exploit relative price discrepancies between stocks, bonds, options or futures in the hope to add value as soon as the price gap narrows.
Hedge funds could be a useful addition to a portfolio. However, investors need to understand the underlying strategy, as each one of them would work different during various market conditions. ETF-investors of investable hedge fund strategies should also keep in mind that hedge funds indices have flaws. For example, hedge fund managers could decide to list or de-list their fund at any time. In addition, fund managers can back-file the historical data or delete the entire history once the fund leaves the index.
Another group of strategies that are being increasingly discussed in the context of a portfolio hedge is that of managed futures. So-called “Commodity Trading Advisors” (CTAs) have historically shown low correlation to stocks and bonds. Retail investor can access this asset class via ETFs as well. More information on CTAs can be found in our article Commodity Trading Advisors (CTA) Explained.
All strategies discussed in our series has its own pros and cons. Ultimately, investors will need to decide for themselves which strategy better meets their portfolio protection needs. It may well be the case that no individual strategy, but rather a combination, may be the preferred way forward. Irrespective, the most important thing is to fully understand how they work and the risks involved, so as to successfully implementing them in your portfolio.
