Research

REDUCING DRAWDOWN USING ALTERNATIVES

‘The case for Hedge Funds: Can Alternatives offer downside protection in a portfolio of Equities? ’

• 4 April 2019
• By Michael Melluso

Hedge Funds can mitigate the effects of large shifts in the market using short positions and derivative instruments. One would expect that a US-focussed long-short equity manager would provide an effective hedge against the S&P 500 Index or that a CTA manager can effectively protect against shifts in global commodity prices.

But, can adding hedge funds to a traditional equity portfolio improve performance and reduce risk?

We have taken the ‘top’ 5 actively reporting CTA, Long-Short Equity, and Fixed Income hedge funds determined by AlternativeSoft’s ranking algorithm for asset selection.

Attributes that were deemed desirable were:

• A track record of over 80 months.
• USD reporting currency.
• Highest Annual Sharpe Ratio since inception

Table 1: Statistics for the Top Funds Selected.

Data Provided by Eurekahedge.

Table 1 shows annualised returns, volatility, and Sharpe statistics for the funds we have identified; the assets from our search fit the criteria of having high risk-adjusted returns.

This table also shows the calculated “% of Time in Drawdown” value for each fund which describes how much time the fund has historically been in a drawdown state.

Using the same methodology, the historical probability that the indices cumulative returns are in a drawdown state has been found for the S&P 500 and S&P Goldman Sachs Commodities Index (GSCI).

The results, presented in figure 1, show that 78% of the time the equity index is in a drawdown state and 95% of the time the commodities index is in a drawdown state since January 1970.

Figure 1: Probability of being in a drawdown for S&P 500 and S&P GSCI Indices.

We have also calculated the average % of time in drawdown across each of the strategies outlined in Table 1 since inception.

Figure 2 indicates that for all three strategies the probability of an investor staying ahead, on average, is considerably higher than an investor who tracks the market.

Figure 2: Mean probability of being in a drawdown for our Long-Short Equities, CTA, and Fixed Income Funds.

Will adding a 20% allocation to alternatives improve a portfolio if U.S. mid-large cap equities if we select these alternative funds based on historical drawdowns?

We have constructed a small portfolio of 30 blue-chip U.S. mid-large cap equities with equal weightings; the historical cumulative returns can be seen in figure 3.

The bottom 20% of assets, determined by historical probability of drawdown, were removed and replaced with 6 of our hedge funds (Table 1) which include a blend of strategies. The funds selected were FI Fund 1, FI Fund 2, CTA Fund 1, CTA Fund 2, LSE Fund 3 and LSE Fund 2, these funds were all selected for their low % of time in a drawdown.

Figure 3: Cumulative Returns and Cumulative Maxima for both Portfolios.

As seen in Figure 3, we have reduced the frequency and intensity of drawdowns which in turn increases our cumulative returns for Portfolio 2. Table 2 shows the comparative statistics for our portfolio before and after the introduction of these hedge funds. As expected, adding low drawdown hedge funds to the portfolio had a significant impact on the portfolio time underwater.

Table 2: Comparative Statistics for both portfolios.

Table 2 above reinforces the point that we have increased return and decreased risk with a 20% allocation to Hedge Funds.

Obviously, we rebalance this portfolio periodically (based on % time in a drawdown state) and we would end up with a larger allocation to FI Fund 1 as it drastically outperforms the other assets on a risk-adjusted basis.

One final caveat to bear in mind; although this article states that selecting hedge funds using the above metrics can be effective, due to the nature of hedge fund returns we only have a small amount of data points which means it is difficult to test this theory out-of-sample in an accurate manner. However it does serve to reinforce the view that allocation to the right Hedge Funds can offer diversification and downside protection in a portfolio.