Large changes in fixed income markets appear to be afoot. Rumblings of tapering in the US caught fixed income mostly by surprise in May, bringing both carnage and opportunity in June as well as into the third quarter. Meanwhile, the global currency and fixed income markets also seem to be at an inflection point where the performance of economies across different countries and regions appear to be diverging along with monetary policy, resulting in decreased correlations across FX and fixed income markets.
Opportunities within Tactical Trading Strategies
With uncertainty comes opportunity, and we believe higher interest rate volatility coupled with generally lower correlation across global currencies has created a promising environment for tactical trading strategies in currency and fixed income. These strategies exploit the disruption of equilibriums. With large investors re-hedging and shifting portfolios as they grapple with a changing interest rate environment, temporary mispricings are often caused that can be exploited as those equilibriums are restored. For example, the opportunity set for relative value trading in fixed income generally tends to improve as rates become more volatile because moving rates mean more frequent hedging requirements for real-money fixed-income managers (e.g., mortgage portfolios). This re-hedging activity is often done in size and can lead to distortions across assets (e.g., swaps versus Treasuries), along curves (e.g., 4.5s versus 5s versus 5.5s), and across security types (e.g., bonds versus futures).
Additionally, global economies are increasingly diverging from one another, and so monetary policy and foreign exchange movements are also moving more independently. The divergence across region benefits both directional and relative value trading strategies due to the resulting reduction in correlation amongst underlying positions and trades. Hit rates tend to be fairly low – 50% to 60% is typical – in these strategies and so portfolio gains are more reliable when the investment process is applied across a wide array of trading opportunities. As correlations rise across instruments, the large number of trades in the portfolio begins to appear more and more like one larger trade, which tends to increase the portfolio volatility without increasing the returns (i.e., risk-adjusted return quality decreases). Conversely, environments with lower correlation offer more idiosyncratic opportunities, allowing managers to size numerous small trades as opposed to a single big one. To borrow a baseball analogy, home runs can win games, but seasons are made on the back of consistent singles and doubles.
Decline in Cross-Correlations
In recent months, there has been a sharp decline in cross-correlations across a broad cross-section of instruments relevant to liquid trading strategies. The following chart was created using Principal Component Analysis (PCA). This analysis isolates the common drivers across a range of assets and computes the degree of importance of those common drivers. This chart shows the percentage of total variance explained by the top five common return drivers across a broad universe of 50 assets relevant to liquid trading strategies. The chart illustrates the degree to which assets tend to co-move based on common risk factors. These 50 assets include 26 futures contracts on assets in fixed income, commodities, and equity, as well as 24 major currency pairs. This is, in effect, a visual representation of the degree to which a market environment is ‘risk on, risk off’ (i.e., the higher proportion of volatility explained by a small number of risk factors, the more ‘risk on, risk off’ the environment is). The chart shows that the proportion of the volatility explained by the top five return drivers across this wide array of assets has declined sharply in 2013 to levels not witnessed since 2006 and 2007.
Source: ROW Asset Management
Tactical trading strategies in currency and fixed income, including both systematic and discretionary, as well as directional and relative value investment programs, have long been a highly desirable hedge fund allocation due to their return profile and low correlation to equities, bonds, and other hedge fund strategies. However, despite the inherent promise of these strategies, they pose some unique challenges to allocators. Accessing these strategies through traditional commingled funds can be problematic due to the inherent lack of independent risk management and transparency and the inability to leverage the low cross-correlations between different trading teams.
Independent, Real-time Risk Management is Essential
In tactical trading strategies, hit-rates on individual trades are generally low, but losses can be controlled through active risk management due to the focus on highly liquid instruments. Thus there is an inherent advantage to entities that are able to structure their tactical trading strategy allocations in a manner that enhances active risk management. In fact, the original currency and fixed income trading entities were proprietary desks within banks, which featured quality, real-time, and independent risk control that had teeth. Risk managers monitored traders in real-time and stepped in to stem losses when traders failed to do so themselves. Redemption rights were instant, with risk managers often escorting wayward traders out of the building. Active risk management tends to work best in structures where it has true independence, quality transparency, and the power to intercede in real-time.
The Whole is More than the Sum of its Parts
One of the primary beneficial features of tactical trading strategies is their low correlations, not only to major risk indices, but to each other. By combining multiple tactical trading sub-strategies together into a single portfolio, one can increase the overall information ratio relative to the information ratios of each sub-portfolio in isolation. Additionally, leverage can be more efficiently applied to the portfolio (with lower margin costs and a more stable return stream) to achieve the overall volatility target necessary to generate adequate returns.
At PAAMCO, we continually endeavor to improve transparency, control, and ultimately returns through innovation in the structuring of investments. This includes the development of PAAMCO-structured vehicles* and our Separate Fund Platform (PAAMCO’s proprietary managed account platform). Recently we have expanded this list to include a bespoke solution for tactical trading strategies, which allows us to:
- Access quality, real-time, and independent risk management, and critically, to have the ability to act on that information in order to effectively reduce manager selection errors.
- Take advantage of the capital efficiency, low cross-correlation, and liquidity inherent in these structures by aggregating a well-diversified exposure and applying modest leverage with the goal of engineering a better return series.
- Derive cost savings from paying for performance, not access, and also from the efficiencies of scale gained through aggregation of certain infrastructure and operational costs.
Sam Diedrich is an Associate Director and Portfolio Manager for the fixed income relative value strategy. He is responsible for manager research and portfolio construction within the strategy. In addition, he also serves as the main point of contact for certain institutional investor relationships. Prior to joining PAAMCO, Sam worked as an electrical engineer for the Johns Hopkins Applied Physics Laboratory (Laurel, MD). Sam received his MBA from the University of Chicago Booth School of Business, his MS in Electrical Engineering from Johns Hopkins University, and his BS in Electrical Engineering (Distinction) from the University of Washington.
*PAAMCO-structured vehicles are funds for which PAAMCO controls the selection of one or more board members and where PAAMCO either selects the investment adviser on Funds of One or is itself the investment adviser and appoints the underlying manager to serve as subadviser on Separate Fund Platform Funds (“SFP Funds”).
Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.
This document contains the current, good-faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.
Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore, Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.