Roadmap To Absolute Returns – Part 2: ‘Behave Yourself And Mind The Gap!!’
When asked about the behavioural and personality characteristics of successful traders, Jack D. Schwager, author of several books on ‘Market Wizards,’ answers with “People who are successful traders will have the ability to quickly admit that they’re wrong ... discipline is also important.”
An adequate evaluation of the manager’s behavioural biases is paramount to the effective identification of absolute return strategies within the hedge fund universe. As well, a comprehensive inventory of the strategy’s embedded explicit and implicit volatility (vega) and gap-risk (gamma) postures are also important in the assessment of a manager’s propensity to generate absolute returns.
Active Risk Management And Behavioural Biases
The hedge fund universe’s constituents generally exhibit an impressive arsenal of idea generation and research talent. This, overlaid with position-specific and/or portfolio-level risk mitigation, represents what most hedge funds are all about. The risk mitigation toolbox includes, for example, diversification, paired positions, systemic and/or sector hedges, market neutrality, and targeted risk calibration. Hedge fund managers and investors have sought comfort in these risk mitigation tools in their quest for absolute returns. As recent history demonstrated, none of the risk mitigation tools offers a guarantee to absolute returns.
The propensity of absolute return is immensely superior through a framework better described as ‘active risk management’ rather than risk mitigation. This is because active risk management allows one to conquer two destructive behavioural biases: overconfidence and the disposition effect.
Overconfidence is typically revealed by the deep due diligence investors’ unwillingness to discount widely available information. They tend to overestimate the value of proprietary and hard-earned superior inventory of publicly-disclosed data points to identify and formulate non-consensus and high-conviction investment ideas. However, it is the ‘widely available information’ that dictates the direction of price movement of securities.
The market forces, fueled by collective perceptions of reality, generally exceed those of the valuation gaps identified through deep proprietary research and analysis. As a matter of fact, the deeper the due diligence, the most time required for the rest of the investor universe to uncover, digest, and discount the information and only then drive asset price. And until this chain reaction actually takes place, both the individual security and the overall markets are subject to changes and events that will further widen the price spread from its true intrinsic valuation. At these junctures, leveraged portfolios and underlying positions come under price pressure. Managers are at times forced to dispose of positions at a loss to honour redemptions that all too often co-incide with overall market dislocations. Overconfidence is an enemy, rather than an ally, in the generation of absolute return and the protection of capital.
The disposition effect refers to a very human, but irrational, behavioural trait whereby individuals are inclined to be more eager to sell securities of value, but tend to be willing to hold securities that have lost value. Essentially, we are pre-disposed and unwilling to experience the pain of realizing loss of capital through disposition.
As market perceptions and volatility regimes further alienate securities’ prices from fair valuation and the manager’s portfolio entry points, refraining to withdraw capital among these ideas further contributes to the deterioration on the return profile and the manager’s ability to protect capital.
When you find yourself in a hole, stop digging – Will Rogers, American humourist
The propensity to generate absolute returns and protect capital is greatly enhanced as the manager suppresses the destructive behavioural biases. There should be very little, if any, tolerance to allocating capital among ideas while waiting for the market to eventually agree that they are right. The manager dwelling on a risk mitigation overlay through paired positions, diversification, or hedges will tend to accept a higher loss tolerance at the position and portfolio levels for the benefit of longer-term results. Risk mitigation tends to further subsidize the behavioural biases such as overconfidence and the disposition effect, whereas an effective risk management framework will tend to suppress these behavioural biases.
Not that there is anything wrong with hard-earned research and due diligence in the formulation of an investment thesis, however, it should not dictate the position implementation and sizing and the portfolio construction process. Idea generation and portfolio implementation, per se, are two very distinct activities in the management of absolute return strategies. They are unfortunately, and too often, confused and applied sequentially.
Generally, the time and effort spent in the formulation of high-conviction ideas tends to be highly correlated with:
- the amount of capital allocated to the idea
- the investment horizon willing to assume to eventually monetize the hard-earned idea
- the marked-to-market loss tolerance allowed within the required investment horizon
- the willingness to gross-up or double-down on the position undergoing negative price pressure within the intended holding period
At this point, the manager is emotionally attached to his hard-earned ideas and claims superior knowledge to the market (i.e., the destructive behavioural biases are then dictating the portfolio management process).
Volatility And Gap Risk
Obviously, to harness volatility and gap risks in your favour will increase to propensity of generating absolute returns. However, it is most imperative and paramount that one should avoid any elements of explicit and implicit short vega and short gamma exposures as well.
Vega and gamma are both friend and foe in the context of generating absolute returns and protecting precious capital. Any explicit or explicit exposure to negative vega or gamma risks should be construed as an alienation or impediment to a higher propensity to deriving absolute returns.
As simple as it is to replicate or derive a forward currency contract through an inter-listed stock, it is also possible to embed therein a short gamma exposure if passively held in a portfolio. The lesson was painfully leaned by non-U.S. institutional investors who overlaid their portable alpha program with a linear currency hedge. Although with the right intentions, the hedge embedded implied a short gamma exposure that single-handedly dismantled all hopes of absolute returns, let alone alienating the overall portfolio from the then broad and severe drawdown.
Things are not always as they seem. Essentially, linear positions in plain vanilla instruments can, in some cases, implicitly generate significant and potentially damaging non-linear relationships.
The issue is relevant to the investment committees that institute a ban on the selling of options in the investment policy, but allow the inclusion of a strategy that, although at face value does not engage in option transactions, may effectively replicate a short option pay-off profile. The concern is particularly applicable to any investor allocating to hedge funds with the objective of absolute returns, protection of capital, and providing a de-correlation to the broad market drawdown risks already assumed in the traditional long-only allocations.
If there is a certainty about volatility, it is the fact that it is persistent and, most of all, ‘volatile.’ The quest for absolute return is better achieved by keeping volatility on your side, rather than allowing it to work against your portfolio.
The almost ideal absolute return strategy is a perpetual ‘straddle’ on the market (i.e., long an at-the-money call option and long an at-the-money put option). Consider the hedge fund fee structure as the premium paid, as in options, to hold a perpetual straddle and reap the benefits of both the upward and downward moves in asset prices.
Unfortunately, the strategy type that usually represents the first step forward in the hedge fund space to institutional investors do effectively replicate the exact opposite of the above-described ideal absolute return strategy (replicating a perpetual short straddle or short strangle profile). This strategy is the equity market neutral and for, most particularly, those dwelling on statistical or other quantitative parameters, includes quantitative fundamental data points.
Portfolio diversification allows these strategies to tolerate short vega and gamma risk at the position level. However, these strategies are not able to withstand gamma at the systemic or overall market level without significant impact or ultimate demise.
As a warning to the hedge fund investor considering some form of leveraged market-neutral, carry, credit, relative value, merger arbitrage, volatility arbitrage, mean-reversion, spread-based, long-term trend following, liquidity premium, or long small-cap versus short large-cap strategies: some could embed elements implied short vega and gamma exposures if these risks are not addressed properly and can, therefore, be considered as potentially riskier than traditional long-only mandates when the increasingly frequent and violent second order volatility episodes arise. In reality, they function relatively well in benign environments, but bleed or blow-up in volatile and crisis episodes.
Good Risk Management fosters vigilance in times of calm and instils discipline in times of crisis – Dr. Michael Ong, a professor at the Illinois Institute of Technology
Only skilled qualitative hedge fund analysis resources should be deployed to properly execute diagnostics to identify strategies managed within a disciplined and active risk management framework, while also avoiding the ones embedding implied short volatility and gap risks.
Rene Levesque is founder of Mountjoy Capital (www.mountjoycapital.com).
For Part 1 of this article, ‘Road Map To Absolute Returns (Part 1): It Shouldn’t Be All Greek To You!!’, see the February issue of Benefits and Pensions Monitor