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Alternative Investments Managed Futures and Hedge Funds in a Post-Recession Portfolio

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Aarhus University, School of Business and Social Sciences MSc in Finance Master Thesis June 2013 Alternative Investments Managed Futures and Hedge Funds in a Post-Recession Portfolio Author: Nikita Elbert
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Aarhus University, School of Business and Social Sciences MSc in Finance Master Thesis June 2013 Alternative Investments Managed Futures and Hedge Funds in a Post-Recession Portfolio Author: Nikita Elbert (284931) Academic Supervisor: Carsten Tanggaard Abstract Over the last 15 years, financial markets have undergone a period of economic downturns and high volatility, which impacted investors returns. At the same time, there has been an increasing interest in alternative investment classes, with their low correlation of returns. This paper defines and explores investment in commodities and, subsequently, managed futures as well as hedge funds in terms of their performance, risks and applicable regulations. These assets are combined with a stock and bond portfolio to reproduce the effects of diversification into alternative investments. Based on statistical findings, managed futures appear to be better diversifiers than hedge funds due to their ability to lower kurtosis and improve skewness, although they have an inferior rate of return. Returns and volatility in a portfolio can be further improved if both managed futures and hedge funds are combined with stocks and bonds, as construction of an efficient frontier for a portfolio with these assets has shown. Keywords: alternative investments, managed futures, hedge funds, portfolio optimization, correlation, efficient frontier, finance Character Count (with spaces): Table of Contents Abstract... 2 Introduction... 1 Literature Review... 4 Part 1: Investing in Commodities... 6 Gaining exposure to commodities... 9 Owning the Physical Commodity... 9 Shares in a Commodity Producer... 9 Exchange Traded Products Futures Contracts Part 2: Managed Futures and Commodity Trading Advisors What are Managed Futures? Investing with a CTA Why investors choose Managed Futures? Fees and Minimum Investment Requirements Data and Methodology Managed Futures Performance CTA and CPO Regulation in the United States Risks of Investing in Managed Futures Part 3: Hedge Funds What are Hedge Funds? Data and Methodology Hedge Fund Investment Strategies and Performance Convertible Arbitrage Distressed Securities and Event Driven Equity Long/Short Equity Market Neutral Fixed Income Arbitrage Global Macro Merger Arbitrage... 43 Strategy Comparison Investing in Hedge Funds Hedge Fund Fees and Minimum Investment Risks of Hedge Fund Investment Hedge Funds of Funds Part 4: Combining Managed Futures and Hedge Funds in a Stock and Bond Portfolio Constructing Simple Portfolios Combining Portfolios Efficient Portfolio with Alternative Assets Conclusion References Appendix I: Hegde Fund Strategies Correlation Coefficients Appendix II: Portfolio Statistics with Varying Hedge Fund and Managed Futures Proportions Appendix III: Efficient Frontier Portfolio Weights and Statistics Appendix IV: Hedge Funds Strategies Performance Against Benchmarks Appendix V: Raw Data, Calculations and Tables CD Table of Figures Part 1: Commodities Figure 1.1: S&P Goldman Sachs Commodity Index... 7 Figure 1.2: Monthly correlation Coefficients for Commodity and Equity Markets... 8 Figure 1.3: Correlation Coefficients and Betas for Oil Producers Figure 1.4: Correlation Coefficients and Betas for Gold Producers Figure 1.6: Price Index of Crude Oil vs. DBO ETF Part 2: Managed Futures Figure 2.1: Managed Futures: Assets Under Management Figure 2.2: Managed Futures Indices Figure 2.3: Managed Futures Index Correlation Coefficients Figure 2.4: CTA Performance vs. S&P 500 and US Treasuries Index Figure 2.5: Basic Statistics for EDHEC, S&P500, MSCI World, US Treasuries Part 3: Hedge Funds Figure 3.1: Average Monthly Returns and Volatility Comparison Figure 3.2: Hedge Fund Equal-Weighted Index Performance vs. S&P 500 and US Treasuries Figure 3.3: Basic Statistics for Hedge Funds, S&P 500 and US Treasuries Figure 3.4 Hedge Funds: Assets under management Figure 3.5: HF Market Neutral Strategy Performance Figure 3.6: HF Market Neutral Strategy Basic Statistics Figure 3.7: HF Global Macro Strategy Performance Figure 3.8: HF Strategies Share Ratio Comparison Part 4: Portfolio Analysis Figure 4.1: Managed Futures and Hedge Funds in a 50/50 Portfolio Figure 4.2: Managed Futures and Hedge Funds in a 33/66 Portfolio Figure 4.3: Alternative Investments Portfolio Figure 4.4: Sharpe Ratios for 50/50 Portfolio Combinations with Alternatives Figure 4.5: Sharpe Ratios for 33/66 Portfolio Combinations with Alternatives Figure 4.6: Efficient Frontiers and the Capital Allocation Lines... 57 Introduction Over the last 15 years, financial markets have gone through two recessions and periods of rapidly expanding returns. During this period, US stock market experienced what is now known as the Dot-Com bubble, causing the NASDAQ crash, and more recently the Great Recession of These events were not confined to North America, but were truly global economic downturns. Unprecedented levels of volatility have tested investors resilience and preparedness. This timespan also marked an increase in investors interest in what is known as alternative investments. These are assets outside the conventional stocks, bonds and cash investments. Included in this investment class are hedge funds, commodities and managed futures, as well as some real estate-linked instruments and other, relatively more exotic investments. The interest in these assets has been steadily rising since the second half of the 90 s. The most often cited reason for investment in one of these products is the low correlation of alternative assets returns to conventional investments returns. Inclusion of these assets should give investors a unique opportunity to protect their portfolios during the times of the crises. In order to examine alternative investment classes, this paper seeks to complement and advance previous research by expanding the time span to include recent recessions. The last 15 years of data provide a unique opportunity to examine the performance of alternative assets under unprecedented market conditions, something that previous research fails to accomplish, this testing their diversification qualities. Furthermore, this paper attempts to expand previous research by incorporating performance analysis tools. Page1 One of the rapidly growing alternative investment categories are managed futures. This term includes Commodity Trading Advisors (CTAs), who run specialized commodity funds. These funds, or pools as they are sometimes called, produce returns based on the movements in commodity futures prices. Essentially, managed futures is a term used to describe the trade in commodity futures contracts on the investors behalf by a specialized manager. However, any discussion of managed futures and their performance would not be complete without first touching on the subject of commodities themselves. Investors seeking to gain exposure to commodities have a number of gateways to do so, each with its own particular characteristics. Managed futures industry is often mentioned in the context of its larger and older brother, the hedge fund industry. This somewhat mysterious investment product includes a large number of funds, which trade based on specific investment strategies. These strategies offer investors exposure to various markets and provide them with a number of risk-return profiles to choose from. Each of these alternative investment products offers investors a degree of diversification from the conventional assets. They also have their own specific drawbacks and risks that need to be taken into account when analyzing these investments. Most importantly, these assets claim to offer investors some protection from stock market downturns. Therefore, this paper aims to examine these alternative investment products. In relation to commodities, this research aims to answer the following question: Does the commodities market offer any diversification value and what is the most effective means of getting exposure to this market? As part of further research into managed futures and hedge funds, this paper will answer the following question: What are managed futures and hedge funds, can they provide any degree of protection to investors during the periods of stock market volatility and what are the risks of these products? Finally, in order to examine alternative investments discussed in this paper in a portfolio context, this research will answer the last question: Page2 How do hedge funds and managed futures perform in a combined portfolio with conventional assets? As part of a discussion and research into commodities investment, historical data is used to show why investment into commodities markets can be of interest to an investor seeking to diversify a conventional portfolio. In order to examine the various ways to get exposure to commodities markets, this research focuses on some stock price data and argues that the most efficient way of gaining returns from commodities markets might not be suitable for all investors. A solution is offered in the form of managed futures. Next, a thorough understanding of managed futures must be gained. Past performance of these investments is surveyed based on a managed futures index, examining the returns in comparison to more conventional assets, such as stocks and bonds. Furthermore, a review of the changing US regulatory environment for the managed futures industry is carried out. This research examines the various options of gaining exposure to managed futures and gives a short description of various risks of investing in these products. The focus is then shifted onto hedge funds. The various strategies employed by fund managers are discussed and their unique performance examined to determine which strategies perform best in market downturns. The paper discusses hedge fund fees and minimum investment levels and list the various risks of hedge fund investment. US regulation of hedge funds is mentioned. The topic of hedge funds of funds is touched on briefly. Finally, managed futures and hedge funds are assembled into composite portfolios with stocks and bonds. First, following previous research by Kat (2004) and Liang (2004), the effects of alternative investments on portfolios are examined separately. Then, following the Modern Portfolio Theory (Elton et al., 2011), an efficient frontier is constructed to examine hedge funds and managed futures in a market portfolio context. An assessment is made regarding the viability of investment in alternatives. Page3 While the question of whether one can invest in an index, or replicate its returns, is an important one, it will not be touched on in this paper due to space constraints. Furthermore, this research will not venture into advanced risk management in funds, such as the application of Value at Risk (VAR) framework. These can be topics for further research into the matter. The term alternative investments includes assets that are not mentioned in this paper, like real estate-linked securities. These are said to exhibit similar characteristics as the assets discussed in this research in terms of their correlation to equity markets. Analysis of these instruments is outside of the present research. Literature Review While a fair amount of relatively objective writings exist covering the topic of alternative assets, most of these fail to take into account the most recent recession. Choosing the right period for sampling in time series analysis is always a challenge. This is especially true when comparing various indices and benchmarking, as is the case with this research. Two books by Mark Anson (2002, 2009) address the various topics related to alternative investments. The author is a known and experienced funds manager, previously serving as the Chief Investment Officer of California Public Employees' Retirement System (CalPERS) a 200bn U$ pension fund. He also co-developed an educational curriculum for the Chartered Alternative Investments Analyst (CAIA) program. His books provide an in-depth look at the alternative investments universe. At the same time the data he uses captures only the very beginning of the Great Recession of A similar issue is raised with Harry Kat s (2004) and Bing Liang s (2004) research into combining hedge funds and managed futures in a portfolio. Almost a decade after the publication, their research does not include the recent period of extreme volatility that made many investors take a closer look at alternative investments. In addition to expanding the time horizon to include the recent recession, this paper extends the analysis of asset performance to include what is known as the Sharpe ratio (Sharpe, 1994), defined as: Page4 S = Rp Rf, σp or the ratio of excess returns (returns minus the constant risk-free rate) over the volatility measure (standard deviation). This tool was originally introduced to measure performance on mutual funds. This research will use the Sharpe ratio to compare performance of indexes and portfolios. Finally, this paper will use the Modern Portfolio Theory (MPT) and the mean-variance framework introduced by Harry Markowitz (Elton et al., 2011). Its application allows to combine alternative and conventional assets in a portfolio to examine the effects of diversification in a portfolio on the distribution of returns. Markowitz s MPT is used in conjunction with the Sharpe ratio tool to determine the optional combinations of assets in a composite market portfolio. More precisely, the model will seek to maximize the Sharpe ratio of the portfolio to determine what will be known as the market portfolio. Admittedly, the MPT has a number of unrealistic assumptions behind it, but discussing the applicability of it in real market conditions is beyond the scope of this research. Page5 Part 1: Investing in Commodities In the recent years of high volatility and relatively modest average returns on the stock market and historically low yields on government debt, investors have also witnessed extreme fluctuations in commodity prices, specifically gold and crude oil as well as some consumable commodities. Gaining exposure to commodities is said to have the potential to add valuable diversification benefit to a portfolio. Commodities are claimed to have low correlation to the stock and bond markets, and allocating a portion of the portfolio to gain exposure to this asset class can lower risk and enhance returns. Commodities are a truly alternative asset class. While the value of stocks and bonds can be estimates using models that take future cash flows as inputs, commodities do not provide revenue in the same way stocks and bonds do, so one cannot value them based on net present value (Anson, 2002). Furthermore, commodity prices are not dependent on developments in any single country or region alone. Instead, the prices for most commodities are determined through the global supply and demand dynamics. To illustrate the dynamics of commodity prices, this paper takes as an example the S&P Goldman Sachs Commodity Index, which regularly serves as a benchmark for commodity investors. The GSCI is an investable index and reflects the returns from price changes for many liquid and investable commodities. As Figure 1.1 shows, the last decade has witnessed unprecedented price fluctuations, which certainly presented opportunities to commodity investors, as well as unseen risks associated with the record volatility levels. This was the result of global supply and demand inequalities, as well as, arguably, speculation to a certain degree. Page6 Figure 1.1: S&P Goldman Sachs Commodity Index. Data shows unprecedented volatility over the last decade. Source: S&P, Data accessed through Datastream. Figure 1.2 shows this relationship between commodity markets and equity markets. Changes in oil prices, one of the most closely watched commodity prices, have a relatively low negative correlation of to the changes in US equity market, represented by the S&P500 stock index. Non-US stock market indexes are also negatively correlated to the changes in oil prices: London s FTSE100 has a more significant correlation coefficient of , while Copenhagen s OMXC20 is similar to the S&P500 at This negative relationship is likely due to a negative effect high energy costs have on developed economies. Page7 Prices for gold, another globally watched commodity, show a similar relationship to the equity markets. Correlation coefficients are even lower for the changes in gold prices and changes in equity markets. This can be explained by a perceived safe-haven effect, when investors buy gold in times of uncertainty to protect their wealth. Gold and oil prices have a correlation coefficient of 0.22, which is also relatively low. Figure 1.2: Monthly correlation coefficients of commodity and equity markets. Data for due to availability of OMXC20 time series. Data points to low correlation between equity and global commodity markets, as well as negative correlation of the price of oil and equity market returns. Data accessed through DataStream, Yahoo Finance. Data in this analysis differs somewhat from the research carried out by Mark Anson (2002, 2009) in his two books. While both the data series used in this research and that of Mr. Anson begin in the year 2000, the time series data in this paper contains four more years of information. Recent four years have been very turbulent for the oil prices, as can be seen on Figure 1.1, and for gold prices, which have become somewhat of a safe haven in turbulent times. Interestingly enough, comparing the data in this paper and previous research by Mark Anson in 2008, the correlation of the US stock market to the changes in the price of crude oil has increased in absolute terms from 0.0 to In a recent working paper examining the correlation between oil prices and equity markets, the authors suggest that in a postcrisis environment, the correlation increases (Martín Barragán et al., 2013). King and Wadhwani (1990) also seem to suggest that some correlation coefficients between various markets can significantly increase following severe volatility episodes. Assets with negative correlations are particularly attractive to investors who are looking to hedge against equity market declines. While commodities markets exhibit large swings in prices, the returns have a low correlation coefficient to the stock markets, making commodities a potential diversifier. Therefore, this paper will look closer at some of the avenues an investor or an organization can take to gain exposure to this asset class. Page8 Gaining exposure to commodities While investment in commodities offers some opportunities, like low correlations and perhaps even enhanced portfolio returns, it bares definitive risks, now more than ever before as Figure 1.1 shows. Furthermore, many investors can be intimidated by the perceived challenges and the knowledge required when investing in commodities. Still, investing in this asset class is becoming more accessible to investors and a number of ways exist in which one can gain exposure to the commodity markets. Owning the Physical Commodity Purchasing the commodity is the most rudimentary way of participating in the commodity markets. An investor can purchase a certain commodity was oversupplied globally, store it and sell it when the demand is higher. This kind of commodity investment can also work when investing in commodities with seasonal price fluctuations. However, investors have to be knowledgeable in the areas of commodity transport and storage. When purchasing a particular commodity on an exchange, the quantities are usually large as the trade is done in batches, such as 1000 s of barrels of oil or 1000 s of bushels of wheat. It is fair to say that for an individual investor or an organization that is seeking to diversify its portfolio with exposure to commodities, physical ownership of a commodity is not an appropriate option. However, certain corporations or in
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