Syn the tic H e dg ing in D ire ction al I nve stm e nt S trate gie s
Cont ents
I . Hi s to r y o f A l terna ti v e I n v e s t men t M a n a g e r s 2
I. II . H isto rical perf o r m an ce 3
I I . Fi n a n c i a l c r i s e s an d bla c k s w a n e v e n ts 6
II.III. Im pact o n hedge fund s 7
II .I V. P rev i o u s m itig ati o n s t rategi es 8
I I I . Extr a c ti n g c r i s i s alp h a 10
III.II. Sy nthe t ic hedging 10
III.III. App lic at io n t o cr y pt o as se t s 12
1 | P a g e
I. H is to ry o f Alt e rn at iv e I n v e s t m e n t Ma n agers
I.I . Ov e rv ie w
Acc o rd in g to (Ans o n , 2008 ) , th e h is to ry o f Alte rn at iv e In v e s tme n t Ma n agers (AIMs ) b e gan in th e 1940 s w ith t h e cre at ion o f th e f irs t lon g - s h o rt 1 s tra tegi e s . Ov e r th e f o llow in g e ight d e cad e s , s u ch v e h icl e s e v o lv e d to b e come s ignifi can t m ar ket p lay e rs , ra th e r th an s im p le d iv e rs if icatio n m e th o d s f o r ‘ tra d itio n al’ p o rtfolio s . B ar clay H e d ge , a tra cke r o f th e h e d ge f u n d in d u s try , q u o tes th at as o f Q2 202 1, th e comb in e d AU M o f h e d ge f u n d s is $4.3T .
FIG U RE . C a p tio n : C h a r t s h o w ing th e e s tim a te d vo lum e o f a s s e ts u n d e r m a n a g e m e n t (AU M) a lloc a te d to va r io u s inve s tm e n t ve h ic les c lass if ied a s h e d g e f u n d s . T h e c h a r t s u g g e s ts t h a t th e r e h a s b e e n a sta r k inc r e a s e in AUM.
At th e time , th e re v o lu tio n ar y id e a b e h in d lon g - s h o r t s tra tegi e s w as th e u n d e rta k in g o f b o th lon g an d s h o rt p o s itio n s in m u ltip le in v e rs e ly correlated as s e ts b y t h e AIM. If correctly e x e cu ted , th is m e a n s th at a s ignifi can t p o rtio n o f p o ten tia l los s e s d u e to ch an g e s in o n e o f th e a s s e t p rice s ar e h e d ge d b y a re v e rs e d p o s itio n in an o th e r ass e t. T h is m e an s th at th e n e t v alu e o f th e in v e s tme n t is u n re s p o n s iv e to ch an ge s in th e m ar ket o u tlo o k; ra th e r it ch an ge s th e n t h e v alu e o f o n e p o s itio n ch an g e s b e cau s e o f ch an ge s to th e v alu e o f t h e u n d e rly in g a s s e t.
Imple m e n ta tio n o f th is s e e m in gly cou n terint u itiv e id e a o f ta kin g p o s itio n s in b o th d ire ctio n s , w as f u rth e r m ad e m o r e e f f i cie n t w ith th e in tro d u ctio n o f th e f irs t m o d e rn o p tio n s o n th e Chicago Boa rd Op tio n s E xch an ge (C B OE ) in 1973 . T h i s allo w e d m an ag e rs to e f f e ctiv e ly h e d ge m o r e o f th e ir lon g - b ias e d p o rtfolio an d b e n e f it f ro m id ios y n crat ic ch an ge s in as s e t p rice s w h ile p ro tectin g th e ir p ro f its f ro m th e m aj o rity o f s y s tem ic, m ar ket - w id e , m o v e m e n ts . T h at s aid , to th is d ay , p e rf e ct h e d ging o f th e e n ti re p o rtfolio re m ain s largel y im p o s s ib le f o r larg e in v e s tm e n t h o rizo n s , m e an in g th at to th is d ay th e m aj o rity o f AIMs m ain ta in lon g - b ias e d p o rtfolio s .
1 Man y au th o rs r e fer to th e s e s o rt o f s tr ate g i e s a s l o n g /s h o rt , rat h e r th an marke t - n e u tr al. O fte n ti me , mark e t - n e u tr al s tr at e g i e s are th o s e t h at aim fo r p e rf e c t h e d g i n g o f marke t ri s k i n th e s h o r t
T h e o b jec tiv e o f in v e s tme n t m an agers at th e h e lm o f th e s e v e h icl e s w as s im p l e - to h ar v e s t p ro f its th at w e re n o t av aila b le to m o re ris k av e rs e in v e s to rs an d in d iv id u als . Du e to in con s is ten t re p o rtin g p o li cie s , AU M d at a f o r th e e ar ly d ay s o f th e h e d ge f u n d in d u s try is s p ar s e 2 . H o w e v e r, it is kn o w n th at , after th e tu rb u le n t d e cad e in th e 1970 ’ s th at le d to th e liqu id at ion o f ro u gh l y 70% o f h e d ge f u n d s , th e re m ain in g f u n d s h ad s o m e $300 M in AU M acco rd in g to (Rya n , 2007 ) . T h is f igur e th e n gre w 3380 - f o ld 3 to t h e aforem e n tio n e d $4. 3 T in Q 2 2 021.
As an y o th e r in v e s tme n t m an ager, th e s e v e h icl e s h ad a m an d at e to m ax im is e th e ir alp h a - e xce s s re tu rn s ab o v e a giv e n b e n ch m ar k - w ith in th e s cop e p e rm itt e d b y th e re gu lat ion s gov e rn in g th e ir i n v e s tme n t p o lic ie s . In e f f e ct, h e d ge f u n d s o p e ra te m o re d y n amic ally th an th e ir tra d itio n a l cou n terp ar ts in th e ir acce s s to v ar iou s to o ls , in clud in g c e rta in s tru ctu re d p ro d u cts , o r techn iq u e s s u ch as in v e s to r act iv is m . Be cau s e o f t h is , t h e s e v e h icl e s we re a b le t o a tt ra ct s ignifi can t amou n ts o f p riv at e cap ita l w ith m o re ris k ap p e tit e th an , f o r i n s ta n ce , a p e n s io n f u n d . T h at s aid , in re ce n t y e ar s it h a s b e com e com m o n p lace f o r ris k av e rs e m an agers , s u ch as p e n s ion f u n d s , t o allo cat e s o m e p o rtio n o f th e ir p o rtfolio to alt e rn at iv e in v e s tme n t v e h icl e s , in clud i n g h e d ge f u n d s , as s h o w n in a Febr u ar y 2016 rep o rt b y P re q in . U S - b as e d p u b lic p e n s ion f u n d s , f o r in s ta n ce , allo cat e d 9% o f th e ir A U M t o h e d ge f u n d s in 20 16, co m p ar e d to 7.1% in 20 10. Fo r E u ro p e an p u b lic p e n s ion f u n d s th e allo cat ion s w e re 6.2% an d 5.1% , re s p e ctiv e ly . For A s ia - b as e d an d all o th e r p u b lic p e n s ion f u n d s th e in cre as e is e v e n m o re s ta rk w ith a 9.9% allo cat ion in 2016 a n d 5.0% in 2010.
FIG U RE . C a p tio n : C h a r ts s h o w ing th e a lloc a tio n o f p e n s io n f u n d s to va r io u s a lte r n a tiv e inve s tm e n t ve h ic les (left: p e r c e n ta g e o f p e n s io n f u n d p o r tfo lio, r igh t: b r e a kd o w n b y a lte r n a tive inve s tm e n t ve h ic le c lass if ic a tio n /type ). T h e s e c h a r ts s u g g e s t th a t th e r e h a s b e e n a s ign if ic a n t inc r e a s e in a lloc a tio n o f p e n s io n f u n d s - s o m e o f th e m o r e r is k a ve r s e m a n a g e r s - to a lte r n a tive inve s tm e n t ve h ic les. In p a r tic u lar ,
2 S o me d ata c an b e fo u n d h e re b u t i ts s p a rs i ty i s ac kn o w l e d g e d
3 A d ju s te d fo r i n f l ati o n b as e d o n US D valu e i n 1978
ru n .
th e ir a ll o c a tio n t o h e d g e f u n d s h a s a ls o inc r e a s e d s ign if ic a n tly, th o u g h is s till a m ino r ity a m o n g s t a lloc a tio n s to o th e r a lte r n a tive ve h ic les.
Since th e ir in c e p tio n , th e m e rito crat i c n at u re o f th e s e v e h icl e s w as an o th e r f act o r f o r in cre as e d cap ita l allo cat ion . G e n e ra tin g re tu rn s s im ilar to t h o s e o f m ar ket b e n ch m ar ks is d e f in itio n ally p o s s ib le th ro u g h p as s i v e in v e s tme n t v e h icl e s s u ch a s m u tu al f u n d s . U n s u r p ris in gly, m an agers o f act iv e f u n d s , in clud in g AIMs , aim to o u tp e rf o rm th e b e n ch m ar k in o rd e r to ju s tify ch ar ging h igher f e e s an d m ain ta in in g re v e n u e s h ar e m o d e ls to align in ce n tiv e s . Ma n ager p e rf o rm an c e act s b o th as a s i gn al to p o ten tia l in v e s to r s an d is con s e q u e n tly a n in ce n tiv e f o r AIMs to s triv e f o r h ighe r alp h a to at tra ct m o re cap ita l. In tere s tin gly, (Sun , Wa n g an d Zh e n g, 2018 ) id e n tif ie s th at w h ile m an age r p e rf o r m an c e d u ri n g p e riod s o f b u lli s h mark e ts d o e s n o t h a v e a s ignifi can t im p act o n f u tu re p e rf o rm an c e , p e rf o rm an c e d u rin g b e ar is h m ar kets d o e s , s u gge s tin g th at m an ager s kill is p ar ticu larly e v id e n t in h o w th e m an ager is ab le to d e al w ith ch alle n ging m ar ket con d itio n s , s u ch as p rice s m o v in g in th e o p p o s ite d ire ctio n t o t h e ir n e t p o s itio n .
I.I I. H is to rical p e rf o rm an ce
(G rin b lat t e t a l. , 2020 ) f in d s th at h e d ge f u n d s h av e b e e n ab le to ge n e ra te p ro f its o f 14 b as is p o in ts p e r q u ar ter in e xc e s s o f m o re m ain s tream m u tu al f u n d s o v e r th e p e riod b e twe e n J u ly 2005 an d De c e m b e r 201 2. T h e p ap e r f u rth e r at trib u te s th e o b s e rv e d p e rf o rm an ce g ap to s u p e rior as s e t - s e le ctio n s tra tegi e s , w h ich ar e av aila b le th ro u gh acce s s to p riv at e an d in s tit u tio n al le v e ra ge as w e ll as p rim e b ro kerage , allo w in g f o r s p e cu lat iv e s tra tegi e s to b e d e p loy e d m o re e f f e ctiv e l y th ro u gh ta ilored s e rv ice s o f b an kin g p ar tn e rs . Su ch s e rv ice s in clud e acce s s to cros s - collat e ra liza tio n o r in cre as e d s h o rt - term lev e ra ge f o r u rge n t tra d e s . As s e t - s e le ctio n for m s b u t a f acet o f th e u n iq u e clas s o f s t ra tegi e s th at h e d ge f u n d s can e xe cu te.
In ad d itio n to ass e t - s e le ctio n s tra tegi e s , h e d ge f u n d s can u s e th e ir u n iq u e le gal s tr u ctu re to m ain ta in a v ar ie ty o f le gal s tru ctu re s , in clud in g f o r e xa m p le m as ter - f e e d e r f u n d s , in o f f s h o re ju ris d iction s allo w in g th e m to tra d e th e m o s t e xo tic an d ta ilored s tru ctu re d p ro d u cts , w h ich m ax im is e s th e i r ab ili ty to e xt ra ct p ro f it f ro m th e m ar kets . Fina l ly , ce rta in ju ris d iction s allo w h e d ge f u n d s to h o ld ris kier f in an cial p ro d u cts , s u ch a s certa in t y p e s o f O T C d e riv at iv e s a n d o th e r b e s p o ke f in an cial p ro d u cts , o n th e ir b ala n ce s h e e ts . Be cau s e
4 T h e c ri s i s p e ri o d i s c h o s e n to b e Ju n e 2007 to March 2009
5 T h at s ai d , th e re i s c u r re n t l y n o r e s e arch to s u g g e s t th e e x i s te n c e o f c au s ati o n
o f th is , h e d ge f u n d s can ta ke ad v an ta ge o f m o r e co m p le x s tra tegi e s t h ro u gh a more n u an ce d a n d s o p h is ticat e d u s e o f ris k - an d a lp h a - o v e rlay p ro d u cts .
T h is p e rf o r m an ce d o e s n o t co m e w ith o u t e xp o s u re t o o th e r ris ks , if n o t th e s ame o n e s th at th e s e v e h icl e s s e e k to h e d g e . Wh ils t lon g - s h o rt s tra tegi e s , as th e n ame s u gg e s ts , gre at l y re d u ce th e in v e s tme n t m an a ge r' s e xp o s u re to m ar ket ris k, th e to o ls b y w h ich th is is ach ie v e d con trib u te to in cr e as e d cre d it an d liq u id ity r is k s .
(Me tz g e r an d Sh e n ai, 2019 ) c alcu lat e s th at o v e r th e ro u gh l y 10 - y e ar p e riod b e tw e e n J u n e 2017 an d J an u ar y 2017 , h e d g e f u n d s o f 10 m aj o r s tra tegi e s d e liv e re d an av e ra ge Sh ar p e o f
0.100. Fu rth e r, th e y calcu lat e th at th e av e ra ge Sh ar p e ra tio d u rin g time s o f m ar ket cris is 4 w as - 0.199 an d 0.295 o th e rw is e . For th e s ak e o f comp ar is o n , th e S& P 500 ge n e ra ted 0.0 87, - 0.5 14, an d 0.302, re s p e ctiv e ly . T h e gap in p e rf o rm an c e acro s s d if f e re n t m ar ket con d itio n s in d icates th at w h ile h e d ge f u n d s can p e rf o rm v e ry w e ll, th is is n o t u n if o rm an d th e s u b s tit u tio n o f m ar ket ris k f o r cre d it an d liqu id ity ris k m ak e s it h ar d e r f o r th e m to ge n e ra te alp h a d u rin g cris is p e riod s , id e s t cris is a lp h a.
T h e in ab ili ty o f a s ignifi can t n u m b e r o f h e d ge f u n d s to d e liv e r s u p e rior re tu rn s d e s p ite h igher f e e s an d la x in v e s tme n t re gu lat ion s , con tra d icts th e p u rp o s e o f in v e s tme n t v e h icl e s w h o s e p u rp o s e is t o cap ita lis e o n lowe r ris k - av e rs ion to d e liv e r h igher re tu rn s . A s s u gge s ted in th e im age ab o v e , th e re e xis ts a cle ar correlatio n 5 b e twe e n h e d ge f u n d re tu rn s ( as m e as u re d th ro u gh th e ir alp h a) an d th e ir f e e s : av e ra g e h e d g e f u n d m an agem e n t f e e s h av e d ro p p e d f ro m 1.55 % in 20 08 to 1.37% in 2 020 an d av e ra ge in ce n tiv e f e e s h av e d ro p p e d f ro m 19.3 % to 16. 4% , re s p e ctiv e ly , acco rd in g to th e H FR G lob al H e d ge Fu n d In d u s try Re p o rt. In cre as e d f ra gil ity o f th e f in an cial s y s tem an d h igher e xp o s u re o f m ar ket p ar ticip an ts , h e d ge f u n d s in clud e d , to liqu id it y ris k con trib u te to th e f all in f e e s . For e xa m p le , o v e rn ight Fe d in jec t ion s in th e re p o m ar kets h av e in cre as e d from a ro u n d $22 B i n la te 2013 to a ro u n d $1, 700B in e ar ly 202 2, as re p o rted b y th e N e w Y o rk F e d . T h is s u gge s t s th at th e Fe d is at tem p tin g to in jec t m o re liqu id ity in to th e m ar kets in o rd e r to s h o re u p l iq u id ity r is k s 6 .
6 T h e s e c o n c e rn s h av e als o b e e n e c h o e d b y th e E u ro p e an S y s te mic R i s k Bo ard i n th e i r “ L i q u i d i ty r i s ks ari s i n g fro m marg i n c all s ” re p o rt i n Ju n e 2020
FIG U RE . C a p tio n : S h o w c a s in g h is to r ic a l r e tu r n s o f h e d g e f u n d s a s m e a s u r e d t h r o u g h t h e ir a lph a .
FIG U RE . C a p tio n : S h o w c a s i n g h is to r ic a l inc e n tive a n d management f ees char ged b y hedge f unds to thei r cl i ents . T o g e th e r , th e c h a r ts s u g g e s t a c lea r c o r r e lat io n in f e e s a n d r e tu r n s - b o th p e e k a r o u n d 2010 a n d p r o c e e d t o f a ll th e r e a f te r .
Since th e tu rn o f th e c e n tu ry , th e re h av e b e e n in cr e as e d con ce rn s re gard in g th e o p e ra t ion s o f h e d ge f u n d s . Following th e after m at h o f th e G lob al Fi n an cial Cri s is , th e Dod d - Fran k
7 Mo rg an S ta n l e y, G o l d man S ac h s , Ba n k o f A me ri c a Me rr i l l L yn c h , JP Mo rg an , Ci tg ro u p , W e l l s F arg o , S o c i e te G e n e ral e , BN P Pa ri b as ,
act w as in tro d u ce d , lim itin g th e m an d at e o f m an y b an ks f ro m in v e s tin g w ith alt e rn a tiv e m an agers . In E u ro p e , a s im ilar re f o rm w as e n act e d w ith th e p ass in g o f t h e Alte rn at iv e In v e s tme n t Fu n d Ma n ager Dire ctiv e . T h e s e h ighligh t th e in cre as e d con ce rn o f re gu lat o rs o v e r th e in v e s tme n t p ra ctice s o f a ltern at iv e in v e s tme n t m an agers .
N o n - uni f o rm p e r f o rm an c e o f t h e s e v e h icl e s d u rin g d if f e r e n t m ar ket con d itio n s e xp o s e s o n e o f th e ir m ain f laws – o n b o ar d in g o f id ios y n crat ic, a s o p p o s e d t o s y s tem at ic, ris ks. T h e s e m ain ly in clud e m ar k e t, liqu id ity , an d cre d it ris k. T h e s e ris ks ar e ta ken o n b y all m ar ket p lay e rs to s o m e e xt e n t. H o w e v e r, th e e xt e n t to w h ich an y in v e s tme n t v e h icl e o r its s p e cif ic f u n d is exp o s e d t o ea ch o f t h e r is ks , d e p e n d s o n t h e s tra tegy o f t h e fu n d .
Ma rk e t - n e u tra l h e d g e f u n d s s tra tegi e s ar e ab le to o f f s e t th e ir m ar ket o r p rice ris k b y ta kin g o n s trictly m ar ket - n e u tra l o r n o n - d ire ctio n al p o s iti o n s . Alth o u gh in v e s tme n t re gu lat ion s an d m an d at e s p ro v id e th e le e w ay f o r th e u s age o f n e c e s s ar y in s tru m e n ts (li ke acc e s s to s h o rt - s e lli n g) f o r ta kin g o n s u ch p o s itio n s , it is cos tly f o r h e d ge f u n d s . It re q u ire s m o re cap ita l th an as s u m in g a d ire ctio n al p o s itio n , w h ich com e s at b o th an o p p o rtu n ity cos t if th e h e d ge f u n d p ro v id e s it in tern ally . On th e o th e r h an d , if th e f u n d acq u ire s t h is cap ita l v ia le v e ra ge , it e xp o s e s its e lf to cre d it ris k. (Lian g an d Qiu , 2019 ) f in d s th at 73 % o f h e d ge f u n d s h av e u s e d s o m e f o r m o f le v e ra g e , w ith 34% o f h e d ge f u n d s re ly in g o n m ar gina l le v e ra ge (inv e s tm e n t p o s itio n s f in an ce d in p ar t o n m ar gin) b e t w e e n 2002 an d 2017 . ( Bart h , H amm o n d an d Mo n in , 2020) f in d s t h at SE C - q u alif y in g p riv at e fu n d s h o ld a n av e ra ge to ta l l e v e ra ge o f 1. 74, b as e d o n o b s e rv at ion s o f 35,397 q u ar terly f ili n gs b e t w e e n J an u ar y 2013 to Ma rch 2019.
Cre d it ris k is an o th e r s ignif ican t ty p e o f f in an cial ris k. T y p ically , m an agers o f lon g - s h o rt an d m ar ket - n e u tra l s tra tegi e s u s e th e ir lon g - p o s it ion s as collat e ra l f o r ta kin g o n s h o rt p o s itio n s . By th e e n d o f 2020 , th e larges t 18 d e aler - b an ks 7 h e ld $9.4T in p le d ge d collat e ra l f ro m h e d ge f u n d s - ro u gh ly 2.5 - f o ld t h e v alu e o f m an aged as s e ts at $3.8 T in th e s ame p e riod . In cre as in g v e loci ty o f collat e ra l in tertw in e s th e m o re an d m o re con tra cts in th e f in an cial e con o m y le ad in g to its in cre as in g d iv e rge n ce f ro m th e re al e con o m y d u e t o o v e r - collat e ra l iza tio n as w e ll as in tro d u ce s u n m o d e llab le cris is con ta gion n e twork s , th u s in cre as in g th e d if f icult y o f s ta b ili s in g th e e con o m y if t h e n e e d ar is e s . In p ar ticu lar, d u rin g p e riod s o f in cre as e d m ar ket v o lat ili ty p e riod s , th e
R BC , CIB C, T o ro n to Do min i o n . S o me d e ri vative s d ata fo r S o c i e t e G e n e ral e an d CIB C w as n o t r e p o r te d in th e i r an n u al r e p o rt s
De u ts c h e Ba n k , Cre d i t S u i s s e , U BS , Ba rclays , R BS , H S BC , N o mu ra ,
v alu e o f p o s itio n s as s u m e d b y th e f u n d m ay d e cre ase u n e xp e ctedly , le ad in g to m ar gin calls . In tu rn , th e s e m ay p u s h t h e fu n d t o liq u id at e it s p o s itio n s p re m at u re ly , lead in g to more lo s s e s a n d fu rth e r m ar gin calls from cre d ito rs .
Wh e n liqu id at in g p o s itio n s , b e it to cov e r m ar gin cal ls o r to u n e xp e ctedly lim it los s e s in cu rre d d u rin g s e v e re m ar ke t tu rm o il, th e in v e s tme n t v e h i cle m u s t f in d cou n terp ar ties th at ar e w ill in g to p u rch as e t h e s e cu rity . In time s o f m ar ket cris is , th e m ar ket d e f in itio n ally e xh ib its a d o w n w ar d s , b e ar is h m o v e m e n t. Con s e q u e n tly , th e re w ill b e f e w e r cou n terp ar ties th at w o u ld b e w i lli n g to p u rch as e tro u b le d as s e ts o r s e cu ritie s o f th e in v e s tme n t v e h icl e in q u e s tio n . T h is ris k o f in s u f f ici e n t m ar k e t liqu id ity m ay f o rc e a h e d g e f u n d to e xit th e ir p o s itio n s at an e v e n gre at e r p rice los s th a n th e o n e th at w as cau s e d b y th e s aid cris is . De s p ite p re v ailin g con ce rn s ab o u t liq u id ity ris k in ri s k an d p o rtfoli o m an agem e n t, th e m aj o rity o f e f f o rt goes in to cou n tering s y s tem ic liqu id ity ris k , s u ch a s d u rin g t h e 2008 - 20 09 cre d i t cris is , m e an in g th at little at ten tio n is p aid to id ios y n crat i c liqu i d ity ris k w h ich can b e ju s t as d amagin g e v e n i f to th e re tu rn s o f a h an d f u l o f m an agers th at h o ld aff e ct e d p o s itio n s .
A s trik in g e xa m p le o f th is is th e f ailu re o f Am ar an th , a h e d ge f u n d th at to o k o n o v e r $4B o f los s e s o n n at u ra l gas f u t u re s con tra cts o v e r le s s th an 12 d ay s in Se p tem b e r 2006 . (C h in carin i, 200 8) n o tes t h at A m ar an th ’ s p o s itio n at th e time w as s o v a s t th at it con s tit u ted n e ar ly 100% o f o p e n in tere s t o n ce rta in m at u ritie s , m e an in g th at th e re p ra ctically n o cou n terp ar ties th at w e r e w ill i n g to p ar ticip at e in th e m ar k e t . As Am ar an th ’ s cas h o n h an d w as d e p le ted , it w as f o rc e d to liqu id at e its p o s itio n s at a d i s cou n t s o h igh t h at th e f u n d collap s e d .
As s e t m ar keta b ili ty re f e rs to th e amou n t o f f riction th at m u s t b e o v e rcom e in o rd e r t o s e ll th e as s e t, w h e re as as s e t liqu id ity e n comp as s e s b o th its m ar keta b ili ty an d p rice s ta b ili ty . T h e re f o re , liqu id ity ris k can b e d ri v e n b y th e d e teriora tio n o f a s s e t m ar ket ab ili ty .
H e d ge f u n d s s e e kin g n e t m ar ket - n e u tra lity at te m p t to h e d g e aga in s t m ar ket p rice r is k. I n o rd e r to a ch ie v e t h is h e d ge , t h e m an ager m u s t in cu r in cre as e d e xp o s u re to o th e r id ios y n crat ic ris k s . T h is ra is e s th e q u e s tio n o f f in d in g t h e e q u ili b riu m p o in t b e tw e e n ta kin g o n th e s e ris ks . G iv e n th e u n s ta b le h is to rical h e d ge f u n d p e rf o rm an c e d u e to cris is p e riod s , it is w o rth e xa m in in g w h e th e r a p o rtfolio th at is h e a v ily s kew e d away f ro m p r ice ris k is in f act e con o m icall y e f f e ctiv e .
II. Fin an cial cris e s a n d b lack sw an ev e n ts
II. I. Ov e rv ie w
(C laes s e n s an d Ay h an Ko s e , 2 013) id e n tifi e s f in an cial cris e s as p e riod s in th e m ar kets w h e n th e re ar e s u b s ta n ti al ch an ge s in cre d it v o lu m e an d as s e t p rice s , s e v e re d is ru p tio n s in f in an cial in ter m e d iat ion an d th e s u p p ly o f e xt e rn al f in an cing to v ar iou s act o rs in th e e con o m y , large s cale b ala n ce s h e e t p ro b le m s (of f irm s , h o u s e h o ld s , f in an cial in term e d iari e s an d s o v e re ign s ), o r large - s cale gov e rn m e n t s u p p o rt (in th e f o rm o f liqu id ity in jec tio n s an d re cap ita liza tio n ).
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e p e r f o r m a n c e (i n b a s is p o int s ) o f th e S & P 500 ind e x - a b r o a d g a u g e o f th e w o r ld a n d U S , in p a r tic u lar, e q u ity m a r ke ts. T h e c h a r t i s o ve r laid w ith g r e y r e g io n s th a t a r e g e n e r a lly c o n s ide r e d r e c e s s io n p e r io d s o f fa lli n g ret u r n s .
With in th e Alte rn at iv e s In v e s tme n t in d u s try in p ar ticu lar , cris is p e riod s a re ch ar act e ris e d b y h igh v o lat ili ty a n d a f all i n cre d it e xt e n d e d to m an age rs . T h e lat ter is p ar ticu larly im p act f u l d u e to th e s ignifi ca n t amou n t o f le v e ra ge h e ld b y th e s e in v e s tme n t v e h icl e s . G i v e n th at th e m aj o rity o f h e d ge f u n d s ar e lo n g - b ias s e d 8 , e ith e r b y ch o ice o r re gu lat ion , th e y in cu r lo s s e s d u rin g p e riod s o f h igh v o lat ili ty d u e to in cre as e d ch an ce s o f u n f av o u ra b le as s e t p rice m o v e m e n ts an d as s o ciated m ar gin calls . T h is act s as a call to act ion s f o r AIM s to at tem p t to re v e rt th e ir p o rtfolio an d acq u ire , if p o s s ib le , a re v e rs e n e t - p o s itio n . H o w e v e r, d o in g s o m ay n o t o n l y b e p ro h ib ited b y th e ir in v e s tme n t m an d at e s b u t w ill als o ta k e liqu id ity a w ay from t h e mark e ts a n d a m p lif y cred it is s u e s .
FIG U RE S . C a p tio n : C h a r ts s h o w c a s ing th e b r e a kd o w n o f h e d g e f u n d s tr a te g ies int o th e ir A U M ( to p ) a n d a ve r a g e 1 - yea r n e t r e tu r n s ( b o tt o m ). As c a n b e s e e n in th e l e f t c h a r t, th e m a jo r ity o f h e d g e fu n d s A U M i s a lloc a te d t o lo n g - b iase d s tr a te g ies, w ith d e lta - n e u tr a l str a te g ies fo llowing .
Kami n s ki in tro d u ce s th e f o l lowi n g con ce p t o f v o lat ili ty cy cle s , w h e re b y a s ta te o f re lat iv e m ar ket n o r m alcy (I) , as s o ciated with lo w v o lat ili ty an d o b s cu re d r is ks, is follo w e d b y a p e riod o f in cre as e d v o lat ili ty (II) in re s p o n s e t o e xo ge n o u s f act o rs . T h is p e riod e xp o s e s s o m e ris ks th at w e r e p re v iou s ly h id d e n . It is th e n f o llow e d b y a p e riod o f m ar ket u n ce rta in ty (III) w ith e v e n h igher v o lat ili ty an d , s u b s e q u e n tly , a p e riod o f s ta b ili s at ion ( IV) w ith f allin g v o lat ili ty . Fina lly, th e m ar ket re tu rn s to its in itia l s ta te o f n o rm alcy an d th e cy cle re p e a ts . With in th is f ra m e w o rk , f o r th e p u rp o s e s o f t h is an aly s is , a cris is p e riod e n comp as s e s b o th s ta tes (II ) a n d (II I).
II.II. Id e n tifi cat ion
Id e n tifi cat ion o f f in an cial cris e s is e s s e n tia l to a n y lon g - term p o lic y m ak in g an d f o re cas tin g . Du e to th e v ar ie d n at u re o f th e s e e v e n ts , it is ch alle n ging to id e n tify th e m an d e v e n m o re ch all e n ging to forecas t t h e ir o ccurr e n c e .
8 A ro u n d 19% o f all A U M i n Jan u a ry 2022 w as d e p l o ye d to l o n g o r o ve rwhe l min g l y l o n g s tr ate g i e s - th e mo s t o f an y o th e r s tr ate g y
typ e , ac c o rd i n g t o A u r u m , a f u n d o f f u n d s manag e r
(Olbr y s an d M aj e w s ka , 2015) p ro v id e a d e ta ile d o v e rv ie w o f th e v ar iou s ap p ro ach e s th at h av e b e e n u s e d in con tem p o ra ry f in an cial m at h e m at ics to id e n tify cr is e s an d o th e r b lack s w an e v e n ts . T h e ir p ap e r, alo n g w ith m an y o th e rs , id e n tifi e s th at (Paga n an d Sos s o u n o v , 2003 ) p ro v id e s th e m o s t ro b u s t y e t e f f e ctiv e f ra m e w o rk f o r th i s id e n tifi cat ion . (Olbr y s an d Ma jew s ka , 2015 ) als o s tres s th at th e re is lit tle con s e n s u s a m o n gs t re s e ar c h e rs o n t h e s p e cif ic d e f in itio n o f a cris is p e riod an d , b y e xt e n s ion , little con s e n s u s o n forecas tin g me t h o d s .
Vola tility an d p o rtfolio correlatio n s , b o th w ith in it s e lf an d w ith th e w id e r m ar kets , ar e c ru cial m ar kers as s o ciated w ith p e riod s o f cris is in f in an cial m ar kets . Still, th e re ar e f e w m o d e ls th at can acco u n t f o r b o th v o lat ili ty a n d s h if tin g correlatio n s . For in s ta n ce , ARC H an d G A RC H m o d e ls , in tro d u ce d in (E n gle , 19 82) an d (B o ll e rs le v , 198 6 ) re s p e ctiv e ly , th at ar e ty p ic ally u s e d f o r m o d e lli n g o f v o lat ili ties , d o n o t ta ke in to acco u n t th e correlatio n s w it h o th e r as s e ts a n d th e wider m ar ket.
(K u m ar an d D e o , 201 2) u s e s Ran d o m Ma trix T h e o ry to u n cov e r, f o r e xa m p le , in c r e as e d correlatio n s b e t w e e n E u ro p e an an d U S s to ck in d ice s d u rin g time s o f cris is . U s in g s im ilar m e th o d s , (San d o v al an d De Pa u la Fran ca, 2012 ) f in d s th at in cre as e d v o lat ili ty d riv e s in cre as e d correlatio n 9 b e twe e n e q u ity in d ice s . Correl at ion coef f ici e n ts , p re s e n te d in Fig u re s 28 to 31 in cre as e 2 to 4 time s d u rin g m u ltip l e h is to rical p e riod s o f in cre ase d v o lat ili ty . (Sylligna kis an d Kou re ta s , 2011 ) f in d s almo s t id e n tical re s u lts u s in g a Dy n amic Con d itio n al Correl at ion m u ltiv ar iat e G ARC H m o d e l . T h is m e an s th at e v e n th o u gh e xp lic it id e n tifi cat ion o f cris e s m ay b e p ra ctical ly d if f icult , p o rtfolio s can b e ad ju s ted d u rin g th e e ar ly s ta ge s o f a cris i s b as e d o n o b s e rv at ion s o f in cre as e d co rre lat ion s b e tw e e n a s s e ts a n d a s s e t clas s e s 10 .
II.III. Impa ct o n h e d ge fun d s
T h e m ain d riv e rs b e h in d th is gap in h e d ge f u n d p e rf o rm an ce b e twe e n p e riod s o f m ar k e t s ta b ili ty an d cris is ar e n at u ra lly at trib u ta b le to th e ir in v e s t m e n t p ra ctice s . On e o f th e d e f in in g ch ar act e ris tics o f m o s t h e d ge f u n d s a n d AIMs i s th e ir s u p p o s e d h e d ge aga in s t m ar ket (or p rice ) ris k. In
9 T h e re ve rs e re l ati o n mig h t al s o b e tr u e , th o u g h ( S an d o val an d D e Pa u l a F ran c a, 2012) d o e s n o t clai m th at.
10 T h i s w o u l d re q u i re tr ac ki n g t h e e vo l u ti o n o f c o rr e l ati o n b e tw e e n vari o u s as s e ts o ve r ti m e . T h e CB O E Impl i e d Co rr e l ati o n In d e x i s o n e o f th e to o l s th at c an b e u s e d fo r s u c h an alys i s - i t tr ac ks th e 3 - mo n t h l ag g e d c o rr e l at i o n o f th e to p 50 e q u i ti e s i n t h e S &P 500 i n d e x . T h at s aid , ti me - b a s e d an a l ys i s o f c o rr e l ati o n i s d i ff i c u l t to vis u ali s e an d i s fu rt h e r c o mp l i c ate d b y t h e n e c e s s i ty to s e l e c t re l e vant a s s e t s o r as s e t c l as s e s fo r an alys i s , c o u p l e d w i th a fit ti n g l ag . T h i s c an o b s c u re
th e o ry , th is s h o u ld im p ly a l o w e r d e gr e e o f p e rf o r m an ce s e n s itiv ity to v o lat ili ty , w h ich is tra d itio n ally s e e n as a ri s k d riv e r . As s u ch , s u ch m ar ket agent s s h o u ld act as ab s o rb e rs o f m ar ket ris k b y acq u irin g m a rk e t - n e u tra l p o s itio n s i n a s s e t s an d t h u s s ta b ili s in g t h e ir p rice .
In p ra ctice , h o w e v e r, th e to o ls u tilis e d b y s u ch m an agers m e an th at re d u ce d e xp o s u re to m ar ket ris k come s at th e cos t o f in cre as e d e xp o s u re t o cre d it an d liqu id ity ris k. In p ar ticu lar, amas s in g a m ar ket - n e u tra l p o s itio n d e f in itio n ally im p lie s a s h o rt - p o s itio n w ith i n th e p o rtfolio . T o ach ie v e th i s , AIMs m u s t ta ke o n le v e ra ge f ro m cre d it p ro v id e rs , w h ich is o f ten s e cu re d b y t h e co llat e ra l in t h e form o f t h e u n d e rly in g as s e t in w h ich th e AIM w is h e s to ta ke a p o s itio n . T h e re f o r e , w h ile th e m an age r’ s p o s itio n , if p ro p e rly e x e cu ted , m ight n o t b e s e n s itiv e to p rice m o v e m e n ts , th e ir collat e ra l s e cu ritiz at ion w ill . T h is is n o t th e cas e w ith m an y tra d itio n al in v e s tme n t v e h icl e s th at ta ke o n s trictly lon g - p o s itio n s , p o ten tia lly b y p ass in g th e n e e d f o r le v e ra g e . T h is e f f e ct is a d ire ct con trib u to r to cre d it ris k at th e e xp e n s e o f m ar ket ris k 11 .
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e c o r r e lat io n b e twee n c r e d it a n d m a r ke t r is k in th e e c o n o m y. T h e c h a r t h igh ligh t s th e c o r r e lat io n b e twee n th e two typ e s o f r i s k, w h e r e c r e d it r is k is p r o xie d b y th e h igh yield o p tio n - a d ju s te d s p r e a d a n d m a r ke t r is k b y th e VIX, a c o m m o n ly a c c e p t e d m e a s u r e o f vo lat ili ty in th e US e q u ity m a r ke ts.
H o w e v e r, th e n e e d f o r ta kin g o n h ighly le v e ra ge d p o s itio n s s tem s f ro m o th e r s o u rce s as w e ll. Fo r e xa m p l e , (Lian g an d Qiu , 2019) f o u n d t h at “ th at t h e p ro b ab ili ty t h a t a f u n d t ak e s o n m o re le v e ra ge in cr e as e s b y 0.42 p e r o n e s ta n d ar d d e v iat ion in cre as e in t h e p as t m o n th ' s p e rf o rm an ce ” , s u p p o rtin g t h e logical claim th at AIMs d e s ire to m ain ta in th e ir p e rf o r m an ce le v e l. At th e s ame ti m e , giv e n th e
may b e o c c u rr i n g . T o ad d re s s th i s i s s u e , Pa re to T e c h n o l o g i e s h as d e ve l o p e d a c o rr e l a ti o n an aly ti c s to o l , Man i fo l d , w h i c h al l o w s th e u s e r s to avo i d a ran g e o f i s s u e s as s o c i ate d w i th t rackin g t h e e vo l u ti o n o f c o r re l ati o n s in fi n an c i al mark e ts d e s c ri b e d ab o ve .
11 E ve n w i th c ro s s - c o l l ate ral i z ati o n , c re d i t r i s k r e main s ju s t a s i mp ac tfu l . Du r i n g ti me s o f marke t s tr e s s , as e x p l ai n e d b e fo re , as s e t p ri c e c o rr e l ati o n s te n d to i n c re a s e me an i n g th at marg i n c all s an d l i q u i d at i o n s take p l ac e ac ro s s th e b o ard , as o c c u rr e d d u ri n g t h e 2008 - 2009 fin an c i al cri s i s .
th e tr u e n at u r e o f th e c o rr e l ati o n an d , b y e x te n s i o n , th e c ri s i s t h a t
d if f icult y o f con s is ten tly id e n tifyin g s u p e rior in v e s tme n t o p p o rtu n itie s , s u b o p timal p o s itio n s th at d o n o t m ax im is e alp h a s u b jec t to f e as ib ili ty , m u s t b e s u p p le m e n ted b y in cre as e d le v e ra ge to m ain t ain a ta rge t le v e l o f re tu rn s . Ad d itio n ally , in cre as e d le v e r age m ay b e u s e d to m ain ta i n ta rge t re tu rn s in th e f ace o f in cre as in g AU M an d th u s a gre at e r n e e d for cre d it - h e av y h e d ging.
As s u ch , alt e rn at iv e in v e s tme n t m an agers ar e w e ll - p o s itio n e d to re d u ce v o lat ili t y in th e m ar kets t h ro u gh th e con s id e ra b le s ize o f th e ir as s e ts u n d e r m an agem e n t an d a ro b u s t s cre e n in g crite rio n f o r in v e s tme n ts . Rat h e r AIMs act as amp lif ie rs o f b o th id ios y n cr at ic (K o n d o r, Sad ka an d Kan g, 2012) an d s y s tem ic ris ks (K aa l an d Krau s e , 2016 ) . Rat h e r th an ab s o rb in g m ar ket s tres s , th e y in cre as in gly con trib u te t o it as m o s t s tra tegi e s im p ly tra d in g o n h e av ily le v e ra ge d m ar gin in o rd e r to h e d g e ag ain s t m ar ket ris k. H o w e v e r, a re d u ctio n in th e amou n t o f cre d it ris k in cu rre d , w ill allo w th e f u n d s to re tu rn to th e m an d at e th e y h is to rically m ain ta in e d .
II. IV. Prev iou s mitigat ion s tra tegi e s
G iv e n th e d e trim e n ta l e f f e ct t h at cris is p e riod s h av e h ad o n AIM re tu rn s , v ar iou s s tr at e g ie s h av e b e e n d e v e lop e d in o rd e r to re d u ce th e im p act o n p o rtfolio re tu rn s . A com m o n f e at u re o f s u ch s tra tegi e s is to e xh ib it lon g con v e xity o f re tu rn s , m e an in g th at re tu rn s ar e h ighly correlated w ith a b e n ch m ar k an d th at th e s tra tegy d e liv e rs h igh re tu rn s i n time s o f e xt re m e m ar ket con d itio n s , b lack s w an , an d low - p ro b ab ili ty ev e n ts .
In th is con text, con v e xity r e f e rs to th e o ccurr e n ce o f e xt re m e e v e n ts . E v id e n ce f ro m f in an cial m a rk e ts is ab u n d an t , b u t can als o b e f o u n d e ls e w h e r e 12 . For e xa m p l e , (And e rs o n e t a l. , 2017 ) f in d s e v id e n ce o f low p ro b ab ili ty e v e n ts o ccurr in g in a n u m b e r o f an im al p o p u lat ion s , a n d (Qu igg in , 2018 ) d is cu s s e s low p ro b ab ili ty e v e n ts amp lif ie d b y cli m at e ch an ge in f ar m in g an d agricu ltu re . In cre as in g con v e xity in f in an cial m ar kets is as s o ciated w ith time s o f d e p ar tu re an d d i v e rge n ce f ro m th e E f f ici e n t Ma rk e t H y p o th e s is ( E MH ), in w h ich ass e t p rice s ar e f u rth e r im p act e d b y t ra n s ito r y ef f e cts s u ch as con ta gion . (Re b o n at o an d Ron za n i, 2021 ) , f o r e xa m p le , f in d s th at th e comm o n ly acce p ted n o tio n th at con v e xit y is alread y p rice d in d o e s n o t h o ld for at leas t f o u r an aly s e d maj o r s w ap mark e ts .
Su ch p e riod s o f d i v e rge n ce f ro m th e E MH giv e ris e t o con v e rge n t an d d iv e rge n t s tra tegi e s . T h e f irs t as s u m e th at
12 T h e R u s s i an i n vasi o n o f Uk rai n e i n l ate F e b r u ary 2022, i s p ri m e e vid e n c e o f i n c re as i n g c o n ve x i ty o f e ve n ts . Me re d ays b e fo re th e i n vasi o n b e g a n , man y s o u rce s w e re s c e p ti c al o f th e p o s s i b i l i ty o f c o n fli c t at th e h e art o f E u ro p e d e s p i te i n te l l i g e n c e re p o rt s re l e a s e d b y th e US an d i t s all i e s . In th e fo l l o w i n g d ays , te n s i o n s tu r n e d i n to o n e o f th e b l o o d i e s t w ars i n re c e n t h i s to ry - an e ve n t th at man y h ad
as s e t p rice s ge n e ra lly f o llo w th e E MH an d th e re f o re ge n e ra lly s e e k to g e n e ra te alp h a o n th e d is cre p an cy b e twe e n cu rre n t as s e t p ric e s an d m e an - re v e rtin g as s e t p rice s , as ge n e ra ted b y th e E MH . On th e o th e r h an d , d iv e rge n t s tra tegi e s e xp e ct c o n v e x e v e n ts to b e ‘ re cu rre n t e n o u gh ’ in o rd e r to g e n e ra te alp h a o n s u ch low - p ro b ab ili ty , h igh - im p act e v e n ts (on b o th glob al an d loca l s cale ), w h ich ar e as s o ciat e d w ith e xt r e m e m ar ket con d itio n s an d h igh u n ce rta in ty . A comb in at ion o f s u ch s tra tegi e s re d u ce s th e ris k tra d itio n ally ass o ciated w ith d ire ctio n al s tra tegi e s th at ar e m o re d e p e n d e n t o n d e riv at iv e s an d o t h e r cre d it - b as e d in s tru m e n ts t o h e d ge t h e ir a s s e ts d ire ctly .
Ma n aged f u tu re s s tra tegi e s ar e o f ten s e t u p in o rd e r to cap tu re alp h a d u rin g time s o f m ar ket cris is . At th e ir core, th e s e s tra tegi e s ar e act iv e tren d - f o llo w in g a u n iv e rs e o f as s e ts an d a ta ke o n f u tu re s p o s itio n s o n th e m . Ma n age d f u tu re s s tra tegi e s b e n e f it f ro m th e r e lat iv e ly lo w cos t o f th e ir as s e ts , re lat iv e to th e ir in tere s t - b e ar in g cou n terp ar t s . H o w e v e r, av o id an ce o f d ir e c t h e d ging o f m ar k e t ris k v ia d e riv at iv e s an d cre d it in s tru m e n ts , m e an s th at m an ag e r s w h o e n gage in th is s tra tegy m u s t h av e acce s s to to o ls th at allo w th e m to th o ro u gh ly e x amin e all s o rts o f correlatio n s th at th e ir (p o ten tia l) p o rt f o li o is e xp o s e d to ; th u s , allo w in g m o re r e le v an t ris k m an agem e n t in o rd e r to m ain ta in re tu rn s d u rin g lo w - p ro b ab ili ty , h igh - im p act (i.e., con v e x) e v e n ts .
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e p e r f o r m a n c e o f E u r e ka h e d g e C T A ind e x - a g a u g e f o r th e p e r f o r m a n c e o f managed f utur es s tr ategi es . D es pi te the v ol a tility o f h e d g e f u n d r e tu r n s in g e n e r a l, th e p e r f o r m a n c e o f m a n a g e d f u tu r e s s tr a te g ies h a s b e e n s te a d ily r is ing , a s s u g g e s te d b y t h e c h a r t. T h is i s c o m p a r e d to th e p e r f o r m a n c e o f a ll h e d g e f u n d s , ir r e s p e c tive o f s t r a te g y. As e x p e c te d , d u r ing tim e s o f c r is is , th e CT A in d e x o u tp e r f o r m s t h e o ve r a ll in d e x.
An o th e r ap p ro ach to m ain ta i n in g alp h a an d ta rge t re tu rn s , h as b e e n s ty le - d rif tin g an d s ty le - s h if tin g 13 . In p ar ticu lar, m an y m an agers ch o o s e to ad ap t th e ir in v e s tme n t p ra ctice s
13 S tyl e - d ri ft i n g re f e rs to mo re te mp o rar y an d s h o rt - te rm d i ve rg e n c e o f a man ag e r fro m i t s man d ate , w h e re as s ty l e - s h i fti n g c ap tu re s mo re p e rma n e n t c h a n g e s to th e man d ate i t s e l f. S tyl e - d ri fti n g c an als o o c c u r n atu ral l y w i th th e e vo l u ti o n o f a p o rt fo l i o an d c h an g e s i n it s r i s k make - u p o r r e l ati ve val u e o f a s s e t s
d i s c ard e d a s ‘lo w - p ro b ab i l i ty’ .
d u rin g p e riod s th at th e y id e n tify as cris e s . N at u ra lly, th i s id e n tifi cat ion re q u ire s f o rm id ab le s kill an d th e ir p e rf o rm an c e is th e re f o re d e p e n d e n t b o th o n th e ir ab ili ty t o id e n tify th e cris is , as s e s s th e ch an ging ris k p ro f ile o f th e i r cu rre n t p o rtfolio , a s we ll a s t h e s h if tin g ris k p r e m ia.
Fina lly, s u cce s s o f s ty le - s h if tin g als o re lie s o n av aila b le liqu id ity to re s tru ctu re th e ir p o rtfolio in a w ay th at w o u l d b e n e f it f ro m th e ch an ge s in th e m ar kets in d u ce d b y th e cris is . (J ian g, Lia n g an d Zh an g , 2022 ) f in d s th at o n av e ra ge 7.68% o f h e d g e f u n d m an ager s b e twe e n 1994 an d 2013 s h if t th e ir in v e s tme n t s ty le e v e ry q u ar ter. Fu rth e rm o r e , th e y f in d th at m an agers w h o ch o o s e to ch an ge th e ir in v e s tme n t s tra tegy ar e m o re like ly to o u tp e rf o rm th o s e w h o d o n o t o n av e ra ge . In p ar ticu lar, ‘ ad ap ta b le ’ m an agers ar e th o s e o f y o u n ge r f u n d s o r th o s e w ith h igher in v e s to r s u b s crip tio n (i.e ., h igher ca p ita l in f lows ). Bo th o f t h e s e gro u p s a re , a s t h e p ap e r f in d s , m o re l ikel y to ad j u s t th e ir s tra tegy. Con v e rs e ly , f u n d s w h o s e s tra tegi e s re m ain e d s ta gn an t an d f aile d to e v o lv e w ith ch an ging m ar ket con d itio n s w e re u n ab le to ge n e ra te a s mu ch r is k p re m ia.
III . E xt ra ctin g cris is a lp h a
III .I. O v e rv ie w
De p ar tu re f ro m n o n - d ire cti o n alit y can b e b e n e f ici al to m an agers w h o ar e w ill in g to loo k p as t th e con v e n tio n th at n o n - d ire ctio n alit y can in trin s ic ally p ro v id e re tu rn s . G iv e n th e in cre as in g d e n s ity o f e v e n t s d iv e rge n t f ro m th e E MH , o n b o ar d in g o f s tra tegi c d ire cti o n alit y allo w s th e m an ag e rs to ach ie v e t h e p o rtfolio - l e v e l h e d ge t h at is b e in g s o u gh t.
Ma n aged f u tu re s s tra tegi e s , m e n tio n e d in th e p re v iou s s e ctio n ar e an e xa m p l e o f d ir e ctio n al s tra tegi e s th at p e rf o r m ge n e ra lly w e ll d u rin g cr is e s . (Me tz g e r an d Sh e n ai, 2019 ) f in d s t h at t h e ir p e rf o rm an c e in 2008 - 20 09 w as s e con d o n ly to th at o f s h o rt b ia s s tra tegi e s . In cre as e d re tu rn s o f n e t s h o rt s tra tegi e s in th o s e y e ar s is n at u ra lly d riv e n b y a s e rie s o f s h ar p d ra w d o w n s in as s e t p rice s , m e an in g th at b e ar is h m an agers w e r e ab le to h ar v e s t m o re alp h a f ro m th e m ar ket. H o w e v e r, ad m in is tra tio n o f con tra rian s tra tegi e s re q u ire s f o rm id ab le m an ager s kill a s fou n d b y (G rin b lat t e t a l. , 2020)
In o rd e r f o r m an agers to ad ap t to t h e ch an ging m ar ket con d itio n s an d p ro tect th e ir alp h a, th e y m u s t e v o lv e in lock s tep w ith th e m . T o th at e n d , n e w techn iq u e s o f p ra ctical, p o rtfolio - le v e l ris k m an agem e n t ar e re q u ire d as o v e r re lian ce o n cre d it - link e d in s tru m e n ts h as alread y b e e n s h o w n to b e in e f f e ctiv e , if n o t o u trigh t d e trime n ta l. A m o re ro b u s t a n d all - cov e rin g ap p ro ach o f s ynt h e tic h e d g in g is o n e s u ch v iab le s o lu tio n .
We claim th at p e rf o rm an c e s im ilar to th at o n m an aged f u tu re s s tra tegi e s can b e ach i e v e d b y u s in g o th e r d ire ctio n al s tra tegi e s w ith a s ynt h e tic h e d g ing o f m a r ke t r is k o r s im p ly , s y n th e tic h e d ge , a s a q u alit y o f an in v e s tme n t h o ld in g t h a t s im u lat e s n o n - d ire ctio n alit y a n d e f f e ctiv e l y h e d ge s it aga in s t m ar ket ris k.
Sta tis tical h e d ging, a s u b s e t o f s y n th e tic h e d ging, is alread y b e in g e xp lored in lit e ra tu re . For e xa m p l e , (B u e h l e r, 201 9) con s id e rs v ar iou s w ay s o f im p le m e n tin g o p tim al h e d gin g le v e ls o f a p o rtfolio w ith o u t b lind re lian ce o n th e G re e ks as ris k m e as u re s , w h ich, as claim e d , d o e s n o t cap tu re th e tru e ris k ass o ciated w ith a p ar tic u lar p o rtfolio , an d th e re f o re le ad in g to m is - o p timi za tio n w h e n re d u cing m e an - v ar ian c e . T h e p ap e r p ro p o s e s an d s u m m ar is e s a n u m b e r o f ris k m e as u re s th at can b e u s e d in o rd e r to as s e s s th e ro b u s tn e s s o f p o rtfolio h e d ging w ith o u t th e u s e o f ‘ tra d itio n al’ techn iq u e s an d in s tru m e n ts , w h ich re d u c e s tra n s act ion an d re s tru ctu rin g cos ts , an d alle v i at e s th e n e e d to p rice comp le x p ro d u cts w ith h igher d e gre e s o f u n ce rta in ty . Fu rth e rm o re , Bu e h le r h ighli gh ts th at s ta t is tical h e d ging acco u n ts f o r d iv e rge n ce in m ar ket b e h av iou r, m e an in g th at it i s
ap p lic ab le ev e n wh e n t h e E M H d o e s n o t h o ld .
As can b e s e e n , at te m p t s to s tee r away f ro m ‘ m o r e tra d itio n al’ h e d ging m e th o d s ar e alread y b e in g d e v e lop e d . Su ch at tem p ts s h o u ld n o w b e e xp an d e d f u rth e r to in clud e o th e r in v e s tme n t p ar ame ters , o f w h ich s t at is tical h e d ging i s a s u b s e t.
III.II. Sy n th e tic h e d gi n g
Sy n th e tic h e d ging can b e a ch ie v e d th ro u gh ap p ro p riat e u s age o f a n u m b e r o f in v e s t m e n t techn iq u e s . In p ar ticu lar, th e m an ager m u s t correctly u n d e rs ta n d p ar ame ters w h e n s e le ctin g as s e ts s u ch as p o rtfolio correlatio n , p o s itio n d u ra tio n an d timi n g o f e n try ( an d e xit), ris k - o n /ris k - o f f ra tio in o rd e r to m ak e u p f o r th e lack o f e xp lic it h e d ge to allo w f o r p o s itio n - le v e l d ire ctio n alit y w h ile m in im izin g p o rtfolio le v e l d ra w d o w n s .
Po rtfolio corre lat ion re f e rs b o th w ith in - p o rtfolio an d acro s s - m ar ket corr e lat ion . T h e f irs t h ighligh ts h o w as s e t p rice s , an d o th e r ch ar act e ris tics , a re co rre lat e d for as s e ts t h at a re h e ld . T h e lat ter con s id e r th e correla tio n o f th e p o rtfolio a s a w h o le to th e w id e r m ar ket (v ar iou s as s e t clas s e s , o r m e as u re s s u ch as in f lat ion o r i n tere s t ra t e s ). (B u ra s ch i, Kos o w s ki an d T ro ja n i, 2014 ) f in d s th at m o s t s tra tegi e s , in clud in g lon g - s h o rt e q u ity , o p tio n , f u n d s o f f u n d s , a n d m an aged f u tu re s p o s s e s s “ s ignifi can t n e gat iv e exp o s u re t o co rre lat ion r is k” .
FIG U RE . C a p tio n : b e ta o f va r i o u s h e d g e f u n d s tr a te g ies o ve r tim e .
Fu rth e r, th e y f in d lowe r cor re l at ion e xp o s u re s f o r f u n d s w ith low d ire ctio n al n e t e xp o s u r e an d a p o s itiv e correlatio n b e twe e n correlatio n ris k e xp o s u re an d d ra w d o w n s . In tere s tin gly, t h e s e d ra w d o w n s o ccur f o r m an y h e d ge fu n d s s im u lta n e o u s ly , s u gge s tin g th at “ correlatio n ris k [ is ] a s y s tem at ic ris k f act o r in th e cros s - s e ctio n o f h e d ge f u n d re tu rn s ” . T h e p ro ce s s o f correlatio n - b as e d s to ck s e le ctio n , d o e s n o t n e ce s s ar ily im p ly id e n tifyin g as s e ts w ith p airwi s e n e gat iv e correlatio n to ass e ts alread y h e ld in th e p o rtfolio . A
m an ag e r s triv in g to ach ie v e a lo w p o rtfolio - l e v e l correlatio n m u s t als o co n s id e r th e imp lic at ion s o f a n y a d d e d s e cu rity t o th e p o rtfolio an d con tin u o u s ly re ad ju s t th e p o rtfolio in o rd e r to ach ie v e m in im al v ar ian ce an d correlatio n s b e twe e n all s u b s e ts o f t h e a s s e ts in t h e p o rtfolio .
H o w e v e r, in v e s tme n t m an agers m u s t als o con s id e r th e p o s s ib ili ty t h at d e s p ite ass e ts e xh ib itin g n e ar - zero P e ar s o n correlatio n , n o in f o rm at ion a b o u t e ith e r as s e t’ s p rice tren d is re v e aled. Som e o f s u ch cou n terint u itiv e d e ta ils ar e cov e re d b y (Lh ab ita n t, 2012 ) w h ich ar is e d u e to th e f act th a t s u ch correlatio n m e as u re s o n ly con s i d e r d at a as a time s e rie s , lack in g an y s u p p o rti n g s tru ctu re an d h av in g n o m e an in g s e p ar at e ly - o n ly w h e n co n s id e re d as s o m e n o n - d e term in is tic fu n ctio n o f t h e o th e r v ar iab le . Be cau s e o f t h i s , s e e m in gly at tra ctiv e low corr e lat ion v alu e s can o b s tru ct t h e tru e p ictu re o f th e p o rtfolio ’ s h e alt h an d giv e a f als e s e n s e o f s e cu rity t o in v e s to rs .
FIG U RE . C a p tio n : s e e in d iag r a m
T h e e f f e ct o f in cr e as in g as s e t p rice corre lat ion s o n cre d it ris k p re s e n ts a u s e f u l m e tric as it d e m o n s tra tes th e im p act th at a p o o rly correlated p o rtfolio can h av e o n a m an ager’ s re tu rn s . In p ar ticu lar, a n in v e rs e re lat ion s h ip b e twe e n as s e t p rice correlatio n an d d e f au lt p ro b ab ili ty h as b e e n e s ta b lis h e d f o r cre d it p o rtfoli o s in a w id e ly cite d p ap e r b y (Lo p e z, 2004 ) as w e ll as b y th e Bas e l Ac cord s f o r b an k cap ita l re q u ire m e n ts . T h o u gh th is m ay s u gge s t a m o re id ios y n crat ic n at u re o f cre d it ris k, in h e re n t to a giv e n ass e t, its e m p iric al e xis ten ce re m ai n s u n ce rta in . For e xa m p le , (Voz ze lla an d G ab b i, 2011 ) p re s e n t a con tra d ictin g f in d to th at o f (Lo p e z, 2004) , in line w ith a 2009 w h itepa p e r b y M o o d y ’ s .
14 In p art i c u l ar, o n e o f th e re as o n s fo r th i s tr e n d i s d u e to th e s i z e o f th e i n ve s tm e n t u n i ve r s e . G r e ate r b o o k valu e s g e n e ra l l y i mp l y th at th e a s s e t ma n ag e r h as an a p r i o r i h i g h er e x p o su r e t o v a r i o u s m a r ket m o v emen ts .
(Lo p e z, 2004 ) als o s h o w s th at b o o k v alu e o f a s s e ts in a p o rtfolio in cre as e s cros s - ass e t correlatio n s 14 , im p ly in g t h at th e n e e d f o r re d u cing cros s - as s e t correlatio n s an d s tricter ris k m an agem e n t p o lic ie s in cr e as e s f o r large r p o rtfolio s izes . T h is s u gge s ts th at at ten tio n m u s t b e p a id to s h if ts in p ric e correlatio n s in th e p o rtfolio , as th e s e can h av e a s ignifi can t im p act o n p o rtfolio p e rf o rm a n ce .
Po rtfolio correlatio n 15 , th e re f o re , f o rm s a cru cial as p e ct o f an in v e s tme n t s tra tegy th at m u s t b e caref u lly u n d e rs to o d an d con tro lle d . H o w e v e r, d o in g s o is ch alle n ging as correlatio n s b e tw e e n s e cu riti e s as w e l l as th e w id e r m ar ke t can ta ke a v ar ie ty o f f o rm s an d h a v e v ar y in g s tren gth s , time f ra m e s an d cros s - correla tio n e f f e cts . Ad d itio n ally , th e w id e r m ar ket e n v iron m e n t can d is to rt correlati o n b e h av iou r, o b s cu rin g it f ro m th e in v e s tme n t m an agers . For e xa m p le , s y s tem ic e v e n ts s u ch as m as s cre d it d e f au lt con ta gion , can d is to rt f u n d ame n ta l correlatio n b e twe e n as s e t p rice s . Since th e 2008 cris is , b o th w ith in - as s e t - clas s correlatio n s a n d a cros s - ass e t - clas s co rre lat ion s h av e falle n .
An o th e r f act o r th at m u s t b e con s id e re d is th e s e n s itiv ity o f th e p o rtfolio as a w h o le to ch a n ge s in th e ris k - ap p e tit e o f th e m ar ket. Wei gh ts p lace d o n a s s e ts in th e p o rtfolio m ay n e e d to b e re ad ju s ted if th e w id e r m ar ket con d itio n s ch a n ge 16 . Du rin g a p e riod o f in cre as e d m ar ket v o lat ili ty , m ar ke t p ar ticip an ts ’ av e ra ge ris k to le ra n ce d e cr e as e s , d ra w in g in v e s to rs to low - ris k as s e ts s u ch as cas h o r U S treas u ry b ill s . On th e o th e r h a n d , th e d e cre as e d m ar ket v o lat ili ty , coin ciden ta l w ith a b u lli s h tren d in th e m ar kets , act s as a s igna l to in v e s to rs to ta ke o n s e cu ritie s w ith a h igher av e ra g e r at e o f re tu rn an d h igher ris k p re m ia, as f o u n d b y (G an za ch an d Wo h l, 2018 ) w h ich an aly s e s correlatio n s b e twe e n th e ris k - f re e r at e a n d d e m an d for ris kier a s s e ts .
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e S tr e s s In d e x a s c o m p iled b y t h e S t. Lo u is Fed , a ve r a g e d o u t a t 0. T h e ind e x i s u s e d a s a b r o a d g a u g e o f va r io u s r i s ks in U S m a r ke ts, inc lud ing c r e d it a n d liqu idit y r is ks. T h e c h a r t is o ve r laid w ith g r e y p e r io d s th a t a r e c o n s ide r e d , b y th e S t. Lo u is Fed , t o b e r e c e s s io n a r y p e r io d s . T h e c h a r t s u g g e s ts th a t p e r io d s o f
15 S e e i n te r e s ti n g n o te o n Ke n s h o Co rr e l ati o n s
16 A s e min al p ap e r o u tl i n i n g th e p ro c e d u re fo r s e n s i t i vit y an alys i s o f me an - vari an c e p o rt fo l i o s c an b e fo u n d i n ( Bes t an d G rau e r, 1991)
a b o ve - a ve r a g e s tr e s s leve l s a r e n o t u n c o m m o n a n d m u s t b e th o r o u g h ly a c c o u n te d fo r .
Stra tegi e s w h o s e s u cce s s is con tin ge n t o n v o lat ili ty ar e n o t th e s ame as th o s e t h at ar e d e p e n d e n t o n con v e xity . I n p ar ticu lar, con v e x lon g - v o lat ili ty s tra tegi e s ar e th o s e th at d e liv e r s u p e rior alp h a in b o th e xt re m e ly h igh n o n - d ire ctio n al an d in n o n - v o lat ile d ire ctio n al m ar ket r e gim e s . Pu re lon g - con v e x s tra tegi e s , o n th e o th e r h an d , ar e th o s e th at d e liv e r s u p e rior alp h a in e xt re m e b u ll/bear m ar ket re gi m e s ; s h o rt - con v e x o r con cav e s tra tegi e s ar e d e f in e d s y m m e trica lly. Lo n g - v o lat ili ty s tra tegi e s f o r m y e t an o th e r ch ar act e ris at ion o f s tra tegy b e h av iou r th at ge n e ra tes s u p e rior alp h a d u rin g p e riod s o f n o n - d ire ctio n al m ar ket r e gi m e s w ith h ig h v o lat ili ty ; s h o rt - v o lat ili ty s tra tegi e s ar e d e f in e d s y m m e trica lly. A s tra tegy ca n e xh ib it an y comb in at ion o f th e s e b e h av iou rs , n at u ra lly in cre as in g in comp le xity an d re d u cing in e f f i c ie n cy as th e n u m b e r o f con s tra in ts in cre as e s .
Wh e n loo kin g to e xt ra ct cr is is alp h a, AIMs m u s t con s tru ct an tifragile p o rtfolio s w ith ap p ro p riat e e xp o s u re to as s e ts w ith low o r in v e rs e correlatio n w ith th e m ar ket, irre s p e ctiv e o f th e ris k - ap p e tit e o f th e w id e r m ar ket s o as to ta ke ad v an ta ge o f m ar ket con ta gion o r p re v ailin g s e n time n t in th e m ar ket. T h is is in s tru m e n ta l in con s tru ctin g a lon g - con v e xity in v e s tme n t s tra tegy (i.e ., a s tra tegy th at ten d s to p e rf o rm w e ll in e xt re m e m ar ket co n d itio n s ).
Activ e AIMs ar e ab le to , in b ro ad term s , re as s e m b le th e ir p o rtfolio to re act to ch an ging m ar ket con d itio n s . Po s itio n d u ra tio n is th e av e ra ge e xp o s u re time , o f a giv e n tra d e , t o th e m ar ket an d is th e re f o re th e time p e riod w ith w h ic h m ar ket con d i tio n s ar e re e v alu at e d . (C alv e t, Cam p b e ll an d Sod in i, 2008 ) in tere s tin gly f i n d s th at h o u s e h o ld s ten d t o re b ala n ce th e ir p o rtfol ios , b e twe e n ris k - o n an d ris k - o f f as s e ts in p ar ticu lar, in time s o f a ch an g in g in v e s tme n t lan d s cap e . Sim ilar re s u lts w e r e f o u n d in (H e rrm an n , Roh le d e r an d Scho lz, 20 16) w h ich id e n tifi e s s ignifi can t correlatio n s b e tw e e n th e ab il ity o f U S e q u ity m u tu al f u n d s to s h if t in s ty le s an d th e ir re tu rn s . From a th e o re tical p e rs p e ctiv e , (Wu , Von g an d Zh o u , 2021 ) d e riv e s an o p tima l p o s itio n d u r at ion o f a p o s iti o n w ith a ra n d o m ly e v o lv in g p rice giv e n a le v e l o f ris k av e rs ion o f th e in v e s to r 17 . T h u s , as th e ab o v e - m e n tio n e d re s e a rch s u gge s ts , timi n g m ar ket m o v e m e n ts an d h av in g th e ab ili ty an d m ar ket d e p t h n e ce s s ar y to re act to ch an gin g m ar ket d y n amic s ar e o f th e u tmos t im p o rta n ce .
17 S to c h as ti c all y - vari e d p ri c e , c o n d i ti o n al o n a ri s k - aver s i o n fa c to r
If p ro p e rly u tilis e d , a co m b in at ion o f th e s e to o ls an d in v e s tme n t p ra ctice s allo w s th e in v e s tme n t m an ager t o m itigat e , i m p lic itly " h e d ging", m ar ket ris k w ith o u t ta kin g o n s ignifi can t amou n ts o f cre d it ris k. With in th e con s tra in ts o f acce p ta b le liqu id ity ris k p re m ia 18 (accou n tin g f o r ch alle n ge s p o s e d b y p o ten tia lly in s u f f ici e n t m ar ket d e p th ), th e m an ager is ab le to re p o s itio n th e m s e lf s o as to b o th m in im is e th e d ra w d o w n an d ta ke ad v an ta ge o f th e s u b s e q u e n t w ith in - as s e t - clas s p rice corre ctio n , as f o u n d b y (B e rn h ar t e t a l. , 2011) . N at u ra lly, t h e a b ili ty t o d o s o is lim ited b y t h e mark e t con d itio n s , m e an in g th a t th i s s y n th e tic h e d ge come s at th e cos t o f a r e d u ce d ra n ge o f s u i ta b le as s e t clas s e s , s tra tegi e s , an d p o s itio n s ize (an d th e re f o re , s tra tegy s cala b ili ty ) an d in v e s tme n t h o rizo n . In p ar ticu lar, th e s e s tra tegi e s ar e ap p lic ab le t o t h e d ig ita l cu rre n cy u n iv e r s e , wh e re a s s e ts a re kn o w n f o r h igh v o lat ili ty in p rice s , low m ar ket d e p th , an d s e lf - corr e ctin g b e h av iou r o f p rice s is m o re f re q u e n t alo n g w ith r ap id ly ch an ging m ar ket re gim e s .
III.III. Ap p l i cation t o cryp to a s s e ts
Ap p lic ab ili ty an d re le v an ce t o th e cry p t o s p ace als o s tem s f ro m th e o ccurr e n ce o f large - s cale liqu id at ion s o f h o ld in g s b y e xch an ge s , w h ich o ccur e f f e ctiv e ly at ra n d o m f ro m th e p e rs p e ctiv e o f m o s t s m alle r m ar ket p ar ticip an ts as th e y can n o t d is tu rb as s e t p rice s s ignifi can tly o r ra p id ly . Du e t o th i s , th e cry p to m ar ket is p ro n e to s u d d e n d ra w d o w n s , m e an in g th at h ighly le v e ra ge d s tra tegi e s w ill in cu r s ignifi can t los s e s w h ich ar e o f ten u n kn o w n p rior t o re aliz at ion , comp ris in g largel y th e clas s o f k n o w n u n kn o w n s (e .g., m o n e ta ry p o lic y d e libe ra tio n s ) an d a n o th e r clas s o f u n kn o w n u n kn o w n s (e .g., lar ge s cale cat as tro p h e s ), w h ich ar e fu rth e r m o re b y d e f in itio n u n m o d d e llab le . It is t h e r e f o r e e s s e n tia l th at th e m an ager is in a p o s itio n to re act to th e s e q u ickly , if n o t au to m at ically .
Cryp to m ar kets d if f e r f ro m m o s t tra d itio n al m ar ketp lace s in th at p ar ticip an ts an d agent s o f ten e n jo y d ire ct acc e s s to th e m , w ith o u t th e n e e d to r o u te o rd e rs th ro u gh a s e le ct n u m b e r o f b ro kers o r b ro ker - d e aler b an ks , w h o s e ro le i s s o lidifi e d in com m o n law ju ris d iction s as a re gu lat o ry b u f f e r f o r tra d e rs acce s s in g m ar kets . Alth o u gh s u ch d e ce n tra lis at ion is ge n e ra lly con s id e re d a b e n e f ici al an d d e f in in g f e at u re , ch alle n g e s w ith re s p e ct to ris k m an agem e n t ar is e . In p ar ticu l ar , re ta il agent s o f ten lack th e ris k - m an age m e n t s e rv ice s th at a re o f f e r e d b y b ro kers , w h ils t in s tit u tio n al agent s o f ten d o n o t h av e th e s ame f ails afe s o r le v e ra ge th at can b e o f f e re d b y p rim e b ro kers . Be cau s e th e s e s e rv ice s ar e m o s tly p ro v id e d b y th e e xch an ge v e n u e s th e m s e lv e s , w h ich d o n o t ge n e ra lly h av e s im ilar lon g - ter m
18 T h e c h all e n g e h e re o f c o u rs e i s th e fac t th at l i q u i d i ty c ru n c h e s
te n d t o h a p p e n d u ri n g ti me s o f ( r ap i d o n s e t ) m ark e t s tr e s s .
p ar tn e rs h ip con tra cts w ith its cli e n ts , e xch an ge s ar e o f te n f o rce d to ta ke u n ilat e ra l act io n , f o r e xa m p l e , in th e f o r m o f au to - liqu id at ion s . An o th e r in t e re s tin g as p e ct is th at d u e to th e lowe r p re s e n c e o f in s tit u tio n al in v e s to r s w ith lon g in v e s tme n t h o rizo n s (ov e r 5 y e ar s ) an d h igher b o o k v alu e s , th e ge n e ra l ris k ap p e tit e an d ab ili ty to w ith s ta n d v o lat il e p rice s w in gs is m u ch lowe r, m e an in g th at p rice f alls can n o t o n ly trigge r a u to - liqu id at ion s o n e xch an ge s b u t al s o m ass h y s teria a n d b an k ru n s , as in th e re c e n t collap s e o f T e rra , a s ta b le coin with a $41B mark e t cap o n r e cord .
T h e n at u re o f m ar ket p ar ticip an ts in th e cry p to - s p ace is d if f e r e n t f ro m th at in th e tra d itio n al as s e t s p ace. For in s ta n ce , th e p ro p o rtio n o f re ta il in v e s to rs is comp ar ab le if n o t h igher th a n th e p ro p o rt ion o f in s tit u tio n al in v e s to rs . Be cau s e o f th is , an d b e cau s e o f th e ab s e n ce o f an as s e t cu s to d ian ro le , ty p ically f u lf ill e d b y b ro kers in tra d itio n a l m ar ket s , th e m aj o rity o f t h e tra d e f lo w ta kes p lac e i n circ u m v e n tio n o f b ro kerage h o u s e s 19 , m e an in g th at e xch an ge s p ro v id e all th e le v e ra ge an d th e re f o re b e ar th e ris k as s o ciated w ith it. E xch an ge s im p le m e n t au to - d e le v e ra ging m e ch an is m s th at liqu id at e h o ld in gs in cry p to - as s e ts au to m at ically if th e e q u ity o f a p o s itio n d ro p s b e low a giv e n v alu e d u e to f alls in ass e t p rice , w h ich o ccur ro u gh ly e v e ry 3 m o n th s , as p ro xie d b u t th e time b e tw e e n th e le v e ra ge ra tio cros s in g its 50 p e riod SMA f ro m ab o v e (s e e b e low) . Au to m a tic liqu id at ion s f u rth e r d e p re s s th e p rice o f th e cry p to a s s e t in q u e s tio n as th e y o ccur s im u lta n e o u s ly w ith th e v e ry p rice f alls th at cau s e th e m . From th e p e rs p e ctiv e o f a m ar k e t p ar t ici p an t, th e s e e v e n ts h ap p e n s e e m in gly at ra n d o m 20 , m e an in g th at m e ch an i s m s m u s t b e p u t in p lace in o rd e r to : p re p ar e e x a n te , cou n teract d u rin g an d re s p o n s e e x p o s t . an d p re v e n t a d e teriora tio n o f p o rtfolio r e tu rn s .
19 R e p o rt e d O T C tr ad i n g vo l u m e s v ary w i d e l y. T A BB G ro u p re p o rt s th at O T C tr an s ac ti o n vo l u me i s as mu c h as 3 ti me s h i g h e r t h an e x c h an g e tr ad e d vo l u me i n c ryp t o .
20 W h i l e t h e li ke l i h o o d o f th e s e e ve n ts d o e s i n c re as e w i th d ramati c d i re c ti o n al mo ve me n t, p i n p o i n t i n g e x ac tl y w h e n th i s w i l l b e taki n g p l ac e an d th e d e g r e e to w h i c h th e au to d e l e ve rag i n g w i l l take p l ac e
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e a ve r a g e leve r a g e r a tio o n a n u m b e r o f c r ypt o e xc h a n g e s . C lea r ly, th e c h a r t ind ic a te s th a t o n a ve r a g e , e x c h a n g e s a r e b e c o m ing h igh ly leve r a g e d in g e n e r a l. Furth e r m o r e , s h a r p d r o p s c a n b e n o tic e d a n d a tt r ibu te d to a u to - d e leve r a g ing e ve n ts w h e n e xc h a n g e s f o r c e f u lly liqu ida te p o s itio n s o n th e ir c lien ts’ a c c o u n ts to p r o te c t th e ir b o o ks. T h e a b u n d a n c e o f th e s e ‘ d r o p s ’ s u g g e s ts th a t th e s e e ve n ts m u s t b e ta ke n int o c o n s ide r a tio n b y a n y p a r tic ipa n t in th is m a r ke t.
With in t h e cry p to cu rre n cy u n iv e rs e mas s iv e d ra w d o w n s a re o n e o f th e f e at u re s , b ak e d in to s u ch ass e ts d u e in p ar t t o re lat iv e ly lack in g re gu lat ion , l ar ge OT C v o lu m e , d if f e re n t ris k p ro f ile s o f in v e s to rs an d th e ge n e ra l lack o f th ird p ar ties s u ch as b ro kers . Cou p le d w ith th e a b s e n ce o f a tra d itio n al ce n tra l b an k 21 , th e re ar e f e w m ar ket p ar ticip an ts w h o can o f f e r p rice s ta b ili s at ion in th e lon g term . Rat h e r th an le av e th e as s e t clas s e n tirel y , giv in g u p p o ten tia l alp h a, i n v e s tme n t m an agers m u s t d e v e lop s tra t e gie s th at w ill allo w th e m to h ar v e s t th e alp h a w ith o u t o v e rre ach in g an d in ad v e rten tly e xp o s in g t h e m s e lv e s t o cred it r is k m o re t h an is p ru d e n t.
FIG U RE - can n o t f in d a p ro p e r s o u rce . C a p tio n : C h a r t s h o w c a s ing th e d if f e r e n c e s in a c tu a l a n d p r e d ic te d U S int e r e s t r a te s a s g iven b y e c o n o m is ts p r io r to Fed r e lea s e s . T h e c h a r t c lea r ly ind ic a te s c o n s is te n t d iver g e n c e in p r o f e s s io n a l p r e d ic tio n s a n d a c tu a l d a ta , h igh ligh tin g th e d iver g e n c e b e twee n t h e rea l a n d th e fina n c ial e c o n o m ies.
On e o f th e is s u e s w ith d e riv at iv e s - b as e d h e d ging in cry p to m ar kets con ce rn s E T Fs th at ar e o f t e n u s e d f o r th e s e p u rp o s e s . De riv at iv e s u n d e rly in g cry p to E T Fs f a ce is s u e s o f p o s s ib le ar b itra ge an d b re ak d o w n o f s p o t - to - d e riv at iv e p ric e
Ch an g e s to l e v e rag e re q u i r e me n ts at a r e g u l ato ry l e ve l an d tr ad e flo w o n vari o u s tr a d i n g ve n u e s i s e vo l vin g rap i d l y s o make s i t ve ry c h all e n g i n g to ke e p u p w i th .
21 T h at s aid , an i n t e re s t i n g tak e o n th e s u b je c t o f c ryp to c u rr e n c y c e n tr al b an k s w as b ri e fly e x p l o re d i n a Do o mb e rg art i c l e ti tl e “ Do l l ars E x Mac h i n a”
i s n o t a tr i via l p ro b l e m e ve n w i t h ac c e s s t o i n s t i tu ti o n a l - l e ve l d ata .
correlatio n s , as th e E T Fs ar e li n ked n o t to t h e s p o t p rice s o r f o r p rice o f n e ar - i m m e d ia te d e liv e ry b u t to f u tu re s con tra cts 22 . For th e s e re ason s , th e SE C h as con tin u o u s ly re jec t e d p ro p o s als to e s ta b li s h a Bitcoin s p o t E T P, citin g con ce rn s o f th e in ab ili ty to m e an in gf u lly p re v e n t ar b itra ge an d fron t - ru n n in g a cros s v ar i o u s t ra d in g v e n u e s .
T h is extra lev e l o f s e p ar at ion ca n fu rth e r amp lif y t h e co n v e x p h e n o m e n a an d w ip e o u t e n tire p o rtfolio s th ro u gh u n m e t m ar gin calls o r au to - liqu id at ion o n e xch an ge s . U n d e rly in g as s e t m is m at ch d o e s n o t th e o re tically con trib u te to f ra gil ity b u t it f u rth e r in cre as e s v o l at ili ty an d in s ta b ili ty in th e m ar kets .
An o th e r cru c ial f act o r th at e s ta b lis h e s th e re le v an ce o f s y n th e tic h e d ging to cry p to m ar kets is fin an cial fragility .
FIG U RE . C a p tio n : o n e o f th e m e a s u r e s o f f ina n c ial f r a g ili t y c o m p il e d b y th e S a n Fr a n c is c o Fed , s h o w c a s ing th e c yc lic a l yet c lea r in c r e a s e in fr a g ili ty o ve r t im e .
In d icato rs comp ile d b y th e San Fran cis co Fe d b as e d o n tra d itio n al f in an cing in p u t s , s u ch as m o rtga ge - d e b t - to - G DP , all go to h ighligh t th e in c re as in g f in an cial f ra gil ity in tra d itio n al m ar kets o v e r th e l as t d e cad e s (s e e ab o v e ). Ov e r time , th e f in an cial e con o m y d iv e rge s f u rth e r f ro m th e re al e con o m y th ro u gh (ov e r) f in a n cializa tio n , d o m in an ce o f th e U S d o llar as w e ll as th e f o rw ar d - loo kin g n at u re o f th e f in an cial mark e ts wh ich p ric e in fu tu re ev e n ts (if o n e a d o p ts th e E MH ) w h ils t e con o m ic i n d icato rs p ro v id e lagge d d at a o v e r p as t p e riod s . De s p ite th e f act th at e v e r in cr e as in g v o lu m e o f d e riv at iv e s tra d in g is a con trib u tin g f act o r to d e cre as in g v o lat ili ty an d e n ab ling p rice d is cov e ry i n tra d itio n al f ra ctio n al re s e rv e s y s t e m s , s u ch p ro d u cts can con trib u te to cris e s o u trigh t, as w as t h e cas e w ith collat e ra lize d s y n th e tic o b lig at ion s d u rin g th e G FC . Fu rth e rm o re , e f f e ctiv e f u n cti o n in g o f d e riv at iv e s as m ar ke t d amp e n e rs is co n d itio n al o n e f f e ctiv e cle ar in g m e ch an is m s .
T h e cry p to s p ace, o n th e o th e r h an d , e xh ib its th e o p p o s it e b e h av iou r, in h e re n t v o lat ili ty d u e to m ar ket s tru ctu re d e cre as in g w ith in cr e as in g n u m b e rs o f m ar k e t p ar ticip an ts o v e r time . T h at s aid , tra d itio n al as s e t m an agers ar e b e comi n g in cre as in gly an d h e av i ly in v o lv e d in ce rta i n
22 S o me E T F s are l i n ke d to p e r p e tu al s w ap c o n tr ac ts o n th e u n d e rl yi n g as s e ts , w h i c h mo re c l o s e l y re s e mb l e th e b e h avio u ral
m ar kets b y w ay o f cry p to p ro d u cts . Be cau s e , in term itt e n t in cre as e s in v o lat ili ty d o o ccur .
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e va lue s o f U S r e a l a n d n o m ina l G DP. T h e c h a r t h igh ligh ts t h e ir inc r e a s ing d iver g e n c e fo llowing t h e ir c r o s s ing b e twee n 2011 a n d 2013 .
Ce n tra l b an ks w ith in f ra ctio n al re s e rv e s y s tem s u n d e rs ta n d th at w ith tim e th e ir i m p a ct o n th e re al e con o m y i s d e cre as in g d u e to th e d iv e rge n ce w ith th e f in an cial e con o m y w h e re in th e m aj o rity o f c e n tra l b an k in s tru m e n ts o p e ra te. In p ar ticu lar, th e ra m p an t s w e l ling o f ce n tra l b an k b ala n ce s h e e ts as p ar ts o f v ar iou s q u an tit at iv e e as in g p ro gramm e s h ighligh ts th e n e e d to d e p loy m o re cap ita l in o rd e r to re in i n th e m ar kets . Ce n tra l b an ks ac t as an an tifragili ty m e ch an is m w ith in th e m ar kets , y e t e v e r in cre as in g b ala n ce s h e e ts - m o re th an 5 - f o ld s in ce 2 007 t o 2021 o n av e ra ge , as b e low - s u gge s t th at s u ch a go al m ay b e u n at ta in ab le . Still, th is d o e s n o t ju s tify d ra m at ic s w e lli n g o f ce n tra l b an k b ala n ce s h e e ts , w h ich can con trib u te, if n o t d riv e , w age an d p rice in f lat ion . In f act , th i s i s s e e n as o n e o f th e m ain d riv e rs o f m u lti - d e cad e - h igh in f lat ion in 2022 , alo n gs id e s u p p l y - ch ain d is ru p tio n a n d t h e war in Ukra in e .
FIG U RE . C a p tio n : C h a r t s h o w c a s ing th e s ize o f b a lan c e s h e e ts o f va r io u s m a jo r c e n tr a l b a n ks a r o u n d th e w o r ld. In c r e a s in g b a lan c e s h e e ts a r e , in p a r t, d u e t o q u a n tit a tive e a s ing p o lic ies. T h e c h a r t f u r th e r h igh ligh ts a s te e p inc r e a s e f o llowing t h e c o vid p a n d e m ic in e a r ly 2020 - s u g g e s tin g t h a t c e n tr a l b a n ks a r e inc r e a s ing ly w o r r ied a b o u t n o t b e ing a b le to m a int a in s ta b le p r ic e s in t h e e c o n o m y, lea d in g th e m to a c c u m u lat e m o r e a s s e ts o n t h e ir b a lan c e s h e e ts in o r d e r t o
p ro p e rt i e s o f th e as s e t i ts e l f. H o w e ve r, th i s arr an g e me n t re main s u b o p ti ma l
h a ve so m e in s tr u m e n ts t o h a ve t h e c a p a c ity t o in f lue n c e t h e m a r ke ts in a n y sign if ic a n t w a y.
IV. Su m m ar y a n d co n clus ion
In re ce n t y e ar s , th e im p o rta n c e o f cr e d it ris k h as b e e n w id e ly u n d e rp lay e d . In cre as e d p ar ticip at ion o f re ta il tra d e rs 23 , ala rm in gly in cre as in g a m o u n t o f m ar g in d e b t an d h igher m ar ket v o lat ili ty , all con trib u t e to th e p re d is p o s itio n o f th e m ar kets to f as t, u n p re d ictab le d ra w d o w n s . Du e to t h e s e an d o th e r f act o rs , cre d it ris k h a s in cre as e d s ignifi can tly , as can b e s e e n th ro u gh th e as tro n o m ical growth in th e d e f au lt ra te f ro m 0.15 % in 1981 t o 2.74% in 2020 f o r corp o ra te b o n d s (b o th in v e s tme n t - an d s p e cu lat iv e - grad e ) acco rd in g to an an n u al S& P re p o rt .
Be cau s e o f th is , it h as b e come e v e r m o re i m p o rta n t f o r in v e s tme n t m an agers to m in im is e th e ir e xp o s u re to cre d it ris k. For alt e rn at iv e as s e t m an agers (m an agers o f h e d ge f u n d s ), in p ar ticu lar, w h o u s e cre d it ris k to h e d g e th e i r e xp o s u re to m ar ket ris k, th e q u e s tio n t h e n b e come s o f m ain ta in in g s im ilar le v e ls o f e f f e ctiv e h e d ge aga in s t as s e t p rice d ra w d o w n s w h ils t re d u cing th e ir r e lian ce o n ris k - o n p ro d u cts for h e d ging.
Ris k - o n m an age m e n t h as b e come d o u b tles s v ita l in re ce n t y e ar s d u e to in cre as e d a b u n d an ce o f s h o rt - s q u e e ze p h e n o m e n a. Wh e th e r s u ch e v e n ts o ccur b e cau s e o f in cre as e d re ta il in v e s to r p re s e n ce 24 , coo p e ra tio n an d th e ab ili ty to amas s s ignifi can t n e t p o s itio n s (as in th e cas e o f ra p id in f o rm at ion d is s e m in at io n d u rin g th e G ame Sto p d e b acle ), o r f ro m e xt e rn al p rice p re s s u re s (as in th e cas e o f s u p p ly ch ai n b o tt le n e cks in la te 2021 o r com m o d ity s carcity d riv e n b y ge o p o litics ), s h o rt s q u e e ze e v e n ts can s ignifi can tly aff e ct e xis tin g a s s e t p rice t re n d s .
Fu rth e rm o re , g e o p o litica l an d e xo ge n o u s e v e n ts , s u ch a s th e v o lat ili ty o f e n e rgy p rice s in E u ro p e in lat e 2021 an d e ar ly 2022 as w e ll as m ar ket tu rb u le n ce d u e to u n ce rta in ty in u p comi n g m ar ket in terv e n tio n (s u ch as q u a n tit at iv e e as in g o r tigh ten in g, m o n e ta ry p o lic y , an d o p e n m ar k e t o p e ra tio n s ) con trib u te to th e i n cre as e d f ra gil ity o f th e f in an cial s y s tem 25 . In cre as e d f in an cial f ra gil ity d riv e s n o t o n ly s y s tem ic ris k its e lf b u t als o con trib u tes to in cre as in g im m in e n c e o f b o th cre d it an d co u n terp ar ty ris k.
Some o f th e in s tru m e n ts th at can b e u s e d to ach ie v e s y n th e tic h e d ging h a v e b e e n p re s e n ted in th is ar ticle . Predo m in an tly , th e ab ili ty to ge n e ra te a s y n th e tic h e d ge li e s in a d e e p e n e d u n d e rs ta n d in g o f correlatio n s th at u n d e rp in
23 Blo o mb e rg In te l l i g e n c e ' s L arr y T ab b , ac c o rd i n g to th e F i n an c i a l T i me s , e s ti mat e s th at “ re ta i l i n ve s to rs h ave o n aver a g e ac c o u n t e d fo r 23 p e r c e n t o f all US e q u i ty tr a d i n g i n 2021, mo re th an tw i c e th e l e ve l o f 2019”
24 De c re as i n g c o s ts o f marke t e n t ry fo r re tai l i n ve s to rs , i n c l u d i n g frac ti o n al s h are tr ad i n g a n d c o mmis s i o n - fre e b ro ke rag e , me an s
th e m ar ket as w e ll as th e ir h i s to rical e v o lu tio n . In v e s tme n t m an agers m u s t con s id e r correlatio n b o th b e twe e n o n e as s e t p rice o r re tu rn s w ith th o s e o f it s p e e rs , an d t h e correlatio n s w ith th e w id e r m ar ket an d w ith th e p e rf o r m an ce o f o th e r as s e t clas s e s . With th is u n d e rs ta n d in g, in v e s tm e n t m an agers m u s t p o s itio n th e m s e lv e s in a w ay th at ad m its d e ris kin g o f th e ir h o ld in gs an d ra p id s t y le s h if tin g. Sy n th e tic h e d gin g re p re s e n ts o n e w ay o f p e r m it tin g s u ch re s p o n s e s t o v ar iou s m ar ket con d itio n s w ith little e xp o s u re to th e v e ry con d itio n s th at it h e d ge s .
De ris kin g in clud e s , f o r in s ta n ce , d ire ct u n w in d in g o f as s e t h o ld in gs an d s u b s e q u e n t con v e rs ion o f p ap e r p ro f its to cas h - on - h an d , f lig h t to s afe h av e n s o r in cre as in g th e n e t s h o rt b ia s o f th e p o rtfolio in ca s e o f ass e t p rice d e t e riora tio n . H o w e v e r, in o rd e r to s u cce s s f u lly d e p l o y a s tra tegy th at can ad m i t d e ris kin g, s ty le s h if tin g is re q u ire d . In th e cry p to s p ace in p ar ticu lar, s ty le s h if tin g is v it al d u e to th e ra p id ch an ge s w ith in th e m ar ket v ia t h e im p le m e n ta tio n o f n e w techn o lo gie s o r s tra tegi e s b y m ar ket p ar ticip an ts . T h is is n o t as n e ce s s ar y in tra d itio n al m ar kets as th e y ar e w e ll - e s ta b lis h e d an d h av e p ip e lin e s th at ar e f airly cry s ta lli s e d allo w in g f o r th e lon g - ter m p e rs is ten ce o f s in gle s tra tegi e s . For an in v e s tme n t m an ager t o con s is ten tly p e rf o rm w e ll, d e p loy e d s tra tegi e s m u s t e v o lv e n o le s s q u ickly th an th e m ar ket. T h e c ry p to mark e t, d u e t o it s r ap id ev o lu tio n a llow s f o r e v e n le s s lag th an tra d iti o n al m ar kets . T o p e rm it th is agility , s ty le s h if tin g m u s t b e b ak e d in to th e p h il o s o p h y o f th e s tra tegy f ro m in ce p tio n an d b e an e xp e cta tio n , ra t h e r th a n a n e ce s s ar y m e as u re to con t ain ad v e rs e e f f e cts o n m ar ket m o v e m e n ts o n t h e p o rtfolio .
In v e s tme n t m an agers ar e e xp o s e d to all kin d s o f ris k s , w h ich can b e e xt re m e ly ch alle n gin g to cap t u re u s in g tra d itio n a l m e as u re s s u ch as th e Sort in o o r Sh ar p e ra tio s . T o th at e n d , it is v ita l f o r m an agers to p u t in e f f o rt to e xe cu te s im ilarly con v e x s tra tegi e s in o rd e r to p ro tect th e ir b ala n c e s h e e ts i n time s o f tu rb u le n t m ar ket p e rf o r m an ce at w o rs t an d to cap ita lis e o n low - p ro b ab ili ty an d b lack s w an e v e n ts at b e s t. For in s ta n ce , Sh ar p e ra tio s s h o u ld b e re d e f in e d to cap t u r e th e correlatio n b e h av iou r, ra th e r th an is o lat e d v o lat ili ty to b e tt e r re p r e s e n t th e lack o f h e d ge a gain s t con v e x p h e n o m e n a.
T h e t ru e ch alle n ge s till lie s with in t h e p ro b le m o f id e n tifyin g f o rth comi n g low - p ro b ab ili ty e v e n ts an d b e s t h e d ging ris k s
th at p ro fes s i o n al man ag e rs mu s t e i th e r s h i ft in to ass e t clas s e s th at are i n ac c e s s i b l e to re tai l tr a d e rs ( th u s g i vin g u p p o te n ti a l alp h a) o r ad ju s t t h e i r s tr ate g i e s i n o rd e r to p u t u p w i th h i g h e r vo l ati l i ty an d l o w e r p re d i c tab i l i ty o f pr i c e s an d re tu r n s o n th e i r as s e ts .
25 T h i s to p i c i s e x p l o re d i n an art i c l e b y Pa re to T e c h n o l o g i e s o n th e s h i fti n g te c to n i c s i n th e h e g e mo n y o f th e US d o l l ar
as s o ciated w ith it. On e f e as ib le s o lu tio n to th is ch alle n ge is e xe cu tin g lon g co n v e x s tra teg ie s th at in h e rit th e p ro p e rty o f s y n th e tic h e d ge allo w in g n at u ra l p ro act iv ity to s u ch e v e n t s s h o u ld t h e y mat e rialize.
T h at s aid , lim ita tio n s o f s y n th e tic h e d ging m u s t als o b e ack n o w le d ge d . Chie f ly , its e f f e ctiv e n e s s an d re le v an ce i s re d u ce d f o r s tra tegi e s w ith h igher allo cat e d cap ita l, f o r s tra tegi e s ta rge tin g l e s s o r o u trigh t ill iq u id p ro d u cts , an d f o r s tra tegi e s ta rge tin g h ighly comp le x p ro d u cts . For s u c h s tra tegi e s , im p le m e n ta tio n o f s y n th e tic h e d ging m ay b e tro u b le s o m e b e cau s e o f t h e in ab ili ty o f r ap id s ty le s h if tin g if m ar ket d e p th d o e s n o t allo w f o r s u ch o r b e cau s e o f th e in ab ili ty o f t h e man ager t o u n w in d t h e ir p o s itio n in t im e .
Synth et ic h edg in g sh o u ld b e p ri o ritis ed wh e n d ev el o p in g an tifrag il e s tr at egi es o r stra te g ies tha t a re respo n si v e t o fin an cial frag il ity . As cap ital all o cati o n t o a stra te g y in cre ases, an tif rag il ity b ecom es v ital an d sy n thetic h edg in g b ecom es an o p ti m al t o o l t o ach ie v e it.
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