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A Primer on Overlays www.mcubeit.com Dr. Arun Muralidhar Arun Muralidhar - Bio Chairman of Mcube Investment Technologies, LLC and Managing Director at FX Concepts, Inc. Head of Investment Research and Member of Investment Management Committee, World Bank Investment Department, 1995-1999 Derivatives and Liability Management, World Bank Funding Department, 1992-1995 Managing Director and Head of Currency Research, JPMIM, 1999-2001 BA, Wabash College (1988); PhD, MIT Sloan (1992) 2 Agenda Overlays – TAA or Currency Underused by most funds Internal versus External Capability, fees and product offerings New paradigm: alpha from good decisions AlphaEngineTM: empower clients to make better decisions 3 Case for Overlays Markets are inefficient – currency is best example Low correlations across assets - “informed decision making” will be profitable Can be implemented with little cash (derivatives) An excellent source of uncorrelated alpha Sophisticated Clients can Implement at Low Cost 4 TAA Case Study: Many Possible Ideas Total Portfolio US Equity 50% EAFE 20% US Fixed Income 25% Cash 5% Decisions to be made on allocation between asset classes: Domestic vs International Equities (Stock-Stock) Domestic Equities vs Domestic Bonds (Stock-Bonds) Domestic Bonds vs Cash (Bonds-Cash) Assume Asset Limits of +/- 5% from Benchmark Weight 5 Simple/Intuitive Rules Tested Rule Rule Description Cash vs. Bonds, based on Gold Duration choice based on price of gold. If the spot price of gold is higher than it was a year ago, overweight cash, otherwise overweight bonds Stocks vs Bonds: Halloween Effect Stocks vs Bonds: Inflation/Growth Market Volatility Stocks tend to underperform bonds between June and Sept - apparently works in 16 out of 18 stock markets, so underweight stocks during this period Equities undervalued when inflation rises (Modigliani-Cohn insight); equities favored when industrial production is increasing Low equity volatility in a rising stock environment is bullish for equities. Oil and Economy Rising oil prices affect the economy and tend to depress equities. P/E Ratio Rule Value rule for equity (vs FI) using the S&P 500 P/E Fed Model When equity yield is higher than treasury yield then buy equity, else sell equity Unemployment Rate Buy stocks when the unemployment rate is falling (good for economy) US/EAFE: LIBOR Rates Overweight equity market with the stronger currency (higher interest rate) US/EAFE: Favor Underperformer Overweight equity market which has underperformed over past year (i.e., buy the laggard) 6 Rule Performance (1998-2004) Excess Annualized Information Confidence Success Ratio Good Max Return Ratio in Skill Ratio /Bad Risk Drawdown Rule Cash vs. Bonds, based on Gold 0.04% 0.20 68.8% 56.4% 1.30 -0.44% Halloween Effect 0.98% 0.88 98.0% 63.8% 1.42 -1.58% Inflation/Growth 0.50% 0.57 93.1% 79.7% 1.07 -1.31% Market Volatility 0.12% 0.11 67.8% 56.4% 1.41 -2.74% Oil and Economy 0.45% 0.57 91.6% 70.5% 1.16 -0.84% P/E Ratio Rule 0.17% 0.39 87.1% 50.0% 2.12 -0.80% Fed Model Unemployment Rate 0.47% 0.51% 0.50 0.61 91.8% 94.1% 61.5% 59.0% 1.43 0.99 -2.17% US/EAFE: LIBOR Rates US/EAFE: Favor Underperformer 0.17% 0.53% 0.43 0.95 84.7% 99.3% 55.1% 64.1% 1.07 1.33 -0.71% -1.11% -1.07% Monthly Decisions – No Transactions Costs 7 Strategies (Mix of Rules) Tested Strategy Name Strategy Description Rebalancing I Quarterly Rebalancing to Benchmark Weights Rebalancing II Rebalance to Benchmark Weights when Range of +/-5% Breached Combination of Rules: 6 Best Excess Annualized Returns () and Information Ratios – Cash vs Bonds, Halloween Effect, Inflation/Growth, Unemployment Rate, Fed Model, US/EAFE: Favor Underperformer (all equally weighted) 6 Lowest Annualized Standard Deviation (Risk) - Cash vs Bonds, Oil and Economy, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor Underperformer (all equally weighted) 3 Highest and 3 Lowest Risk - Cash vs Bonds, Halloween Effect, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor Underperformer (all equally weighted) Strategy 1 Combination of Rules: Strategy 2 Combination of Rules: Strategy 3 8 Strategy Performance (1998-2004) Strategy Rebalancing I Quarterly Rebalancing II Range of 5% Strategy 1 (highest 6 Excess Returns/IR) Strategy 2 (lowest 6 risk) Strategy 3 (Highest 3 Excess, lowest 3 Risk) Excess Annualized Return Information Confidence Success Ratio Good Max Ratio in Skill Ratio /Bad Risk Drawdown -0.22% -0.87 NM 29.5% 1.26 -1.50% -0.42% -1.11 NM 33.3% 0.96 -2.74% 0.44% 1.29 99.97% 64.1% 2.11 -0.21% 0.32% 1.20 99.90% 61.5% 1.54 -0.28% 0.36% 1.42 99.99% 57.7% 2.09 -0.20% Informed decisions significantly outperform rebalancing Rule diversification enhances information ratios 9 Fixed Income 30% Strategy 2 Strategy 3 n98 Ju l-9 Ja 8 n99 Ju l-9 Ja 9 n00 Ju l-0 Ja 0 n01 Ju l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 4 Ja 4 Ju l -0 3 Ja n04 Ju l -0 2 Ja n03 Ju l -0 1 Ja n02 Ju l -0 Strategy 1 Ja n98 Ju l-9 Ja 8 n99 Ju l-9 Ja 9 n0 Ju 0 l-0 Ja 0 n0 Ju 1 l-0 Ja 1 n02 Ju l-0 Ja 2 n03 Ju l-0 Ja 3 n04 Ju l-0 4 4 Ju l-0 3 Ja n04 Ju l-0 Ja n03 2 Ju l-0 Ja n02 1 0 Ja n01 Ju l -0 9 Ja n00 Ju l -9 8 Ja n99 Ju l -9 Ja n98 55% Ju l-0 Ja n01 0 Ju l-0 Ja n00 9 Ju l-9 8 Ja n99 Ju l-9 Ja n98 Historical Allocations to Asset Classes US Equity 25% Intl Equity 50% 20% 45% 15% 25% 5% 20% 0% Strategies 2 & 3 have same rules/allocation 10% Cash All strategies have same rule/allocation 10 Currency Case Study: Easy Alpha Currency Portfolio JPY (30%) EUR (50%) GBP (20%) Three rules make money: Trend, Carry/Yield and Options Work in Divergent, Convergent and Sideways Markets, respectively Potential to add in other currencies and make more complex Rules will, by construct, have high tracking error: +100%/-100% 11 Simple Rules Work (1994-2004) Trend – if 25 day moving average > 65 days moving average, BUY, else SELL Carry – SELL currency with low interest rate Yield – SELL currency with steep yield curve Options – Are overpriced, SELL Not highly correlated – good diversification Need Not Pay Active Fees for Simple Rules 12 Performance of JPY Rules/Strategies Rules Evaluated: (a) yield curve; (b) carry; (c) moving average USD/JPY Strategy = 40% Yield curve and Carry, 20% MA Diversification improves information ratio, skill, & drawdown Strategy/ Rules USD/JPY Strategy USD/JPY Yield Curve USD/JPY Carry USD/JPY MA 20-65 Annualized Annualized Std Return Deviation Information Cumulative Confidence Success Ratio Return in Skill Ratio Ratio Good Max /Bad Risk Drawdown 4.59% 8.56% 0.5365 57.45% 94.17% 52.86% 0.9103 -20.45% 4.54% 11.59% 0.3919 56.68% 85.59% 53.43% 0.8564 -26.21% 4.33% 11.59% 0.3741 53.57% 84.26% 52.37% 0.8613 -26.21% 3.62% 11.59% 0.3121 43.22% 79.05% 51.12% 1.06 -20.51% 13 Performance of EUR Rules/Strategies Rules Evaluated: (a) yield curve; (b) carry; (c) moving average USD/EUR Strategy = 40% Yield curve and Carry, 20% MA Trend model losses are meaningful; but moderate lower drawdown and worst single performance of the strategy Strategy/ Rules USD/EUR Strategy USD/EUR Yield Curve USD/EUR Carry USD/EUR MA 20-65 Annualized Annualized Std Information Cumulative Confidence Success Ratio Good Max Return Deviation Ratio Return in Skill Ratio /Bad Risk Drawdown 3.79% 5.09% 0.7444 45.69% 98.89% 55.21% 0.9793 -7.78% 5.20% 6.26% 0.8301 40.10% 98.42% 82.95% 0.8599 -8.08% 8.48% 9.71% 0.8729 127.66% 99.56% 55.21% 0.8997 -13.07% -5.22% 9.72% -0.5372 -41.86% 3.13% 46.68% 1.1392 -49.12% 14 Can Be a Consistent Alpha Source 15 Internal versus External Internal May require use of derivatives (not critical as portfolio drift/rebalancing is an active decision) Can keep costs down; better control External Some Less strategies better suited – Options career risk; long record of having added alpha 16 AlphaEngineTM: Empower Clients Brings state-of-the-art management to pension funds Easy to use: Clients generate ideas – software does work Test strategies in a few minutes Client can customize to their structure and objectives No consulting!! Client can make all decisions better Very transparent: See impact of all decisions on individual asset class or entire fund (easy to read) 17 Summary Many (explicit and implicit) decisions in a portfolio Each is an opportunity for alpha/risk management Overlays can help manage these risks for return Good governance: cost/return impact of every decision Must aggregate impact of all decisions on portfolio AlphaEngineTM: adopt best practices quickly and easily 18 Appendix Fund Responsibilities AssetLiability Risk Tactical & Benchmark Risk Manager/ Active Risk Responsibility Responsibility Trustees Internal Staff Managers Monitor Decision Frequency Annually Daily/Monthly Monthly Manage How to Manage the Risk Strategic Allocations & Funding Policy Asset, Sector, Style and Currency Allocations Manager Selection and Allocation Staff are Making Many Decisions (Implicitly) Periodically 20 Effective Decision Making Low asset correlations allow “informed decision making” Identify rule ideas to allocate across asset classes Select criteria for rule/strategy evaluation (excess return, information ratio, skill, success rate, drawdown) Analyze rule performance, test different strategies (rule combinations) - diversification benefits not obvious Test alternative policies versus rebalancing options Assumed Monthly Decisions (1998-2004); No Transaction Costs 21 Extensions Each decision is an opportunity for more returns/risk management More tiers = greater diversification, efficacy = more returns Within asset classes (Fixed Income, Equities, Currencies) Managers: Active versus passive and across managers Leverage asset managers to generate research ideas for decisions Rule were equally weighted; opportunity to further improve Evaluate ideas in isolation as well as part of a total portfolio (aggregation produces results that are not obvious) Improve fund governance, and in turn, returns and risk 22 Relaxing Asset Limits to +/- 10% Excess Annualized Information Confidence Success Return Ratio in Skill Ratio Strategy Ratio Good Max /Bad Risk Drawdown Rebalancing II - 5% Range Rebalancing II - 10% Range -0.42% -0.11% -1.11 -0.16 NM 31.95% 33.3% 46.2% 0.96 1.60 -2.74% -2.48% Strategy 1 - 5% limit Strategy 1 - 10% limit 0.44% 0.93% 1.29 1.29 99.97% 99.97% 64.1% 68.0% 2.11 1.91 -0.21% -0.50% Strategy II - 5% limit Strategy II - 10% limit 0.32% 0.51% 1.20 1.16 99.90% 99.85% 61.5% 62.8% 1.54 1.91 -0.28% -0.26% Strategy III - 5% limit Strategy III - 10% limit 0.36% 0.75% 1.42 1.50 99.99% 99.99% 57.7% 66.7% 2.09 1.90 -0.20% -0.44% Change in asset range produces higher ; other measures improve or stay within acceptable range 23 Multi-tiered Alpha Aggregation Alpha = 1.5% Total Portfolio Asset allocation/ rebalancing strategy US Equity 50% Intl Equity (EAFE) 20% US Fixed Income 25% Cash 5% Alpha = 0.5% Equity strategy – Large vs Small Cap Small Cap Russell 2000 Alpha = 0.5% Large Cap S&P500 Manager rule to determine allocation between managers/index Passive (S&P500) Enhanced Index (Manager A) Active (Manager B) Alpha = 0.5% 24 Performance of GBP Rules/Strategies Rules Evaluated: (a) yield curve; (b) carry; (c) moving average USD/GBP Strategy = 40% Yield curve and Carry, 20% MA GBP is hardest to model Strategy/ Rules USD/GBP Strategy USD/GBP Yield Curve USD/GBP Carry USD/GBP MA 20-65 Annualized Annualized Std Information Cumulative Confidence Success Return Deviation Ratio Return in Skill Ratio Ratio Good Max /Bad Risk Drawdown 1.50% 5.56% 0.2703 16.29% 77.97% 53.20% 0.9408 -17.50% 0.15% 7.80% 0.0192 1.53% 47.49% 49.53% 1.0048 -29.22% 3.00% 7.80% 0.3847 34.85% 86.41% 53.54% 0.9758 -17.95% 0.50% 7.80% 0.0642 5.18% 53.18% 52.97% 0.8862 -29.63% 25 -20% 0% Jun-04 Dec-03 Jun-03 Dec-02 -100% Jun-02 -80% Dec-01 -60% 0% Jun-01 -40% -20% Jun-04 Dec-03 Jun-03 Dec-02 Jun-02 Dec-01 Jun-01 Dec-00 Jun-00 Dec-99 Jun-99 Dec-98 Jun-98 Dec-97 Jun-97 Dec-96 Jun-96 Dec-95 Jun-95 Dec-94 Jun-94 USD/JPY HEDGE POSITION Dec-00 20% Jun-00 40% Dec-99 60% Jun-99 80% Sell USD Short……Hedge 100% Jun-04 Dec-03 Jun-03 Dec-02 Jun-02 Dec-01 Jun-01 Dec-00 Jun-00 Dec-99 Jun-99 Dec-98 Jun-98 Dec-97 Jun-97 Dec-96 Jun-96 Dec-95 Jun-95 Dec-94 100% Dec-98 Jun-98 Dec-97 Jun-97 Dec-96 Jun-96 Dec-95 Jun-95 Dec-94 Jun-94 -20% Jun-94 0% Sell USD Short………Hedge 100% Sell USD Short………Hedge 100% Allocation Results USD/EUR HEDGE POSITION 100% 80% 60% 40% 20% -40% -60% -80% -100% USD/GBP HEDGE POSITION 100% 80% 60% 40% 20% -40% -60% -100% -80% 26