Quarantined From Market Risk?

by Fred Ingham, Head of International Hedge Fund Investments, Neuberger Berman

We look at whether “uncorrelated strategies” lived up to their label through the COVID-19 crisis.

This edition of CIO Weekly Perspectives comes from guest contributor Fred Ingham.

Three years ago, Neuberger Berman launched a liquid alternatives investment strategy with the goal of creating a return profile uncorrelated to equity or fixed income markets over the medium term. Building this portfolio meant consciously including certain strategies that had demonstrated a tendency to perform well during periods of market disruption.

The crisis in the first quarter of 2020 provided a good test of this principle; how did those strategies fare?

Overall, the uncorrelated strategy groups performed in line with our expectations and generally held up well during the first quarter of this year. Our own portfolios maintained positive performance through the downturn in March, but also during the second-quarter rebound.

The stand-out performers tended to be among the short-term trading and volatility relative value strategies. Let’s take a quick look at how these two strategies work and why they were able to deliver so well in the first part of this year.

The Perfect Edge

There are many varieties of volatility traders with different payoff profiles. In the relative value space, we focus on strategies that buy and sell equity options contracts but seek to maintain “positively convex” payoff profiles—in other words, they generally benefit from sudden large moves. These are differentiated from outright “tail-risk” managers, who are structurally biased toward buying options because relative-value players seek to trade actively on both sides in order to avoid a heavy drag from paying option premia.

Opportunities arose during the first quarter as general panic and forced selling by market participants who were structurally short-volatility created short-term dislocations in options markets. Examples included anomalies in the relationship between the CBOE Volatility Index (VIX) and the S&P 500 option contracts on which it is based, mispricing between options in different regions and countries, and simple cheapness in implied volatility versus realized market movement at certain points in time.

Already on the front foot due to their structural positioning, some sophisticated volatility traders were able rapidly to assimilate and analyze price action, monetize these often short-lived anomalies and move on. By contrast, tail-risk players may have maintained their outright long-volatility exposure into the second quarter and therefore given back a lot of their gains as markets recovered.

Just as faster traders in options markets generally navigated confidently through the sharp up-down-up of February, March and April, so did the faster traders in the broader futures markets across equities, currencies and fixed income.

Short-term futures trading involves holding positions over horizons of weeks, days or even hours. Based on rapid systematic analysis of futures price movements, often with no view on economic fundamentals, they seek to identify very short-term momentum and breaks in markets, as well as situations where markets temporarily lose their co-ordination with one other.

This often gives them the perfect edge when markets become very “technical” and waves of forced or panicked selling and buying set in. February, March and April 2020 will now be a textbook example of these conditions.

Returns and Resilience

This doesn’t mean one can build an uncorrelated portfolio from only short-term trading and volatility strategies.

When market volatility is within normal ranges, strategies such as equity market neutral or statistical arbitrage may have a better chance of generating steady, uncorrelated return profiles.

Moreover, every bear market is different. When shocks and crises amplify rather than reverse recent conditions, strategies such as trend-following or global macro could potentially make bigger returns than short-term trading: it was they who led the pack during the more drawn-out crisis of 2008 – 09, for example.

Diversification is critical, then, in order to maintain acceptable returns over a cycle.

It is also worth noting that the first quarter of 2020 saw very significant dispersion between different managers even within the various strategy categories. Not all volatility relative value managers performed strongly, for example, and some were found to be caught out by the very conditions they professed to be designed for. Building portfolios of uncorrelated strategies therefore demands forensic manager selection as well as the ability to view risk through multiple prisms and maintain control of capital. In our view, investing via managed accounts rather than pooled vehicles lends significant benefits in this regard.

Following these principles, we believe the first half of 2020 has given strong support to the uncorrelated strategies concept.