Investors could arguably be forgiven for their disappointment with returns over the last few years, especially given the alpha-level fees associated with these strategies. James Skeggs, global head of advisory group at Newedge, says: “I have some sympathy with investors who bought CTAs in 2010. The Newedge CTA index has been in drawdown since 2011.”
Buy when it’s cheap?
Despite this slightly confused picture of performance, the shape of redemptions is not straightforward. Where investors stay true to their reasons for allocating to crisis alpha strategies, they are toughing things out.
According to Skeggs: “If an investor is allocating to these strategies because they are not correlated and want the diversification, they should stick with it. Those who understand the fundamental reason exactly why they got into the strategies have typically not redeemed.”
RPM’s Ivarsson, meanwhile, reports: “Some big institutions are moving into the space quite strongly, especially where there is a short decision chain between the analysts and investment decision-makers.”
The outlook for CTAs is arguably more compelling than it has been for some time. One of the dominant reasons for lack of performance from this sector over the last five years has been central bank intervention. By pumping money into the system, central banks have effectively stopped trends before they really got going. As a result, CTA models have either not been triggered or, perhaps worse, have been triggered only to need reversing again shortly after.
“In 2008 the connection between marketexpectations and reaction was disrupted by intervention,” Ivarsson explains. “Any disappointment was counteracted by stimulus. Central bank intervention is now decreasing and the relationship between expectations and market reaction is returning to normal. This is conducive to CTA strategies.”
The normalisation of interest rates should also see a return of the tailwind CTAs have traditionally enjoyed on the income gained from investing their considerable cash stockpiles in bond markets. Newedge analysis of CTA returns over the 23 years between 1989 and 2012 showed this income nearly doubled risk-adjusted returns from 0.35% to 0.67%, increasing annualised compound returns from 3.18% to 6.08%.
The cost of volatility
Meanwhile, the price of volatility is more attractive. The average forward volatility term structure has flattened considerably during the last two years. During 2012 the average forward premium paid on a sixmonth volatility contract was 44% over spot VIX. By March 2014 that premium had more than halved to 20%.
Three month VIX futures prices also fell below 20 for the first time in four years by early 2013 and have largely remained well below that level since (with a brief exception during the ‘Taper Tantrum’).
“After the crisis, everyone wanted to be long volatility so the premiums became very expensive,” Artemis’ Cole reports. “Now investors are less interested so it has become inexpensive. Wise investors should be thinking of allocating to the space.”
Diversification
For investors wanting to diversify and gain potentially return-generating protection from the risk of over-valued equity markets, crisis alpha looks to be in a potentially opportune position. The environment for CTAs is improving while the falling price of volatility suggests the asset class is becoming cheap. The same basic rules apply to crisis alpha as any other asset class: diversify risk, maintain discipline and buy low, sell high.
As the Church Commissioners’ Joy states: “It is difficult to predict when to put this kind of strategy in place, but when it is cheap is often a good time. Now is not the time to give up on diversification.”
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