New Absolute Return Strategies for Wealth Management

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F.S. Lhabitant

Kedge Capital Fund Management Ltd is advised by Steadfast Advisory Services Ltd, a connected company authorised and regulated in the U.K. by the Financial Services Authority.

New Absolute Return Strategies for WealthManagement

Francois-Serge Lhabitant Chief Investment Officer, Kedge Capital, Professor of Finance, H.E.C. Lausanne and EDHEC

[email protected]

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F.S. Lhabitant


References

– Chardon M., Lhabitant F.S., Mirlesse D. (2006), Absolute Returns in Wealth Management: Implementing Risk Controlled Strategies, The Journal of Financial Transformation, vol. 16, pp. 111-121.

– Lhabitant F.S., Mirlesse D. (2007), Global Asset Management, forthcoming at John Wiley and Sons, London, 288 pages.

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Question

How should we allocate to equities as an asset class?

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Long only managers

Long only managers are the traditional way of gaining exposure to equity markets.

Long only managersPortfolio with adjusted

market exposure

Equity Markets

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Little Evidence of Equity Alpha

Mutual fund managers under-perform equity indices on the long-run.

Indexing is more effective.

0.00%

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Return comparison of Lipper and S&P indices.

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Little Evidence of Equity Alpha

VALUE STOCKS

BLEND GROWTH STOCKS

Before tax

After tax

Before tax

After tax

Before tax

After tax

Large Cap 87% 97% 81% 94% 54% 80% Mid Cap 82% 91% 67% 84% 57% 78% Small Cap 43% 94% 17% 44% 16% 29% Source: Morningstar, BGI

Percentage of active managers under-performing their reference index (U.S. equity funds, from January 1995 to December 2004)

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Excessive fees

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Correlation with the market

Implied feesfor active management

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Long only managers

A long only strategy can be decomposed into an active and a passive component.

Passive strategyActive strategy

Indexing vehiclesLong/Short Managers

Long only managersPortfolio with adjusted

market exposure

Equity Markets

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Active Strategies:Long/Short Managers

– Active strategies– Aim at maximizing performance subject to constraints set by

investors.– Investing in skills.– Relative independence from the market cycles.– Possible underperformance during strong bull markets.– Importance of fee structure.

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Active Strategies:Long/Short Managers

Hedge fund indices tend to have significant beta exposure to equity markets. They have a long bias.

But it is still possible to find long/short equity managers that are relatively independent from market conditions.

R2

R2 heat map of an hedge fund index and several active managers regressed versus equity indices.

EDHEC L/S Mgr 1 Mgr 2 Mgr3 Mgr 4 Mgr 5. Mgr 6MSCI WORLD VALUE INDEX

MSCI Value North America USDMSCI EAFE VALUE INDEX

MSCI Value Europe USDMSCI WORLD GROWTH INDEX

MSCI Growth North America USDMSCI EAFE GROWTH INDEX

MSCI Growth Europe USDMSCI Emerging Markets

S&P BARRA VALUE INDEXS&P BARRA GROWTH INDEX

S&P 500 INDEXNASDAQ COMPOSITE INDEX

RUSSELL 2000 INDEXRUSSELL 3000 INDEX

RUSSELL 2000 VALUE IDXRUSSELL 2000 GROWTH IDX

RUSSELL 2000 TECHNOLOGYRUSSELL 2000 HEALTH CARE

RUSSELL 2000 CONSMR DSCRRUSSELL 2000 CONSMR STPL

RUSSELL 2000 INTGRTD OILRUSSELL 2000 OTHR ENERGYRUSSELL 2000 MTRL & PROC

RUSSELL 2000 PROD DURBLSRUSSELL 2000 AUTO & TRNS

RUSSELL 2000 FINCL SERVRUSSELL 2000 UTILITIES

RUSSELL 2000 OTHER

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Passive Strategies:Indexing Vehicles

– Index funds– Traditional tracking vehicle.

– Exchange Traded Funds (ETF) – Low operating cost, liquid and tax efficient.– Issues on brokerage cost and dividends.

– Futures and Synthetic Indexing– Mix of cash and long futures.– Lower transaction costs than ETF and index funds. – Uncertainty on rollover conditions and realized dividend.

– Swaps and Synthetic indexing– Pay Libor + Spread and receive the total return on an index.– No tracking error.– More cost-effective ETFs.– Liquidity and credit exposure issues.

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Passive Strategies:Transaction CostsETF Futures TRS ETF Futures TRS

Commissions 4 4Management Fees 15 6Spread 4 20 2 6Funding 9 9+20 17 17+15Stock Lending -9Dividends Tax 43 0 0 52 0 0Custody 4 4Net Cost 57 33 29 64 27 32Average Daily Deviation -0.14* -0.29** 0 -0.004* -0.005** 0Tracking Error 67 58 0 31 17 0

** Period Dec 02 to Jun 05 *Period Apr 00 to Jun 05** Period Dec 02 to Jun 05 *Period Jan 95 to Jun 05

Europe (STOXX 50) U.S. (S&P 500)

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Equity Risk Premium

On the long run, stocks outperform bonds.

On the short run, equity markets require risk control.

The equity risk premium.over 12-month and 36-month holding periods

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Risk Controlled Strategies: Option Based Portfolio Insurance (OBPI)

– Not a new idea: it was already invented in the late 1980’s.

– OBPI = buy a protective put option on the index.– May also be implemented through call options

– As for any insurance strategy, there is a premium to pay upfront.– an expensive protection implies a smaller amount to allocate to the index,

and therefore, a lower participation to the upside

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Upside participation rate as a function of the capital protection required and the prevailing interest rate. The volatility level is assumed to be 25% for all cases, and

the maturity of the strategy is one year.

Capital protection 100% 95% 90% 85% 80%

2.0% 91.8% 93.9% 95.6% 97.0% 98.1% 3.0% 92.3% 94.2% 95.9% 97.2% 98.2% 4.0% 92.7% 94.5% 96.1% 97.4% 98.4% 5.0% 93.1% 94.9% 96.4% 97.6% 98.5%

Interest rate

6.0% 93.4% 95.2% 96.6% 97.8% 98.6%

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– Out-of-the-money put options are usually far more expensive (in implied volatility terms) than at-the-money options.

– Fear of market crashes ?

– The set of available maturities for put options is limited and the longer term ones are often illiquid.

– Rolling out a sequence of short-maturity options results in a highly path-dependant strategy.

– Alternative– Dynamic strategy with a delta-based readjustment of the hedge.– Drawback: transaction costs, buy high & sell low path type.

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Risk Controlled Strategies: Constant Proportion Portfolio Insurance (CPPI)

– Introduced by Perold, Black and Jones in the 1990s

– Simply stated: buy when the index rises in value and sell when it falls in value.

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CPPI Floor

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– In a flat oscillating market, however, the CPPI will do relatively poorly, as the investor buys on strength only to the see the market weaken

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– In addition, the CPPI strategy is purely driven by the profit and losses of the portfolio, but has no consideration whatsoever of the risk conditions prevailing on the market.

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Risk Controlled Strategies: Volatility Cap

– A dynamic allocation rule that aims at maintaining a constant target risk exposure (measured in terms of volatility) to equity markets.

– Systematically increasing the index exposure as the index volatility falls below the target and decreasing the index exposure when the index volatility rises above the target.

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Risk Controlled Strategies: Volatility Cap

– The VC strategy only attempts to provide downside protection by reducing the index exposure during periods of high volatility.

– No “guarantee” of a floor amount for the portfolio. – Completely ignores the P&L on the portfolio– Ignores any notion of risk budget.

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Risk Controlled Indexation – Key Principles

– Determine the desired annual risk budget (10% p.a.).

– Derive a daily risk budget as a portion of this total risk budget.– Daily Risk Budget = Min (30% of the Total Risk Budget, 3% of

Portfolio Value)

– Establish the corresponding market exposure.– the portfolio’s daily 1% value at risk (at a confidence level of

99% in our case) is always equal to the daily risk budget.

– Adjust the exposure daily according to market volatility and P&L

– Issue a daily series of stop losses based on the available risk budget.

– Benchmark– The relevant index plus a one-year put option @ 90%.

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Risk Controlled Indexation: Historical Comparison

Downside protectionMaximal loss: -10% (risk budget in the presented simulation).

Several cases of outperformance relative to the index.

-50%-40%-30%-20%-10%

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Risk Controlled Indexation versus index: 1 year simulation, daily rolling, January 1990 to June 2004

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Risk Controlled Indexation

The RCI strategy. The numbers on the horizontal axis indicate the level of market volatility (basis of 100 at inception)

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100 143 83 68 39 41 44 43 44 43 45 44 43 43 129 136 136 135 124Volatility Level

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Exposure Index RCI FloorPortfolio value Exposure level

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VC in a Bear Market

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Exposure IndexPortfolio Floor

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CPPI – what would have happened

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RCI - What would have happened

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RCI with an early market crash and a smooth recovery

Deep market fall early in the year brings the equity exposure close to its minimum level.

Market recovery is accompanied by a significant volatility which limits the exposition’s increase.

Discretionary decision could then be taken as whether to close the portfolio or inject some extra risk budget.

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Risk Controlled Indexation: early market crash simulation, 1 year period

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CPPI – what would have happened

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VC – what would have happened

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Portfolio FloorVC Portfolio value Exposure level

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CPPI in a crash and volatile recovery

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RCI – what would have happened

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VC – what would have happened

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Capital Protection: Market Conditions & Summary Table

MARKET VOL. CAP CPPI RBPIBull Market, Low vol +++ +++ +++ +++Bull Market, High Vol +++ ++ ++ ++Bear Market, Low vol --- --- - --Bear Market, High Vol --- -- - -Flat Market, Low vol = = - =Flat Market, High Vol = = -- -

VOL. CAP CPPI RBPI

Downside Protection

Path Dependency

Trading Volume

Equity Exposure

Index Vol. Impact

No Yes Yes

YesYesYes

Depends on the index's

Vega

Depends on the index's Volatility

Limited

Determined by risk

budget and market risk

Determined by P&L to

date

Determined by current volatility

relative to target

Negative Impact

Negatively correlated to the exposure

Reduced exposure

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Conclusions

– An effective way to track an index while having some downside protection.

– The downside protection is based on risk, not just on P&L.

– Costs are extremely low.

– The strategy is highly scalable.

– We are happy…

New Absolute Return Strategies for Wealth Management

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