Thu, Aug 21, 2014
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Opalesque Futures Intelligence

Futures Lab: Insight on how to make the tails of the distribution work for you in hedge fund investing

Tuesday, March 10, 2009

FUTURES LAB

Making the Tails Work for You

A study by three researchers from Graham Capital Management shows that systematic macro and dedicated short bias investments have a positive skew – fat right tails – while most other hedge fund strategies have a negative skew. The authors, Peter Park, Oguz Tanrikulu and Guodong Wang, conclude that conventional measures are not accurate indicators of risk. Below is an edited excerpt from their paper.

The most commonly used metric of hedge fund strategy performance is the Sharpe ratio. This is the ratio between the annualized return and annualized volatility; it implicitly assumes that volatility is a full measure of risk. When returns are normally distributed, the Sharpe ratio is an appropriate measure of reward versus risk.

But when returns are not normally distributed, the Sharpe ratio by itself may lead to a mis-estimation of the potential reward versus risk. One way to analyze this issue is to look at skew, which measures a distribution's symmetry. A skew of zero indicates that the distribution is symmetric; negatively skewed distributions have thicker left tails than right, whereas positively skewed distributions have thinner left tails than right.

All else being equal, an investor would prefer strategies with the most positive skew—thick right tail and thin left tail. These would be strategies with large positive returns and the fewest occurrence of large negative returns.

Another method of measuring this characteristic is the ratio of upside to downside volatility. A low upside-to-downside volatility ratio implies that the underlying strategy has large losses more frequently than large gains. This undesirable property can also be detected through a negative skew with high excess kurtosis—a fat left tail.

The table below contains annualized statistics for major hedge fund style indexes based on monthly returns data from January 1994 to December 2008. The starting date is chosen to coincide with the beginning of CSFB/Tremont hedge fund data, which is used for all strategies except systematic global macro.

The Barclays Systematic Traders Index was chosen to represent systematic global macro. Funds in this strategy may also be classified as global macro, managed futures or trend-following/Commodity Trade Advisor. CSFB/Tremont does not report an appropriate index for this strategy.

We find that most strategies have a low upside/downside volatility ratio, with only systematic traders and dedicated short bias having a ratio around or above one. A low upside/downside volatility ratio would indicate that the distribution of returns is skewed towards the left. This is confirmed by analyzing skewness. Of the styles with low upside/downside volatility ratios, most have negative skew, as shown in the table.

To summarize, except for systematic traders and dedicated short bias, hedge fund styles have low upside/downside volatility, most have negative skew, and most have high excess kurtosis.

Descriptive Statistics of Monthly Returns
  Annualized ReturnUpside/Downside VolSkew
Systematic Traders 6.8%0.90.22
Equity Market Neutral5.6% 0.1-11.9
Fixed Income Arb3.5%0.2-4.6
Event Driven9.6%0.3-2.7
Long/Short Equity9.7% 0.70.02
Convertible Arb5.5%0.3-3.5
Dedicated Short Bias-0.81.30.77
Emerging Markets 6.7%0.7-0.7

Given the skew statistics, it is likely that monthly returns are not normally distributed. Thus it is not surprising that both systematic traders and dedicated short bias are in the bottom half of strategies when the Sharpe ratio is the metric used to measure performance.

A statistical test showed that only systematic trader returns are likely to be normally distributed. For all other strategy types, we can reject the null hypothesis of a normal distribution at the 99% confidence level. We can conclude that the Sharpe ratio is not a good measure of reward per unit risk.

It is highly probable that when a Sharpe ratio calculated from monthly returns is used to assess risk, the estimated risk is too high for systematic traders and dedicated short bias, while it is too low for the remaining strategy types.



 
This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing
  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. Institutions – Texas Employees sets 2015 tactical plan for alternatives, CalPERS' real estate consultant cautions the pension fund's investment committee, Why Sunsuper likes hedge funds[more]

    Texas Employees sets 2015 tactical plan for alternatives From PIOnline.com: Texas Employees Retirement System will invest in up to four new hedge funds in the next fiscal year, which begins Sept. 1. Trustees approved 2015 tactical investment plans for the hedge fund, private equity and in

  2. Private equity follows hedge funds into reinsurance for long-term capital[more]

    From Artemis.bm: It’s not just hedge funds that are entering the insurance and reinsurance market in search of so-called long-term capital to put to work in their strategies, private equity firms targeting the space are also seeking opportunities to add assets under management. The entry of large pr

  3. North America – New York City’s next hot neighborhoods targeted with property funds[more]

    From Bloomberg.com: New York’s real estate world is filled with tales of ordinary people who bought property decades ago and saw values skyrocket to the millions. Seth Weissman is seeking investors to get in early on the next hot neighborhoods. The veteran of Goldman Sachs Group Inc. and hedge

  4. Investing – George Soros bets $2bn on stock market collapse, Warren Buffett's Berkshire reveals Charter stake, cuts DirecTV, Hedge funds lusting to cash out of MGM, Top hedge fund managers are buying Ally Financial, Hedge funds dumped 5m Herbalife shares in Q2, Paulson & Co hedge fund ups Puerto Rico real estate bet, Netflix Inc., Citigroup Inc, Google Inc are top new picks in Tiger Management’s 13F[more]

    George Soros bets $2bn on stock market collapse From Newsmax.com: Billionaire investor George Soros has increased his financial bet that U.S. stocks will collapse to more than $2 billion. The legendary hedge fund manager has been raising his negative bet on the Standard & Poor's 500 Inde

  5. Investors now net short S&P500 and increased Russell shorts, technicals suggest further selling[more]

    Komfie Manalo, Opalesque Asia: Market Neutral funds increased their market exposure to -1% net short from -6% net short last week, according to Bank of America Merrill Lynch’s Hedge Fund Monitor. The report also added