Stop Blaming Witchcraft: Your Portfolio Isn't Cursed

What exactly is a multi-strategy fund? Why are more investors turning to them as a solution, and how do they differ from conventional hedge fund strategies?

 

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Investors have often relied on simple but expensive puts to hedge against downside risk and create convexity. But options are not the only option.

 

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This article first appeared in Forbes here.

Markets like these are enough to make anyone suspect foul play. Surely some malign force lies behind the double-digit losses across equities and bonds?

100 years ago, a young anthropologist named Edward Evan Evans-Pritchard wanted to understand the origins of such superstitious beliefs and the urge to blame the occult. His field work took him to the Upper Nile region and the Azande people. He did not have to press hard to discover their concept of witchcraft. “Mangu, witchcraft, was one of the first words I heard in Zandeland, and I heard it uttered day by day throughout the months,” he reported in his landmark 1937 study, Witchcraft, Oracles and Magic Among the Azande.

One example distils Evans-Pritchard’s thesis perfectly. Old buildings would occasionally collapse. Sometimes people would be injured when the building fell. Witchcraft would be alleged. Someone might challenge this claim by observing that termites had eaten through the wood holding up the building, and so dismiss the accusation. But this was not the point. “Every Zande knows that termites eat the supports in course of time and that even the hardest woods decay after years of service,” Evans-Pritchard explained. “That it should collapse is easily intelligible, but why should it have collapsed at the particular moment when these particular people were sitting beneath it?”

Hexed by Jay

You don’t find many serious-minded investors bemoaning their luck, or not out loud in public at least. They have a process, they conduct rigorous research, they have experience and theory on their side, so how can they have lost money? They may not cite witchcraft explicitly, but you will undoubtedly have seen and heard many portfolio managers or more casual investors and pundits insist that central bankers (or meme traders or some other supposedly irrational actor) have bewitched the markets that have turned against them. And this isn’t just a bear-market phenomenon – plenty of those on the wrong side of the long preceding rally spent those years complaining about Fed puts, QE manipulation and the rest of it. Now, of course, the problem is apparently the ‘policy mistake’ of hiking rates too high, too fast.

Take Risks, But Manage Them

I’m not referring to market discipline in the ‘creative destruction’ sense imagined by Schumpeter. Instead, I simply mean risk management. Risks are often rewarded – most evidently in the long equity rally – but can be punished too. The Fed has a dual mandate; neither of these is to ensure asset prices always go up.

Unfortunately, investors may not be able to rely on traditional asset allocation and trust bonds to have a negative correlation to stocks. Maybe that dynamic will reassert itself when interest rates start to fall again, but that could be further off than many expect. I would argue, then, that the solutions should be to focus less on riskmitigating assets and more on risk-management strategies.

Figure 1. Diversification Brings Down Volatility at Portfolio Level

Source: Man Group; June 2022. For illustrative purposes only.

The word ‘uncorrelated’ does complicate matters, as any 60/40 investor will tell you after this chastening year. My multi-strat colleagues produced this helpful illustration of an alternative way to think about allocations (Figure 2).

Figure 2. Hierarchical Clustering Within a Hypothetical Portfolio

Source: Man Group; June 2022. For illustrative purposes only. Clustering based on correlations of five-day market returns since 2016.

This kind of clustering exercise uses advanced mathematical techniques to group strategies together in a risk hierarchy. Some of the conclusions are intuitive, but have the advantage of being backed by systematic research. Others yield more surprising insights: momentum and fundamental macro may feel like they play different roles in portfolios, but too much exposure to both may concentrate risks in an unexpected way.

The whole analysis is worth reading, but this chart makes the main point (Figure 3). Basically, investors want to stay above 0% on the vertical axis regardless of the S&P 500 performance (the horizontal axis). The blue dots represent rolling monthly puts as a standard hedge. You see immediately that there are plenty of blue dots in the top left, signifying positive returns when the market is down. But these come at the cost of the blue dots in the bottom right – the negative carry from holding hedges when equities are gaining. The yellow dots represent a strategy that is 75% systematic (combining trend-following, the Quality Minus Junk factor, and volatility- and correlation-based overlays) and 25% rolling monthly puts; the left-tail payoffs are still there, but without such a drag on the right-hand side.

Figure 3. Rolling 3-Monthly Returns: Monthly Puts Vs. Systematic & Tail Hedges

Source: Bloomberg data, Man Group calculations. Monthly data, May 2007 to April 2022. Please see the important information linked at the end of this document for additional information on hypothetical results. Simulated past performance is not indicative of future results.