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February 27, 2018 at 09:41 PM
In early February, long-absent volatility made a comeback, as global equity markets sold off and the VIX experienced its largest one day move ever, jumping 116% on Feb. 5, 2018. This was prompted in part by rising inflation fears that pushed bond yields higher worldwide.
With output gaps — the differences between potential GDP and actual GDP — closing in both the United States and globally, a host of sentiment gauges hitting multi-year highs, and unemployment rates at multi-year lows, fears of inflation are certainly justified. Add in the valuation picture, which suggests that this may be the most broadly overvalued market in history, and you’ve got a recipe for investor angst.
If history is any guide, we suspect that this injection of reality into what had been an unnaturally quiet market environment will spur activity in search of strategies that offer true diversification. Given that investment grade debt, which has long played that role, has such a poor outlook on a real return basis, finding impactful diversifiers will be more difficult than in the past. In fact, short of costly market hedges, one of the only strategies that has historically exhibited low correlation to stocks, bonds, and commodities is managed futures.
Admittedly, selecting a managed futures fund is not an easy task. The challenge emanates from the diversity of the strategies employed, and the non-constant exposure, both long and short, across one or more asset classes (i.e., stocks, bonds, commodities and currencies). Because of the lack of consistent exposure, a standard benchmark like the S&P 500 isn’t appropriate, but there are ways to determine a manager’s value add.
Peer groups, while failing many of the criteria needed to be viewed as valid benchmarks, can serve as an attribution tool in a sense, i.e., a proxy to determine the efficacy of the decisions made against the decisions that could have been made. But again, the disparate nature of the strategies employed, and importantly, the varying goals of each fund, make this analysis less than convincing over periods less than a full market cycle.
So where does that leave us if standard benchmarks are of no use and peer groups are lacking as well? Investors need to use benchmark-independent measures of risk-adjusted return, such as the Sharpe Ratio, Sortino Ratio and Omega Ratio. Given the ubiquity of the Sharpe Ratio, we won’t spend time on that metric, except to say that its assumption of a normal return distribution and its equal treatment of upside and downside volatility makes it less than ideal.
The Sortino Ratio is similar to the Sharpe Ratio, but is a preferred measure, as it uses an investor’s Minimum Acceptable Return in the numerator and downside deviation in the denominator. Doing so makes the ratio more relevant to each investor’s specific goals and addresses the fact that we all feel the pain of a loss more than the joy of a gain.
