Systematic indices were hailed as the big investment story of 2013, but it turned out to be a tough year for many rules-based strategies that failed to live up to impressive backtests.
Dynamic volatility, carry, and strategies linked to risk parity all suffered as markets reacted wildly to the Fed’s QE tapering discussions.
“Most vol strategies are relying on trend patterns as signals, but QE and tapering has changed those patterns,” said Stephane Mattatia, head of global equity flow at SG.
“Since the long-lasting put began to fade, we’ve seen a succession of short-lived crises that have been bad for carry-based income strategies, but weren’t enough to create value for hedging strategies.”
As a polarised year, 2013 delivered some large market swings during the first half, while debt ceiling negotiations returned risk premia to more normal levels post-summer.
“It has been a very difficult year for any strategy that manages multi-assets on the basis of risk metrics,” said Guillaume Dolisi, head of systematic strategies at BNP Paribas. “Those strategies tended to be over-exposed to fixed income, which had a bad year.”
Many carry strategies took a beating during the first half due to large directional moves. JP Morgan’s Volemont delivered seven consecutive months of negative performance between February and August, finally clawing its way back to positive territory in the final months of last year as markets stabilised.
“We’ve seen a shift to a new regime of low volatility and a succession of short-term stress events. That combination means that it can be difficult to monetise carry in a sustainable way,” said Arnaud Jobert, executive director, equity derivatives structuring at JP Morgan.
“It’s beyond the realms of expectation to have one algo that delivers alpha for 10 years – a rising rate environment will have an impact on risky assets that might drive the performance of an algo, but there’s no clear picture of what that impact will be.”
Volemont’s annual performance of 1% for 2013 followed two years of double-digit returns and a backtest that boasts 27% gains for 2009 alone. Last year’s near-flat performance reflects the fact that the signal-based index spent little of the year exposed to volatility.
“When there’s a change in regime, especially rate increases, systematic strategies are going to be impacted. We believe that after some initial pain, many of them may recover and profit from a higher rate environment”
For dynamic volatility strategies, which aim to mitigate the roll cost of a long VIX futures position, the environment proved even tougher. SG’s Dynamic Long VIX futures index shed 28% during 2013, while Barclays’ iPath Dynamic VIX ETN was down 27% and JPM’s Macro Hedge US ETF lost 6%. So far in 2013, Macro Hedge is down 25%, while DLVIX has shed 14% in a period when the VIX index has edged up.
New regime
To address changing dynamics, structurers are offering enhanced variations on existing indices. Macro Hedge is a case in point. An updated Duel Hedged Enhanced version incorporating European volatility outperformed the original last year, posting 18% gains.
For its Volemont strategy, JPM now provides flexibility for investors to determine their own signals for triggering long and short exposure.
“These are rules-based indices but you need to adapt ways to allocate risk to suit new market conditions. We’ve been driving a new generation that still aims to monetise the term structure of the VIX futures curve, but in a more cost-effective and defensive way,” said Jobert.
With rising rates largely expected, performance of existing strategies will be keenly watched as many were developed in an extreme low rate environment and are yet to be tested in a live rising rate scenario.
“When there’s a change in regime, especially rate increases, systematic strategies are going to be impacted. We believe that after some initial pain, many of them may recover and profit from a higher rate environment,” said Julien Turc, head of cross-asset quantitative strategy at SG.
“Higher rates could result in losses for equity and fixed income portfolios and all carry strategies could lose money, but momentum strategies are likely to bring substantial gains.”
Equity bright spot
Strategies that were able to capture exposure to an equity rally that saw the S&P 500 gain almost 30% proved the big success of last year.
“Over the last five years, markets have been distorted and haven’t behaved as expected, but equity-based strategies have generally performed as they were designed to as they tend to be based on signals that are more fundamental,” said Alex McKenna, head of systematic funds at Deutsche Asset and Wealth Management.
DeAWM’s equity risk premia fund has returned 2.75% since its November inception. The underlying strategy is up more than 9% over the past 12 months, while the MSCI World has gained 16% over the same period.
The fund has garnered €60m of assets, but wary of backtests that fail to be replicated in live trading – the strategy was shown to outperform the MSCI by more than double over a 10-year period – many investors are awaiting an established track record.
“It’s one thing to create a product that looks good over a five-year history, but what investors really care about is that a strategy does what it’s designed to do. Clients are still interested in seeing backtest performance, but what they really need to see is a live track record to go in with their eyes open,” said McKenna.
“A backtest can’t account for everything, such as a change in market structure, but similarly in active management, political events are capable of wrong-footing the system.”
BNPP’s Dolisi highlights the firm’s Guru index, which outperformed the S&P 500 by 14% last year.
“Equities are still in favour as it is where you get the best yield and typical long/short strategies like Guru do very well. The idea is to look at what successful investors have done over the last century and do the same in a systematic way,” said Dolisi.