DC Spotlight: Defining Strategies is Key to Portfolio Construction

Defining Strategies is Key to Portfolio Construction


In our previous article on managed futures strategies, we discussed the number of unique strategies utilized by commodity trading advisors. It is how Coquest Advisors categorizes the wide variety of CTAs they cover, and it is an essential part of building a diversified investment portfolio. Investors look to include a broad group of non-correlated strategies to increase their risk-adjusted returns.

A good question at this point is, why? If a manager is good and profitable, that manager is worthy of an allocation, right? Well perhaps. But while managed futures strategies, by nature, are absolute return vehicles, they tend to perform better and worse in different market environments. Each unique strategy has certain return drivers and risk factors, which serve as the underlying reasons why a particular strategy may succeed or fail. It is important to have as many non-correlated strategies—and more specifically—non-correlated return drivers and risk factors as possible.

What Coquest does in categorizing managers is to drill down to precisely define that manager’s strategy to help investors create as well-diversified a portfolio as possible. That is done by making sure an investor is exposed to as many robust non-correlated strategies that exploit as many non-correlated return drivers with diverse risk factors as possible.

“When designing the Strategy Matrix our goal was to group strategies in such a way that investors could quickly and easily make meaningful comparisons and distinctions between managers, both within a group and across groups,” says Ryan Hart, CIO and portfolio manager for Coquest.

Return Drivers

The basic return driver for long-term trend following is volatility. Market disruptions create trends that can be exploited, which is why trend following does well in volatile market environments. That volatility only needs to apply to one sector. A weather or trade event can create volatility in the agriculture or energy sector that would have little relevance to the financial sector. Volatility in the ag and energy sector may also create disruptions in many foreign exchange markets. More broad economic disruptions affect global interest rates and stock indexes that may have little effect on most commodity markets. The fact that some disruptions affect some sectors and not others—or not others to the same degree—is a benefit to applying systems to multiple markets, as these disruptions can also create risk.

Going back to our initial question: If a manager is good and profitable, isn’t that manager worthy of an allocation. The answer is yes. The beginning of building a diverse portfolio is to identify strong managers worthy of an allocation. Once you have identified a group of strong managers, you can begin building your portfolio. In other words, every trading program you select must be strong and worthy of an allocation on its own. After it has qualified under that metric, you can go about selecting programs that fall into unique strategy buckets to add diversification. You may be forced to make tough choices between two strong managers with similar strategies, but you shouldn’t stretch to place a manager in your portfolio just because you want to add a strategy not represented.

“The most important thing is to identify good managers who you expect to deliver attractive risk-adjusted returns on a go-forward basis,” Hart says. “All the diversification benefits in the world don’t mean a thing without a quality group of managers to begin with.”

Strategy Buckets

Perhaps the best diversification to long-term trend following is a mean reversion approach. John Henry once said, “I am not that smart; I am a trend follower. I buy when markets are high and sell when they are low.”

Basically, he is explaining that he lets the markets tell him where they are going. Other technical and fundamental traders try and determine where price should be based on historical norms—or in the case of global macro traders—what the fundamentals indicate.

This diversification can come in the form of Coquest’s fundamental/macro bucket or its technical non-trend bucket. Both try and determine where markets are headed by various methods rather than identifying their direction and anticipating that direction persists.

These strategies—when successful—will exploit market reversals that tend to be bad for trend followers and will also exit trades before price—in the case of trend following—dictates that exit. This doesn’t mean that when one of these strategies performs well, trend followers are doing poorly. The fundamental macro and technical non-trend strategies will, generally, get into and out of trades before trend followers, but can successfully exploit the same moves.

Trending Wide

We covered quite a bit about trend following and how many diverse managers may fall under that broad category in our last article. The reason is easy to understand; while there are a variety of ways to identify trends, when certain markets enter long-term trends most diversified managers will jump on board. This can create a situation where various relatively diverse strategies can appear more correlated than they truly are.

For that reason, any solid and robust diversified portfolio can—and probably should—include more than one program that can broadly be defined as trend following.

Some trend followers, particularly larger ones, concentrate 80% of their allocations in financial futures (foreign exchange, fixed income, and stock indexes), while others have rules requiring a minimum allocation to physical commodities. There are some physical commodities and non-U.S. markets that display strong trending capabilities that cannot be utilized by managers of a certain size. Since the essence of trend following is the ability to earn outsized profits on just a few large trends in certain markets or market sectors, these distinctions in markets traded can be significant in adding diversification.

Another important distinction is timeframe. Trends can last for hours, days, weeks, and months. The longer your timeframe, the more movement it will take to trigger a signal. In fact, the difference between a trend and countertrend trade can often be the time it takes to define it. Actually, both could make money within the same move based on time.

This highlights the importance of markets and timeframes in building a diverse portfolio. Once you identify a good group of managers, you should strive to diversify your portfolio across as many of the dimensions Coquest has defined in its matrix as possible.

“Knowing about an investment program’s trading approach, time frame, and investment universe can tell you a lot about what you should expect from that program,” Hart says. “It also allows you to identify similar strategies and evaluate managers versus their peers.”

Another important diversification is combining convergent strategies with divergent strategies and using options. The beauty of options is that a strategy can profit based on movements in volatility as well as, or instead of market direction. A strategy can be long or short volatility and trade volatility based on trend or mean reversion. With options, a manager can also more precisely define risk.

The most common option strategy is option writing, Coquest’s premium capture bucket. This strategy typically sells deep out-of-the-money options in stock indexes (though some option writers trade a diverse group of markets) and collects premium as those options expire. This strategy typically produces consistent steady returns. It benefits from steady and increasing volatility but is vulnerable to sudden spikes in volatility.

The options long volatility bucket operates in a reverse fashion, making small bets in the hopes of a volatility spike. Since it focuses on buying options, its risk is well defined.

Options volatility arbitrage is a relatively new approach for professional managers. It basically combines the typical option writing approach with mean reversion. Option writing is famous for producing strong steady returns but often will experience major negative events with the inevitable volatility spike. That is why it is sometimes mocked for picking up nickels in front of a steamroller. The problem is that as volatility wanes and premiums decline, managers need to sell closer-to-the-money options to realize a substantial premium to capture. The answer is to apply mean reversion principles and try and capture undervalued volatility by buying options when premiums are cheap.

Strategies that rely on momentum can be defined as divergent as they exploit large market moves, while strategies based more on mean reversion—markets returning to “fair value” as defined by certain metrics — can be defined as convergent.

Portfolio diversification is such an important principle that managers themselves have sought to create that diversification within one program to offer to clients a multi-strategy approach. This allows investors who may not have the capacity to build a portfolio of multiple managers to allocate to one and get the benefits of different strategies.

Harry Markowitz, the father of modern portfolio theory, demonstrated that a diversified portfolio is less volatile than the total sum of its parts. By including a diverse group of strategies with different return drivers and risk factors, the volatility of the entire portfolio will be reduced.

Different strategies expose you to different types of risk,” Hart says. “The devil is truly in the details, which is why understanding the underlying strategies is so critical.”

By understanding each type of strategy, what drives its return, and what risk it is exposed to—you are better able to produce a robust low-risk portfolio.


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Disclosure: The risk of loss in trading futures and/or options is substantial. Past performance is not indicative of future results. The information in this message derived from third-party sources is believed to be accurate and reliable; Coquest does not guarantee the accuracy or completeness of the information. Opinions expressed in this material are subject to change without notice. This report should not be interpreted as a request to engage in any transaction of futures, options, and/or OTC derivatives. The information contained in this material is not to be relied upon in substitution for the exercise of your independent judgment. Seek independent financial, tax, legal, and accounting advice from your own professional advisers, based upon your particular circumstances.