A sign on a synagogue:
An addition made by someone with a pencil: 'Lie. I've tried the both. Huge difference.'
(Old Jewish joke).
In this article I offer some thoughts that may hopefully be useful for investors at the stage of allocation of risk to alpha generating strategies as a whole and between hedge funds and GTAA in particular. It is not about which is better and which is worse, but rather an attempt to analyse the distinctions and similarities between the two phenomena that have lately received a lot of traction.
Do you remember those not very remote times when pension funds, especially in Europe, were not particularly keen on GTAA, but instead allocated excessive risk to plain vanilla equities? The 1980s and 1990s happened to be the time of a bull market. Pension funds enjoyed high equity returns and followed a tacit conviction that the markets would go up forever. Everything had gone delightfully well until stock markets crashed in 2000. Then, after lying for some time under a palsy of suddenly appeared huge deficits, the institutional investors began to seriously look for alpha. Hedge funds and GTAA drew the rapt attention from both institutional investors and their consultants.
However, some people had understood the importance of alpha and of tactical selection between asset classes as one of its reliable sources already in the 80s, and a few TAA products were launched then. Nowadays GTAA from a few exquisite brands is available in different forms and shapes, both off-the-shelf and tailored to customer's needs.
Without going too deep into the history of their evolution, we will say that now a typical GTAA process consists of mainly four sub-processes; four sources of alpha that are independent from each other and could in many cases be run on a stand-alone basis. These four dimensions are (figure 1):
Some products include one or two more dimensions like commodities or curve plays but these often stumble upon capacity issues. Emerging markets are also sometimes added to the set but capacity becomes an issue there as well not allowing to take decent risk, to say nothing about higher costs of trading. Up to 13 developed equity markets, 7-8 bond markets and 9-10 currencies can be traded without limiting capacity too much.
Implemented via futures and forward contracts, GTAA strategy does not require any capital allocation except for one needed to meet margin requirements. It can overlay practically any asset mix. That is, it is not just an alpha, it is a portable alpha! Usually investors port it on cash or on traditional equity-bond mix. Recently we have seen emergence of mandates where GTAA was combined with portable beta: for example, GTAA was ported on FTSE-100 replicated using futures.
GTAA is delivered to investors in forms of funds with different underlying assets (but still chiefly with cash), managed accounts, total return swaps or structured notes.
On top of that, usually GTAA optimisers are built in such a smart way that individual risk requirements of clients can be met.
Of course, it is! Any hedge fund's objective should be alpha generation, and GTAA does nothing else but produce alpha. Comparison of forecasted returns of asset classes, different markets within an asset class leads to a portfolio where bets are made on a global basis. Moreover, risk in modern GTAA products is re-allocated dynamically between the sub-processes and between markets. Where a greater opportunity is seen, the risk taking increases and vice versa. That closely resembles the global macro approach. As in many cases GTAA products are model driven and only allow little discretion at the stage of trading; why would we not call them systematic global macro?
Another similarity is involvement of skill as a cornerstone of success of any alpha generating process. From the beginning, hedge funds have been associated with seasoned traders making money in all market environments and bringing desired return to investors. Later, when systematic processes appeared, they did not require as many impressive traders as before but did demand skill at the stage of model creation.
GTAA products are usually model driven. These quantitative models are based on different sets of factors and could be classified as purely fundamental, purely technical or a mixture of the two. These factors are used to detect magnitude of mis-pricing of the markets traded. Once this is done, the information goes into an optimiser that produces a recommended portfolio. In addition, there are risk management procedures, also often very formalised and systematic by nature. Development of all of this does require skill. It demands continuous research efforts as market inefficiencies tend to vanish over time. Leading GTAA houses employ strong teams of researchers whose only task is finding and quantifying new inefficiencies and looking for better ways of portfolio construction. It is becoming more science than art, and while execution still remains a very important part of the game, the need for truly exceptional skill has been migrating towards the model development.
Both the majority of hedge funds and GTAA providers boast low correlations with traditional asset classes and, in some cases, with other hedge fund strategies. Capacity is an issue for most hedge funds and may become an issue for GTAA managers as well. With the fee structure, like hedge fund managers, GTAA managers usually prefer to receive a management fee plus a performance related fee.
Instruments traded are not cash equities or bonds both in case of GTAA and many hedge funds that are free to trade derivatives for both alpha generation and risk control purposes. GTAA products are often packaged as hedge funds.
Of course it is not! A hedge fund's objective should be alpha generation, but do they always achieve that goal? A host of recent studies shows that hedge fund returns can be explained with beta exposure for about a half. Different studies show different numbers, and different strategies provide different beta exposures but still there is so much beta in hedge fund returns that some very respected asset managers have begun to offer products that endeavour to replicate hedge fund returns. Have you seen any product that would dare replicate GTAA returns?
A few funds of funds, eager to only deliver alpha to their investors, attempt to trade beta exposure based on both historical time series of returns and on their understanding of underlying strategies. I cannot say that I am a fan of such an approach but the fact of the matter is that the presence of beta in hedge fund returns is a very well known fact.
On the other hand, unless a GTAA product has an intrinsic bias to equities or bonds, or to some specific country markets, it would be very hard to classify its returns as beta.
That leads us directly to the issue of fees. Firstly, GTAA managers usually only charge their performance fee for the alpha they deliver. Even more, when a product is packaged as a hedge fund, a cash (or some other applicable benchmark) hurdle is often introduced.
In a hedge funds case, an investor usually has to pay for both alpha and beta as they become inseparable for him. What on earth could be that beta exposure for the sake of which one would be willing to engage him, or herself, into long lock-ups and to pay 1.5-2% in management fees and especially 20% in performance fees? Perhaps, that could be some very exotic beta that is really hard to access, but is that the kind of beta sold by an average hedge fund to an average investor?
Clear differences arise as we cast even a superficial glance at competition. How many long/short equity hedge funds are there? How many fixed income hedge funds? Thousands. On the other hand, how many GTAA managers do you know? A dozen, may be more. It is interesting to note that despite this apparent lack of diversity of offering there are not too many newcomers in the area. Does it have anything to do with complexity of the models? I think, not – quite sophisticated models abound in the hedge fund world. In my personal opinion, the main reason is a clear division of the asset management industry between equity and fixed income specialists, almost two different professions. As this division is unlikely to disappear, as the markets are huge, it is hard to believe that the inefficiencies the GTAA managers exploit, will evaporate anytime soon. One way or another, as a result, GTAA managers do not pursue the same opportunities as is often the case in many hedge fund strategies. So their alpha is not that scarce and not as fiercely fought for.
Another interesting implication of this is risk control. With VaR having become a widely accepted measure of risk, it is now calculated by thousands of managers in exactly same way. What can happen if their risk controls trigger exits at the same time, and the market will not be big enough to accommodate all those trades? Simply put, there is a danger that in such an eventuality nobody will stand on the other side of the trade, and the snowball will roll down the hill crushing everyone on its path. Theoretically, that may be the case with GTAA strategies as well, but they are probably more immune to this problem than others due to less crowding and, in some cases, due to the contrarian nature of some of the models' components. This latter feature allows the managers to be 'prepared' for the unexpected as they often take their positions early.
We have already mentioned capacity constraints as a similarity. No, GTAA strategies are not limitless. However, their resources are much deeper than those of traditional hedge fund strategies and measured in tens of billions of dollars.
Capacities of most hedge fund strategies are very limited. What happens as a result? Funds that have not reached their individual capacity ceiling yet, keep accepting the money. The managers think they still have some room for growth. However, because many people have very similar approaches and chase the same ideas, they do not notice how the overall strategy capacity is exceeded. Does anybody measure it?
This, by the way, isone of the reasons of 'everybody losing at the same time' effect. We could see macro events that influence seemingly different strategies simultaneously. Consider a fixed income arbitrager playing a credit spread game and an emerging market manager. Any recollections of 1998?
Another issue is breadth of strategies. GTAA usually evaluates at least 30 markets taking independent bets that may vary in size over time. Different from a typical classic global macro approach, exposure is rarely concentrated in few large bets and large position swings rarely happen.
We mentioned low correlations with traditional asset classes as a similarity. However, correlations between hedge fund managers within particular strategies are on the rise. The same is true about correlations between strategies. Still neither correlation between GTAA managers has increased, nor have their correlations with traditional asset classes or with hedge fund strategies.
Now, how easy or difficult is it to select good hedge funds? I think it is an incredibly hard task. There are so many good funds that do similar things that many institutional investors prefer to avoid the choice and to go fund of hedge funds route, pay another layer of fees and end up with bond type of risk (as they wished) but also with bond type of return (not something they dream of). Selection of good GTAA managers is not that complicated. They are few, and most offer products of institutional quality.
Also, many institutional investors shy away from hedge funds due to fear of low transparency. Indeed, strategies are not always clear, reasons behind decisions are often impossible to understand and instruments traded like illiquid assets or complex derivatives are difficult to price. In all honesty, I'm not sure that an investor would know what to do with all that information should they gain an access to it. However, the demand is there, and the number of hedge fund managers offering their products in discretionary account format is increasing. GTAA, on the other hand, was originally offered as a discretionary account product, with hedge fund packaging having arisen only relatively recently.
Flexibility is another feature that makes a difference. It becomes really handy when investors seek to incorporate GTAA into their portfolio. The product that could be as easily designed to deliver 30% volatility as 1% is a very convenient building block. Also, sometimes investors have short-selling restrictions or want to exclude some markets or even some sub-processes. While quality of alpha would be compromised in such set-ups, in many cases GTAA engines can be used to manage such accounts.
GTAA and hedge funds do have a lot in common. However, similarities should not overshadow the differences. When risk is being allocated to alpha products, one should think carefully not only about past distributions of returns, but also about changes that those distributions are likely to experience in the future.
Fundamental trends that are observed now in the industry are showing certain signs of convergence between GTAA and hedge funds, but the distinctions inherent to GTAA are here to stay for the years to come. Those distinctions are significant enough to justify separate risk budgets for hedge funds and GTAA products in pension funds' portfolios.