Managers of any project or task are faced with choosing and subscribing to a specific methodology of execution. It is fair to say that one evaluates the specific method from a risk/reward consideration. We face these dilemmas daily from the time we dress in the morning to when we choose a route to drive and to how we conduct ourselves socially and professionally. Not to sound too dramatic but we do live and die by our decisions/actions and their consequences. How do we base our decision making process? Are we aware of all the complexities and moving objects? Is there a general guideline that can help reach our conclusions?

Is track record enough?

When investing in real estate people like the phrase ‘location, location, location’ or ‘timing is everything’. But is that enough? Can one say that ‘track record, track record, track record’ is enough? I think not. Can investing be like a single malt whisky or does it require a sophisticated blend? Most specialists agree that there is no one formula and that mostly one can reach a similar goal using different routes. The successful managers usually have a specified goal and target using a rigid guideline to their investing. More importantly they have identified and are resigned to the attached risk that accompanies it. As for every percentage gain there must be incurred risk. The correct formula has to be exercised like a science to get it right.

Most managers try and stick to a style and method. There are the bullish and bearish traders, the short term and long term investors, the fundamental and technical investors, the directional and non-directional traders. Some use a more of an ‘opportunistic’ approach. They tend to keep to a specific investment space otherwise they find themselves spread too thinly. The ‘specialist’ approach usually focuses on a narrow space or trading style, trying to reap yield with a controlled level of risk. The downside with the ‘specialist’ approach is that good times and bad times can be very long, not to mention the unexpected blow up. For example, the traders with a short volatility in the last 5 years looked like geniuses. Unfortunately, a lot of them were hit hard when market volatility behaviour changed.

More than ever people subscribe to a diversified approach. Even when diversifying, one needs to make sure they are aware of the risks in each of the underlying investments and their biases.

Diversify and multiply

Hedge funds usually construct portfolios in which the diversification mitigates the risk in order to successfully navigate unpredictable market waters. But which type of hedge fund is best positioned to profit through ‘normal’ market behaviour and yet be protected or immune from any unexpected market shifts? Which hedge fund or strategies will come out triumphant and which will suffer or become extinct?

Portfolios with the greatest diversity and low intra-portfolio correlation can provide immense stability. The lower intra-portfolio correlation minimises the effects of a unexpected market shift. With a high degree of intra-portfolio diversification, it is more effective to overcome the market changes and minimise risk.

One way to diversify a portfolio is to be invested among various asset classes. Furthermore, by using different investment strategies that utilise several logics and trading styles along with trading a wide range of instruments the portfolio will be less influenced by an individual market move. Higher frequency trading generally means that one is invested in short term commitments. This will further immunise portfolios from unforeseen market vibrations and uncertainties as short-term, high frequency trading reduces a fund’s exposure to long term market movements.

Multi-strategy hedge funds generally offer greater diversification than hedge funds with more generic types of investment strategies. In fact, fund of funds were constructed to provide the same kind of multi-strategy portal, which diversifies to a greater extent than most hedge funds. Coincidentally or not, multi-strategy hedge funds have been outperforming funds of funds. Therefore, institutional investors are increasingly willing to invest directly into multi-strategy hedge funds, which provide the same type of diversification, charge lower fees, and show better returns.

Finding strength in volatility

While the hedge fund industry primes itself for prophesised volatility, investors should also take the time to reflect on their investment priorities. As the market volatility increases, investors’ priorities can shift along the spectrum from maximising returns to minimising volatility. Investors should be aware of their own investment nature and how it is reflected in their portfolio. Moreover, investors should be conscious of their investment temperament in light of increased market volatility and pressurised market factors. To do so, it is important for investors to determine their ideal volatility to return ratio and ensure that their portfolio accurately reflects their investment priorities.

In February, market vibrations incited investor anxiety and lowered confidence in market stability, yet many recognised the disturbance as merely an indication of the possible volatility and market movements to come. The investment community has been rallying, reorganising, and repositioning itself in light of these recent market symptoms. While investors survey the industry, assessing which investment vehicles might best capitalise on the predicted volatility; firms refine and refocus their investment strategies to capitalise on the future market conditions and cautiously position for market uncertainties.

Preparing for the unexpected

With the new behaviour and surges in volatility, funds have begun toself-reflect and prepare for the expected market volatility. Hedge funds with specific volatility biases, meaning hedge funds built to perform under volatile conditions will thrive as the nature of the market becomes less predictable. However, market volatility can be a true obstacle to alpha generation if a fund is not well-positioned. The looming market movements could agitate the industry enough to shake out the players whose strategies lack the agility to perform beyond certain, limited market conditions.

The following factors have a significant impact on market performance. If any of these factors were to change suddenly and/or considerably, it could agitate the markets enough to distress unprepared or inflexible hedge funds. The VIX charts market volatility and has a substantial effect on the markets and hedge fund performance. From 2000 to the beginning of 2004, market volatility was quite high with the VIX fluctuating in the 20 to 40 range. However from 2004 to present, the VIX has stayed within the 10 to 20 range, the lowest volatility the market has seen since the mid 1990s. With the VIX potentially poised to jump back into the higher ranges seen in the early 2000, the hedge funds that have enjoyed the low volatility and carefree market profits may be in for a rude awakening.

These recent months, the Dow and S&P 500 Indices have been at an all time high, steadily climbing since the beginning of 2003. With the VIX remaining low and the Indices consistently climbing, it has been relatively simple for hedge funds to create alpha without intricate, investment strategies; however, a variation in market patterns would generate the need for more active investment policies.Furthermore, the current geopolitical situation contributes and influences the market volatility immensely. The investment community is watching with bated breath as the international political front heats up. International political and radical activities can overwhelm the markets suddenly as they did on 11 September 2001. Any type of catastrophic event has the potential to cause significant market damage.

Funds must hedge cautiously as the fear of a potential catastrophic event grows. However, catastrophic events are not the only aspect of the current geopolitical situation that could affect the hedge fund industry. Elections and national politics can have a significant impact on the financial sector. The outcome of the forthcoming US elections and the impact of Tony Blair’s resignation are major factors in the months ahead that will directly affect the hedge fund industry. As the hedge fund industry’s regulatory fate is primarily determined by national governments, a transfer of political power in both the US and UK could restrict both SEC and FSA regulated hedge funds, reducing their investment flexibility. Furthermore, any regulatory amendments could set precedents for the hedge fund industry in other countries. These factors are merely a sample indication of large market pressures and catalysts. If hedge funds do not possess the ability to anticipate the potential effects of these pressures, they will not be able to successfully navigate the types of market crises that any one of these factors could create.

Adapt or die

Hedge funds, if they retain their current investment agility and do anticipate these market moves, could successfully adapt to the collapse of any of the previously mentioned factors. But what does the future hold for the hedge fund industry and how will it evolve in light of future market pressures?

Hedge funds have generally reveled in their opaque image within the investment community, generally perceived as mammoth investment vehicles offering portfolios in which diversification shields assets from market drawdowns. However, this image faded ever so slightly when many of the epic, household-name hedge funds were proven susceptible to February’s movements. Not only was the hedge fund community unable to produce alpha, but many funds found themselves under-hedged and overexposed in February.

Winners and losers

Many have demanded that the hedge fund industry undergo a transformation by adhering to tighter regulations and by offering greater transparency.

This sentiment reverberates from the financial catastrophes of hedge funds like Amaranth and Long Term Capital Management. However, these stand alone hedge funds are not the only ones which fall into trouble. Many large banks have recently closed their hedge fund arms. For example, in early May, UBS folded Dillon Read Capital Management, its proprietary hedge fund arm. These closures feed the widely repeated statistic that over ten percent of hedge funds close each year. It seems that no fund is invulnerable to this statistic not even global banking groups. Yet even with all the imagined and actual collapses, the hedge fund industry’s assets continue to climb and even the regulators don’t want to check this type of growth. As the EU recently endorsed the current regulatory hedge fund system, it validated the adequacy of the industry’s existing supervision despite its tainted past.

Hedge funds’ unchecked investment nature, despite its controversy, gives the hedge fund industry the agility to capitalise on an extensive range of market conditions. This unrestricted, minimally regulated investment flexibility gives hedge funds a clear advantage over other categories of investment firms. Consequently, hedge funds have at their fingertips both the resources and flexibility to be the best equipped vehicles for the upcoming market movements. But will they successfully hedge and generate alpha?

About Olive Tree Capital

Olive Tree Capital was co-founded by James Casper and Alex Waldman. Prior to founding Olive Tree Capital, he founded and managed a leading online foreign exchange brokerage firm. It was then that Casper was introduced to the field of algorithmic trading. He was inspired by trading algorithms that used logic related to electronic warfare. This experience was the catalyst to develop the methodology that is the foundation of Olive Tree Capital’s investment process.

Olive Tree Capital is a multi-strategy quantitative fund. The fund’s portfolio is comprised of multiple algorithmic trading systems which focus on short-term trading in diversified markets. The fund employs a state of the art, proprietary risk management system to consistently monitor the portfolio, minimise risk and ensure the optimal trading behaviour of each strategy.

Olive Tree sources over 500 algorithms per year, analysing each algorithm through its rigorous due diligence process in order to build its portfolio, which targets annual returns of 20% with less than 5% volatility.