TECHNICAL ANALYSIS TO MANAGE RISK AND MAINTAIN TOP QUARTILE PERFORMANCE

 

 

By Dwayne Strocen

Website:  https://www.genuinecta.com

To manage an effective risk management solution requires more than the calculation of VaR.  Ultimately a successful risk management program requires the execution of an effective hedge.  Technical analysis is a vital element of this strategy.

Recent market reversals brought about by the Sub-Prime mortgage melt down is clearly a significant market correcting event.  No matter if you work in the risk department of a large bank with many employees or a small fund of funds as co-manager, you share the same basic concerns regarding the management of your portfolio(s).

1.                  how to maintain top quartile performance;

2.                  how to protect assets in times of economic uncertainty;

3.                  how to expand business reputation to attract new client assets;

It remains common in the financial industry to hear experienced portfolio managers state their risk management program consists of timing the market using their superior asset picking skills.  When questioned a little further it becomes apparent that some confusion exists when it comes to hedging and the use of derivatives as a risk management tool.

Risk management analysis can certainly be an intensive process for institutions like banks or insurance companies who tend to have many diverse divisions each with differing mandates and ability to add to the profit center of the parent company.  However, not all companies are this complex.  While hedge funds and pension plans can have a large asset base, they tend to be straight forward in the determination of risk.

While Value-at-Risk commonly known as VaR goes back many years, it was not until 1994 when J.P. Morgan bank developed its RiskMetrics model that VaR became a staple for financial institutions to measure their risk exposure.  In its simplest terms, VaR measures the potential loss of a portfolio over a given time horizon, usually 1 day or 1 week, and determines the likelihood and magnitude of an adverse market movement.  Thus, if the VaR on an asset determines a loss of $10 million at a one-week, 95% confidence level, then there is a 5% chance the value of the portfolio will drop more than $10 million over any given week in the year.  The drawback of VaR is its inability to determine how much of a loss greater than $10 million will occur.  This does not reduce its effectiveness as a critical risk measurement tool.

A sound risk management strategy must be integrated with the derivatives trading department.  Now that the Portfolio Manager is aware of the risk he faces, he must implement some form of risk reducing strategy to reduce the likelihood of an unexpected market or economic event from reducing his portfolio value by $10 million or more.  3 options are available.

1. Do nothing -  This will not look favourable to investors when their investment suffers a loss.  Reputation suffers and a net draw down of assets will likely result;
2. Sell $10 million of the portfolio -  Cash is dead money.  Not good for returns in the event the market correcting event does not occur for several years.  Being overly cautious keeps a good Portfolio Manger from achieving top quartile status;
3. Hedge -  This is believed by all of the worlds largest and most sophisticated financial institutions to be the answer.

Let's examine how it's done.

Hedging is really very simple, and once you understand the concept, the mechanics will astound you in their simplicity.  Let's examine a $100 million equity portfolio that tracks the S&P 500 and a VaR calculation of $10 million.  An experienced CTA will recommend the Portfolio Manager sell short $10 million S&P 500 index futures on the Futures exchange.  Now if the portfolio losses $10 million the hedge will gain $10 million.  The net result is zero loss.

Some critics will argue the market correcting event may not happen for many years and the result of the loss from the hedge will adversely affect returns.  While true, there is an answer to this problem which is hotly debated.  After all, the whole purpose of implementing a hedge is because of the inability to accurately predict the timing of these significant market correcting events.  The answer is the use of technical analysis to assist in the placement of buy and sell orders for your hedge.

Technical analysis has the ability to remove emotional decisions from trading.  It also provides the trader with an unbiased view of recent events and trends as well as longer term  events and trends.  For example, a head and shoulders formation or a double top will indicate an important rally may be coming to an end with an imminent correction to follow.  While timing may be in dispute, there is no question a full hedge is warranted.  Reaching a major support level might warrant the unwinding of 30% of the hedge with the expectation of a pull back.  A rounding bottom formation should indicate the removal of the hedge in its entirety while awaiting the commencement of a major rally.

It is evident that significant market correcting events occur infrequently, in the neighbourhood of every 10 to 15 years.  Yet many minor corrections and pullbacks can seriously damage returns, fund performance and reputation.

If you have ever been confronted with upcoming quarterly earnings or a topping formation which has caused you to consider liquidation then you should have first considered a hedge used  in conjunction with the evidence from a well thought out analysis of technical indicators.  Together they are a powerful tool, but only for those who have the insight to consider asset protection as important as big returns.  I guarantee your competition understands and so does your clients who are becoming more sophisticated each year.  It's important that you do too.

Dwayne Strocen is President of Genuine Trading Solutions Ltd.  and an honoured member of Stanford's Who's Who.  He's a registered CTA and derivatives analyst.   He also manages the Genuine USA Index Managed Account Program, and provides risk management analysis and hedging solutions for assessing market risk on behalf of corporations and financial institutions.   View more information about Who We Are and the benefits of Hedging your risk.

TRANSPARENCY IN HEDGE FUND INVESTING IS CRITICAL FOR INVESTORS

   By Dwayne Strocen                                     

Website:  https://www.genuineCTA.com


Transparency In Hedge Fund Investing Is Critical For Investors

Due to some recent high profile fraud cases within the hedge fund industry, many investors are seeking greater transparency from their investment managers.  While many managers protect their proprietary trading programs, there is one sure fire way to address this issue.

Fund redemption's are nothing new.  Every recession or bear market sees investors redeeming their fund investments and moving to asset classes which provide a greater degree of safety.  For most, this is the Government Treasury Bill also called the T-Bill.

While reasons for redemption's are as varied as the investment selections themselves, it seems that individual investors are uncertain of their understanding of what their money has been invested in.  While mutual funds are marketed to the investor with a lower knowledge of investment products, the hedge fund has always been the investment choice for more knowledgeable investors or the "Accredited Investor".  But now it seems even this group is calling for the need of greater understanding from their investment managers.

The battle for returns which out perform the index has resulted in many Portfolio Managers refusing to disclose their trading program for fear others will duplicate their trading style.  It is said by many managers that it's this ability to observe unique characteristics in the market place that differentiates their funds performance from the typical returns generated by bottom quartile performing funds and fund managers.  Of course the unregulated hedge fund industry has perpetuated this myth by trusting the Accredited Investor with an above average knowledge of the market and his ability to select the correct investment for their portfolio.  It seems the Accredited Investors does not always posses greater knowledge than their more un-sophisticated mutual fund brethren. 

So that bears the question of how to obtain this transparency to the satisfaction of the investing public?  And the answer is the Managed Account.

Managed Accounts are simply individual accounts opened in the name of the investor.  These accounts are not pooled, yet they are identically structured and managed by the hedge fund Portfolio Manager in the same style as the pooled fund.  The critical difference is the investors ability to see every trading transaction performed in the account by the fund manager.

The popularity of the pooled investment structure is that investors do not have to deposit large sums of money to utilize the services of a professional Portfolio Manager.  Most successful professional Portfolio Managers do not accept accounts less than US$10 million dollars. 

The hedge fund and mutual fund gained popularity by allowing smaller sums of money to be pooled with other deposits from many other investors.  So while you can currently participate in a hedge fund investment for $100,000 and a mutual fund for $50., a managed account may require a minimum investment in excess of $1 million.  Not so good for everybody.

But lets suppose you can convince your hedge fund manager to accept your $100,000 what advantage do you gain.

1.    the investment account is actually in your name and not in the funds name;
2.    your account is segregated from all other trading accounts;
3.    instead of waiting for your monthly or quarterly statements, you can see the activity in your account on a daily basis in real time;
4.    cash deposits or withdrawals can be simplified;
5.    you have an overall increase of account transparency; and
6.    you can no longer claim you did not know what was going on in your account. (oops, is that a benefit?).

There are also some disadvantages.  Or put another way, the pooled investment structure provides some distinct advantages which originally made them popular since the first hedge fund was created in 1949.  These funds should not be confused with the investment account managed by your stock broker.  The professional Portfolio Manager will continue to exercise complete trading autonomy and does not want your advice on how to manage the assets in your account.

Advantages for remaining in a hedge fund or mutual fund:
1.    investors can obtain the services of a professional fund manager with smaller sums of money;
2.    management costs are cheaper since it is more economical to manage one large account instead of many smaller accounts;
3.    you pay one flat management fee, no commissions; and best of all
4.    you still have someone to blame if things go wrong.

It is estimated the hedge fund  industry managed $2.7 trillion dollars by the end of 2008.  The mutual fund industry manages $19 trillion investment dollars.  So there is no question of the popularity of the industry since that first fund in 1949.

If transparency is an issue for you, you need to take a long, hard look and evaluate the pros and cons wisely.  Take some time to speak with your fund manager about a managed account, it just might be the alternative you've been looking for.


Since 1999 Genuine Trading Solutions has been providing corporations and investment funds with derivatives strategy and comprehensive risk hedging solutions.  View more information about our managed account program and about reducing risk .