Monday, March 13, 2023

Crisis Alpha Vs Panic Alpha

Last year the term crisis alpha got talked about frequently. Markets had a crisis and things like managed futures did very well having the term crisis alpha ascribed to them, rightfully so. The segment did so well that a few new funds came to the market and a lot of financial bloggers started to talk about 15, 20 even greater percentage allocations to managed futures. I'm a huge believer in the strategy. I had one fund for clients during the financial crisis, then bought one fund in early 2020 and finally added a second fund in the fall of last year. My total exposure is probably a little under 5%.

Here's how a few of the funds did today;


They did very poorly on Friday too. The issue seems to be they got caught wrong footed by the massive rally in shorter dated treasuries. One of the funds I use did quite a bit better each day while the other did far worse, down 4.7% Friday and down more than 7% today.

2022 was a crisis type of year. What has gone on in the last couple of days has been a panic. Where tail risk funds didn't do so hot in 2022, they are up dramatically in the last two days. Tail risk funds own puts and treasuries. Markets have been dropping (good for puts) and yields have crashed lower in shocking fashion (good for bond prices) which is why tail risk has done well. Funds that track the VIX Index are also up dramatically because the VIX itself has gone up in a manner that one might expect during a market panic. VIX related funds did well for the first 2/3rd +/- of 2022 before trailing off some later in the year.

Tail risk and VIX could be thought of as panic alpha which is a term I might be able to take credit for, at least I haven't seen it before. There are no absolutes of course, if shorter term treasuries had somehow been flat in this panic then managed futures funds wouldn't have gone down so much but the idea that treasuries will go down in yield during a panic is something the repeats from cycle to cycle...of course though, there are no absolutes on that. 

In terms of trying to protect a portfolio or manage the volatility of a portfolio, are you trying to protect against crises, panics (crashes) or both? There's no wrong answer there. The point is one that we have made here many times which is nothing can be expect to "work" every single time. Managed futures probably is better in longer crises than crashes but it might not work for every crisis. Tail risk might be better for crashes than crises but there certainly could be some random panic where it doesn't "work" like if there was some sort of huge rally in yields coincident to crash. 

I have a couple of each, crash protection and crisis protection, the former is helping now, the latter is not. A catch phrase that applies is diversify your diversifiers. Putting 20% into one diversifier is certainly tidy for doing backtesting but what if we're on day two of something crazy for managed futures that lasts for a while longer? There is some allocation weighting where a drag on returns becomes a problem for returns. That inflection point might be debatable but a 20% allocation is well past the point of being a problem. 

If I had to pick between hedging against a crisis versus a panic, I would say it is more important to hedge against a crisis, a longer event, than a panic. The panic of early 2020 is a good example. The S&P 500 had recovered about 75% of the Covid decline in less than three months. If you're an investor, as opposed to a trader, your time horizon should probably be thought of in terms of years, not months. The longer term events are in my opinion more serious.

Repeating for emphasis, there can be no certainty that things that should go up when equities go up, will do so. There is no guarantee that things that should trade like horizontal lines that tilt upward no matter what will always do so. When you diversify your diversifiers you lower the odds of being hurt during the one event where your favorite diversifier does badly. 

Sorry to say it so bluntly but 20% in managed futures makes no sense. 20% in a VIX fund makes no sense. 20% in a long/short fund makes no sense. 20% in merger arbitrage makes no sense. 20% in short volatility makes no sense. Those are all alt strategies I have exposure to in client accounts. I think they all work well the vast majority of the time but 20% in any single one makes no sense for the unnecessary risk that such a large weighting would expose you to. 

I have no interest or intention of using any of the funds mentioned personally or for clients.

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