Poor performance of traditional asset classes has prompted many investors to turn to alternative investment strategies. The idea is to balance their portfolios and increase returns in a variety of market conditions. Hedge funds are the natural investment to look to in this context, as the basic concept behind them is the provision of stable non-correlated returns.
More specifically, they are seeking strategies that will improve the overall return on their portfolios without exposing them to undue risk. Indeed, one of the main characteristics of hedge funds is that their performance is not dependent on a bull market environment.
While past performance is not necessarily indicative of future results, and hedge funds have at times been at the centre of market turmoil, an allocation to alternative investments can improve a portfolio’s ability to preserve capital and increase wealth. This is especially so if the investment is through a low risk vehicle, such as capital guaranteed bonds.
The top selling points of hedge funds are diversification and risk control. Hedge funds provide diversification by investing in niche areas, such as commodities, and by shorting stocks. The latter is crucial because short selling is something that traditional funds are restricted by law from doing.
Non-correlated
Alternative investment managers have in many cases outperformed their conventional, market-dependent counterparts. It is worth mentioning though, that Chart 1 does not include the cost of liquidity (traditionally lower for stocks) and any performance fee or other commissions.
In order to achieve the objective of providing non-correlated performance with low volatility, alternative investment strategies tend to be highly specialised. Often, they take offsetting positions in closely related financial instruments with the aim of exploiting disparities in pricing relationships. Sub-strategies include fixed income arbitrage and convertible bond arbitrage (the so-called market neutral/arbitrage strategies) or trying to capitalise on market mis-pricings related to a specific event, such as a merger, restructuring or bankruptcy (known as event strategies).
Evaluation
Risk diversification in the portfolio can be achieved by applying a scientific approach to risk measurement. Ideally, there should be a thorough assessment of the level of risk of each single asset when added to the portfolio. This can only begin once the investor’s attitude to risk has been established. A risk evaluation questionnaire should be filled in with the investor.
The next step is establish an objective comparison between the risk associated with a specific financial portfolio and the investor’s level of risk tolerance.
The Kilovar
TradingLab has designed and developed a simple and intuitive risk measurement unit called the Kilovar, in order to allow investors to find the risk level most suitable for them.
This indicator shows the risk associated with any type of investment – shares, bonds, funds, covered warrants and so on. See Chart 2.
Each risk profile relates to a Kilovar range of values. The Kilovar value may vary in range from 0 to 1000. The higher the Kilovar value, the higher the risk.
For example, in the period between January-August 2002, the level of risk calculated by Kilovar for virtually risk-free gilts was, on average, equal to nine. Meanwhile, the Kilovar for 10-year gilts was, on average, equal to 12. For a well-diversified portfolio of British stocks it was between 35 and 45, while a portfolio that would replicate the Nasdaq100 had, for the same period of time, a Kilovar with values between 70 and 85.
Kilovar values are calculated using sophisticated evaluation methods based on the same techniques typically used to evaluate market risks within particular financial portfolios.
The calculation methods are based on historic simulation. This means that the level of risk of each product is obtained by calculating the historical series of returns and subsequent analysis of any losses. The Kilovar is a dynamic measure: it is recalculated daily in order to reflect the market’s fluctuations and is objective because it relies only on market data without any manipulation.
It is a statistical measurement, and it may therefore occur, in rare cases, that effective levels of risk correspond to a higher class of risk.
An important feature of the Kilovar is that it uses a common denominator for investments of widely different types and/or investments linked to markets with varying degrees of volatility. This allows investors to choose the most appropriate investment.
The Kilovar takes into account the effect of diversification, but it should be remembered that the Kilovar of a portfolio is not simply the average of the kilovar of each instrument in that portfolio.
An instrument such as the Kilovar should be combined with the type of risk assessment questionnaire mentioned above. The result of such a questionnaire enables investors to find their personal risk profile. They can then be divided into various categories, such as “risk averse, “cautious”, “balanced”, “dynamic” or “aggressive”.
These classifications allow investors to be matched to a Kilovar level, in line with their own investment style, so that they can adjust the composition of the portfolio whenever the limit is breached.
