In November 2002, Cass Business School Professor Harry M. Kat, Ph.D., began to circulate a Working Paper titled “Managed Futures and Hedge Funds: A Match Made in Heaven,” that later (Q1 2004) would be published in the Journal of Investment Management. The paper described how adding (equity-based) hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility. It also produced an undesired side effect — increased tail risk (lower skew and higher kurtosis).
Kat went on to analyze the effects of adding managed futures to traditional portfolios and the effect of adding both hedge funds and managed futures to traditional portfolios. He found that managed futures were better diversifiers than hedge funds, and that they reduced the portfolio’s volatility to a greater degree and in a more timely manner than did hedge funds, without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with traditional portfolios. Kat’s original period of study was June 1994 – May 2001.
In September 2012, Sunrise Capital published a white paper that revisited and updated Kat’s work. We analyzed the out-of-sample period since the end of his study, June 2001 to December 2011, and found that his observations continued to hold up. During the past 10.5 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for stock and bond portfolios than have hedge funds.
Skewness and kurtosis
When building portfolios using the Modern Portfolio Theory (MPT) framework, investors focus almost solely on the first two moments of the distribution: Mean and variance. According to a 2011 study by Marc Odo, the typical MPT method of building portfolios appears to work well as long as historical correlations between asset classes remain stable. But in times of crisis, asset classes often move in lock-step and investors who thought they were diversified experience severe “tail risk” events. By only focusing on mean return and variance, investors may not be factoring in important, measurable and robust historical information.
Skewness and kurtosis, the third and fourth moments of the distribution, frequently offer vital information about the real-world return characteristics of asset classes and investment strategies. Skewness and kurtosis are paramount to this study:
- Skewness, a measure of symmetry, compares the length of the two “tails” of a distribution curve.
- Kurtosis is a measure of the peakedness of a distribution — i.e., do the outcomes produce a “tall and skinny” or “short and squat” curve? In other words, is the volatility risk located in the tails of the distribution or clustered in the middle?
To understand how vital these concepts are to the results of this study we revisit Kat’s original work. Kat states that when past returns are extrapolated, and risk is defined as standard deviation, hedge funds do indeed provide investors with the best of both worlds: An expected return similar to equities but with risk similar to bonds. However, Kat showed that during crisis periods, hedge funds also can be expected to produce a more negatively skewed distribution. Kat adds, “The additional negative skewness that arises when hedge funds are introduced [to] a portfolio of stocks and bonds forms a major risk as one large negative return can destroy years of careful compounding.”
Kat’s finding appears to be substantiated in Koulajian and Czkwianianc (2011), which evaluates the risk of disproportionate losses relative to volatility in various hedge fund strategies: “Negatively skewed strategies are only attractive during stable market conditions. During market shocks (i.e., the three largest S&P 500 drawdowns in the past 17 years), low skew strategies display: Outsized losses of –41% (vs. gains of +39% for high skew strategies); increases in correlation to the S&P 500; and increases in correlation to each other.”
Skewness and kurtosis may convey critical information about portfolio risk and return characteristics.