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Trading Funds - An Alternative Asset Class

In these times of extreme market volatility trading funds are one option to improve returns and lower risk, Trustee Executors investment analyst Martin Pike says.

Monday, June 29th 1998, 12:00AM

by Philip Macalister

As an investor, have you ever considered whether you might wish to invest in more than just assets that attempt to capture the rise of equity or bond markets? Assets that could offer returns when markets track sideways or, more alarmingly, fall?

Fund managers have in the past used the safe havens of cash or bond investments to smooth overall portfolio volatility, producing the long-term pattern of ‘rollercoaster returns’. There is however, a powerful case for including investments in portfolios which have a low correlation with the performance of equities and bonds (i.e. ones which perform out of synchronisation with these asset classes).

Now a new asset class, which can be termed ‘trading funds’, is being utilised increasingly to reduce volatility during periods of market uncertainty. These funds can serve to widen the overall scope of investment opportunities and provide additional portfolio returns.

Trading funds are often more commonly known as hedge funds. They are offered by experienced managers who utilise their knowledge and understanding of markets and economics to pursue opportunities on the long (buy) and short (sell) side of bonds, commodities, equities, index options and futures, and foreign exchange markets. The primary objective of their analysis is to achieve capital growth irrespective of conditions in conventional equity and bond markets, while maintaining highly disciplined risk control.

Having part of a portfolio invested in trading funds can have the effect of lowering its overall volatility.

Trading funds no longer suffer from the lack of awareness which had previously hindered their appreciation by investors. They are rapidly becoming a widely accepted addition to the traditional equities/bonds/cash mix, accounting for as much as 5 to 10 per cent of portfolios, as indicated by research from pension fund and other professional consultants.

The risk attraction of trading funds

The attraction of trading funds in terms of risk can be measured by the three core statistical measures, namely; standard deviation, drawdown and the Sharpe Ratio.

Trading fund risk can be measured against the acceptable level of risk offered by traditional equity investments as measured by the MSCI. The standard deviation of returns is a measure of volatility and the maximum drawdown is the largest fall in value suffered by the instrument during the period under review. Both of these statistics are considered to indicate low risk if the value is low. The final measure is the Sharpe Ratio, a measure of the risk-adjusted return from the instrument. The higher the number, the more advantageous for the investor and a value over 1 is considered a threshold level for indicating good risk-adjusted investment returns.

Using the Global Asset Management (GAM) Trading US$ Fund from April 1990 to June 1998 we get the following results

  • Standard Deviation for the trading fund was 7.0, almost half that for the MSCI, 13.0
  • Maximum Drawdown for the trading fund was 10.9, again almost half that for the MSCI 19.9
  • The Sharpe Ratio for the trading fund was 1.28 versus 0.60 for the MSCI

The first two statistics lend support to the destruction of the myth that high risk is normally attributed to the trading asset class.

A Sharpe Ratio of 1.28 demonstrates the potential value of this trading asset class within a well-diversified portfolio.

Added to this is trading funds historically outperforming in down markets (when the MSCI is negative) over 80 per cent of the time and comparable performance returns with the MSCI over a long-term period.

In conclusion, trading funds can play an important part in the success of a diversified investment portfolio and the ability to diversify portfolio risk further enables trading funds to stand out as a valid additional asset class.

Martin Pike is an investment analyst with Trustees Executors.

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