C8 Monthly Update – Power of Combination – May 2020

C8 Monthly Update – Power of Combination – May 2020

Power of Combination with Risk Premia

The last few months have seen difficult markets in many asset classes not only in equities.  It is therefore interesting to examine how Alternative Risk Premia (ARP) has performed over the period.  We track ARP in rates, FX and commodity markets.  We also have a US Equity ‘Good Governance’ premia and can facilitate offshore  access to our ARP Index on the Chinese futures markets.  As the charts below illustrate, risk premia has performed well over this period and has acted as a good diversifier to long equity and credit portfolios.

As we have discussed previously, the rationale for risk premia is to extract alpha from long-term financial market inefficiencies. Each risk premia may only generate small, sometimes inconsistent, returns through one key characteristic, such as the slope of a rates curve. However, the key attraction of this approach is that these returns are typically uncorrelated across asset markets and even across individual instruments within the same asset class. It is the  ‘Power of Combination’ where multiple return streams are combined together that makes ARP an attractive proposition.

Combining Rates, FX and Commodity ARP

The most straightforward way is to combine classic risk premia approaches across rates futures, FX and commodity futures markets.  Each produces a better performance than an individual risk premia, but the three combinations are also uncorrelated, so producing a further improvement in risk/return when combined on a simple ‘Risk Parity’ basis (i.e. equal, vol-adjusted weights  rebalanced annually).  This overall combination of monthly-rebalanced Indices has produced a Sharpe Ratio of 2.6. since 2012.

Next step: adding in US Equity ‘Good Governance’ and China Commodity Premia

There are other, less conventional, risk premia indices on the platform, for example, there is a long term ‘Good Governance’ risk premia (long the best governed S&P500 companies, short the S&P500 index).  In addition, offshore investors can now access the risk premia performance in the Chinese commodity markets, via a bank swap between HK and Shanghai.  Adding these in to the mix further improves the risk return.  The correlation table below illustrates why this works so well, with no correlation above 10% between any Index.  This combination of monthly-rebalanced Indices produces a Sharpe Ratio of 2.9.

We are not believers in short vol premia, which can work well for a period, but then gets hit in volatile markets, as illustrated in the past few months. So, note, there are no short vol Indices in C8 Studio.

Of course, the real beauty of the C8 platform is that the client can pick and choose a portfolio exactly to their requirement, e.g. to match their investment mandate or to provide diversification from their existing investment strategies.  In addition, C8 Studio allows clients to explore a number of different ways to combine Indices, once the selection has been made.

JP Omega US Cross Asset Index is now available on the C8 Platform

We are delighted to add our first JPOmega Index to C8 Studio. JPOmega US Cross Asset Strategy employs a systematic and fundamentally new investment approach. The delivery of the strategy is optimised to both participate in booming markets and to provide superior protection in market distress. Risk/reward is measured by the proprietary “Johnson-Omega” methodology which, in a non-discretionary manner, comprehensively takes the economically meaningful statistics into account. The US Cross Asset Index implements predominantly momentum-driven, long-only trades, in highly liquid US-related instruments (S&P500 sectors, Russell 2000, 10 & 30 Year Treasuries, Oil, Gold & Cash), rebalancing monthly.

JPOmega derived “Johnson-Omega” by combining the well-known Omega measure with the flexible family of Johnson distributions. The validity of Johnson-Omega has been published in Risk Magazine (2005 and 2016), where it was demonstrated how Johnson-Omega clearly delivered outperformance across both the 1998 LTCM crisis and the 2008 financial crisis. This resilience has been further demonstrated during the 2020 Covid-19 market dislocations.  It is achieved by moving the return curve to the right, so the Johnson-Omega methodology improves the risk/return by increasing the probability of gains versus that of losses (illustrated in the chart below).

The Cross Asset Index has traded for three years out-of-sample and, despite being a long-only Index, we note that the Johnson-Omega method avoided a major drawdown in March this year, and, as a result, is up nearly 2% ytd.

Dr Passow who developed this methodology founded JPOmega in 2014. He has a PhD in Maths followed by post-doc research in Finance, before working at Gottex Fund Management, HSBC Investments, and Deutsche Bank.  As we discussed above, a key element of C8 Studio is the ‘Power of Combination’,  so the Johnson-Omega methodology has the potential to add further value to combining Indices in C8 Studio.

Favourites function added to C8 Studio

As more providers join C8 Studio, we have given some thought to improving the user experience. To that end, we have added a Favourites button to make preferred Indices easily accessible. By clicking the star to the left of an Index, a Favourite can be selected. Then, selecting the star at the top of the table, displays all the Favourites, see below.

Select Favourites 

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April 2020 Performance

There was a sharp bounce back in equity markets in April, with our ‘Long-only’ equity Indices performing well, though all remain in negative territory for the year.  However, it was also notable that our non-equity indices did not give up too much of their gains, indeed our sample FX Combination gained a further 4%.