As the old saying goes: “insurance seems expensive till the day you need it.” Although crisis alpha differs from insurance, the mentality of investors towards this asset class is much the same – investing too late and getting out just before the next event arrives.
In 2008, while broader markets tanked, some strategies posted strong performance. The notion of ‘crisis alpha’ has since been born.
What is crisis alpha?
Much like tail-risk hedging, or insurance, crisis alpha should ‘pay out’ during periods of market stress by achieving its highest gains. These strategies are fundamentally different in ‘normal’ market environments, however. As active strategies, they can generate slightly positive gains, preventing investors from bleeding money as they would with hedging or insurance.
Generating alpha in a crisis requires some common characteristics: they need to be diversified and unconstrained in order to adapt and exploit changing markets; and should not be negatively correlated to other markets. The last crisis showed how correlations can change during crises and spike to one across a broad range of previously negatively correlated asset classes. They should be uncorrelated, rather than negatively correlated.
“Crisis alpha strategies should not be exposed to liquidity or credit risk,” explains Per Ivarsson, head of investment management at RPM Risk & Portfolio Management. “Crises usually stem from those two factors.”
Commodity trading advisers (CTAs) and volatility strategies are two of the main components of this asset class, but provide outperformance for different reasons. Many CTAs follow trends either systematically or through discretionary management and should be able to exploit those trends – regardless of directionality. During 2008 the Barclay CTA Index posted returns of 14.09% compared to -28.3% for the FTSE 100 and -40.33% for the MSCI World.
Volatility strategies, meanwhile, can also outperform during periods of greater volatility. The vast majority of institutional investors are inherently short volatility, which decreases during periods of sustained growth in equity markets and rises as a crisis (or sharply positive surprise) hits. Long-volatility positions are commonly used as a tailrisk hedge, but are expensive to maintain because of the cost of rolling futures positions.
However, according to Christopher Cole, founder of Artemis Capital Mangement: “Crisis alpha is about balancing long and short volatility positions in such a way that is positively exposed to market crashes while limiting the cost of carry. When executed correctly this provides excellent performance during large declines when traditional strategies underperform, but prevents the portfolio from continuously bleeding value the way many tail-risk strategies do should a full-blown crisis not materialise.”
Bad psychology?
Ideally, as with insurance, investors would buy into these strategies just before a crisis hits and exit once markets normalised. What investors have tended to do, however, is the complete reverse – buying after a crisis and selling just before the next one hits. “The CTA industry has been around for 40 years,” Ivarsson says, “and we have seen the same pattern for 40 years. It is inevitable in a world dominated by past performance and return-chasing. Investors also tend to allocate looking at the overall portfolio context where CTAs make sense, but then evaluate their performance on a stand-alone basis.”
Artemis’ Cole calls this the “post-traumatic deflation disorder”, adding: “Immediately after the financial crisis everyone wanted to be in long-volatility and tail-risk strategies so the premiums became very expensive. Now nobody wants these strategies and things have become really inexpensive again.” Following strong 2007 and 2008 returns, CTAs became popular with institutional investors.
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