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Financial Markets

Financial markets are a realm of entropy

Market participants are constantly testing hypothesis, simple to complex ones. Many rules and metrics govern portfolio management. Both keep changing and require fine-tuning.
Pentagon focuses on risks before reward. The nature of risks is identified and measured before combining them into a portfolio. We treat risk as what impacts adverse move could have on portfolios. To limit negative impact on a monetary basis, we focus on building balanced low/mid Beta portfolio combined with an Alpha component. To us, the percentage allocation depends on two factors, the allocation of money (some risk-budgeting) and the necessity to obtain low correlation between Alpha and Beta. We look for granularity that can be dynamically managed, especially from a liquidity standpoint. From our experience, the Alpha component must act as a backstop during Beta correction. Downside protection by the Alpha component is paramount as it can also be a performance-enhancer i.e.“Alpha generator”.
Similarly, a Family Officer, like a doctor, would collect information, diagnose, and filter out data (intelligence phase), then formulate hypothesis/ prognosis while shielding clients from unforeseen events before they may arise, avoiding deterioration (of wealth).
Within any portfolio, there are always bets on the events compared to various outcomes; and it pays to formulate differing hypothesis prior to portfolio construction so as to a) monitor the events, b) rebalance based on outcomes and c) review the process with a market-adaptive/fine-tuning approach. If there is an edge, it would be found here because at times of higher uncertainties; we know less about outcomes, limiting probability-weighted decisions.
Playing great defense is a constant rule as there can be phases of retrenchment.
When building and monitoring any portfolio, we aggregate risk and account for variability: downside risks, where variability means “volatility trend analysis” and “correlation matrix” through several time frames. There are dynamics, markets and risks being time-sensitive: frequencies, magnitudes, cycles are our measures. When we observe variations in some measures or certain levels, we review the probabilities, which may provide higher degree of confidence, especially in times of re-correlation. We combine return analysis, risk/return ratio, Sortino-like. On a distribution basis, we look at negative returns to assess downside risk, and calculate higher moments: kurtosis and skewness. Any Beta strategy, even smart Beta, will lean towards negative skewness with larger drawdowns than dynamically managed ones or strategies that employ tactical re-allocation with an Alpha component. In other words, long-only strategy or any buy-and-hold strategy will reflect higher downside. We tend to focus on Alpha strategies regardless of academic debates. As practitioners, we also favor tracking several CIOs’ research/analysis of great qualitative value. External non-fragmented reasoning is best. Some are more macro-focused, others are more geopolitically-oriented; some have tendencies for confirmation bias, others not. Overall, it is extremely discerning.
However imperfect and biased our understandings are of market circumstances, the point here is that others’ reasoning is of great value whatever investment style applied or opinions expressed.
Any current circumstances in markets can never be assumed to persist while all parameters remain identical. In effect, a market can continue to rise while risk measures can decrease. The market might not be appropriately pricing in risk. For instance, participants can factor in a differing order of importance macro risk such as Quantitative policies from Central Banks (e.g. QE), EU Sovereign Debt Funding, US Corporate Debt and US-China trade dispute, the latter dominating in 2018, while CBs policy is the front-runner so far since 2019Q4.
Any current state of affair will have a varying weight from past events onto prospective future ones. That is why risk must be looked backward, at current levels and projected forward. The best forward positioning for investors we found, is based on being diversified as per our approach described above plus, devising liquidity plan, diversified among asset classes and instruments– with concentrated diversification e.g. the benefit of holding 8 to 12 underlying funds is virtually identical as holding 25 funds in terms of volatility compression. By the same token, replicating an index of 700 stocks or 300 bonds, or a CTA with 70 positions is not worth considering to us. One of the best forward tools we have is to limit/reduce monetary exposure ahead of unfavorable outcomes/events, defining maximum risk tolerance at specific monetary levels/percentages.
Flexibility in adjusting to market conditions is both risk-adaptive and capital-efficient to us. In our portfolio management approach we like to envision some advanced degree of hedging should downside risks evolve. If a probability of events going bad materializes due to disruption or massive change of perception (e.g. cyclical downturn shifting investor’s focus) we must be prepared to prevent from negative impact. Likewise, during typical “profit-taking” phases, downside protection must be activated.
With its global outreach, the S&P 500 futures index encompasses all economic sectors.
It offers a perfect backstop and a performance-enhancement complementary to any traditional asset allocations: downside protection with de-correlation.
When managed efficiently, it becomes an instrument of first choice to complement investors' strategic portfolio allocations. Besides, the S&P 500, as opposed to single stock or baskets, has no idiosyncratic risk.
When locating a strategy with negative correlation and positive returns, investors can magnify this effect by leveraging the uncorrelated returns by utilizing such strategies as a tactical overlay strategy. For long term capital preservation and enhanced returns, dynamic tactical allocation is compatible within any portfolio along with most asset classes: investors can gain an edge in capital preservation, limiting downside risk and achieving superior returns.
Hedge funds were invented as a way to diversify investor portfolios and to better manage risk (by “hedging”), but the bull run in equities in the past decade has “converted” many to long only exposure one way or another, as if there is no choice but to be long equities if one wants to achieve decent performance. The diversifying nature of hedge funds isn’t just supposed to be to equities. This is otherwise with our Alternative Investment Fund as we move a step further,
Pentagon Alpha Defender Fund V6 & V9 which strategy is differentiated and not simply hedge funds “mainstream”.
Being prepared and playing great defense: in case events go badly, outcomes can turn dramatically negative. Ensuring investors are not too exposed to downside risk while potentially benefiting from adverse moves or abrupt disorder: If you consider hedging your portfolio allocation, we suggest you check your Alpha component, if any, and then review it with an increased sense of robustness complementary to your existing Beta exposure adding a disciplined approach to risk-mitigation and money-management should prove beneficial for pure Alpha genesis.
In Defense of Alpha
By Jean-Marc Bloch-Lambert, CIO, The Pentagon Group
Pentagon Alpha Defender Fund V6 & V9