CAIA Me m b er Contribution

Andrew Rozanov, CAIA

Managing Dire ctor, Hea d of Permal Sovereign Advisory
1. Introduction
This article c onsiders what underlying exposures drive portfolio returns in periods of extreme market stress and

and are now keen to avoid a repeat of that p ainful experienc e, need to identify and c orre ct unintended risk

In this p a per we take a slightly different angle, drawing on a c a demic research and relevant pra ctitioner

develop the c onc ept of a “ c onvexity c om pletion portfolio.”

and very long time horizons – sovereign wealth funds, end owments, found ations, and pension plans – we need
to a cknowled ge two im portant c aveats.

Caveat # 1: trading growth optimality for robustness

Despite the multiple and varied alternative a p proa ches to asset allo c ation and tail risk hed ging, on a

and permanently eliminated.1

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forc ed to unne c essarily give up growth optimality to satisfy politic al and reputational anxieties? If it is the latter,

optimality.

Caveat # 2: growth optimality of equity-centric portfolios

perc eption of equity as an asset class is c onditioned almost entirely on our experienc e of the goo d years, with
solid and relatively uninterrupted e c onomic growth throughout most of the developed world, espe cially in the

2. Three schools of thought

Now let us turn to the main fo cus of the p a per and c onsider in turn the three schools of thought which attem pt to

investment strategies – looking at how they performed in different m a croe c onomic environments and how they
rea cted to various sho cks – would have at least some fa miliarity with three overla p ping, yet distinct schools of

1. Levels and / or changes in volatility (i.e., long vol versus short vol)

nothing to do with hed ge funds: it looked at c onvex and c onc ave return p atterns arising from various portfolio

Although the other two schools of thought a p pear to have their origins in hed ge fund strategies and options
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volatility position? Do I need to mitig ate it in the options market or should I simply rely on disciplined c ontrarian

tra ditional portfolio m ana gement.

m a cro, is where we c an offer most value to institutional investors.

2.1. Exposure to volatility

Analysis of hedge funds in terms of their long or short exposure to volatility has its roots in the seminal p a pers of

fa ctor exposures of different hed ge fund strategies and how one might use this knowled ge to replic ate hed ge

Exhibit 1Payoff to Stra ddle

Source: Author
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Exhibit 2 Payoff to Short Volatility

Source: Author

or short vol.

c olla pse, unsurprisingly, is dedic ated short selling; however, it is linear in its risk and as such is not c onsidered to

2.2. Exposure to non-randomness

Another school of thought fo cuses on im plicit exp osures of different hed ge fund strategies to different p atterns of
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Exhibit 3
Source: Author

strategies.

p arameters, including higher moments, Sharpe and Sortino ratios, and relative perform anc e during times of

Convergent strategies have lower volatility, more neg ative skewness, and larger kurtosis.
Divergent strategies tend to outperform when equity market volatility spikes.

2.3. Exposure to non-linearity

c onvex: during strong and persistent m arket moves in either dire ction its outperform anc e a c c elerates.

The authors also provide a very im portant theoretic al insight into c onvex and c onc ave strategies in the c ontext
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Exhibit 4
Source: Author

Exhibit 5
Source: Author

more from a large neg ative move than it g ains from a similarly large positive move in the underlying market.
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short stra d dle positions: while a large move in the underlying asset in either dire ction lea ds to ever larger and
a c c elerating losses in a short stra d dle position, it c onversely results in ever larger and a c c elerating g ains in the
long stra d dle position.

“What is a c onvex play? Simply put, it is one where you risk a penny to make a million. Your potential losses are
limited and typic ally known beforehand while your potential g ains are immense and unknowa ble. You gain
disproportionately from turbulent developments in the asset m arket of your choic e… The op posite of a c onvex
punt is a c onc ave one, where you risk a million to m ake a penny. Your potential g ains are limited and typic ally
known in a dvanc e, while your potential setb a cks are huge and unc ertain.”

and asso ciated c osts.

3. Practical considerations and challenges

Exhibit 6 Payoffs to Long and Short Stra d dles

Sourc e: Author
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Long volatility = Divergenc e = Convexity

Short volatility = Convergenc e = Conc avity

3.1. Volatility exposure of CTAs

that CTAs really have high volatility dependenc e

or tha t CTAsc a n p roÀt p urely from vola tility c ha ng eslike a n op tion stra teg y.” In option terms, the similarities c ome
from similar long ga mm a or c onvexity exposures, not similar long vega or volatility exposures.

Typic ally, m arket crashes c oincide with spikes in volatility, so it may a p pear that CTAs c ash in due to their assumed

3.2. Institutional rebalancing policies and CTAs

quiet trending markets. In this p articular c ase, the three schools of thought discussed earlier d o not ma p neatly

volatility.

would c ome out on top.

3.3. Divergence versus convexity

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Our c ontention is that it is neither the nature of their strategy on the “ c onvergenc e / divergenc e ” criterion, nor

“When you take an initial position, you have no idea if you are right… [The metho d is] to write a script for the
m arket, setting out how it might behave; and then to test the hypothesis repeatedly with low-risk bets, hoping to
c atch the moment when [the] script [has be c ome] reality...”

m ana gers often changing their style and a p proa ch over time. This is why, in our view, p artnering with experienc ed

c onvex exposures over time.

4. Preliminary conclusions and next steps

interestingly, all three a p pear to have the same messa ge for those investors who w ant to strengthen their fra gile

im portant asymmetry and c onvexity of returns that investors seek during times of crises and market dislo c ations.

allo c ation, we are p articularly interested in how well it c an sup port the portfolio when the main equity growth
engine stalls; in other words, the degree of c onvexity is p articularly relevant in the dom ain of large equity losses.
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an interesting ne w argument: ha ving elimina te d left tail risk, an investor c an the oretic ally c onstruc t a mu ch riskier p ortfolio – say, inste a d

c ontrarian value investor with high risk tolera nc e. Currently, we are not a ware of a ny investors who ha ve im plemente d this a p pro a ch;

Referenc es
Revie w of Finan cial
Studies

Journal of Investment M ana g e ment

Journal of
Portfolio M ana g e m ent

Diverg ent Strate gy A p pro a c h.” The Journal of Alternative Investments

Revie w of Financial Studies

Content of Tra ck Re c ords.” Journal of Portfolio M ana g e ment

Revie w of Finan cial Studies

 CAIA Me m b er Contribution

The Drivers of He d g e
Fund Returns

Financial Analysts Journal

The Journal of Alterna tive Investm ents

Journal of Finan c e

Financial Analysts Journal

Author Bio
Andrew Rozanov, CAIA is M ana ging Dire c tor and He a d of Institutional Portfolio A dvisory

institutional investors on various asp e c ts of asset allo c ation, p ortfolio c onstru c tion, risk

risk strate gies.