Value Investing

Red Rock Capital – A (Diversification) Dream Come True

Red Rock Capital – A (Diversification) Dream Come True

Recently Red Rock Capital has received a lot of questions about how our two strategies may combine together. This is a topic about which we are very fond. Our newer Commodity Long-Short strategy was designed to be systematically different than our original Systematic Global Macro strategy. It is not a surprise to us that our happiest investors seem to be those that have exposure to both of our two programs. In this paper we will examine how the two strategies hypothetically combine together – and how they may benefit portfolios of stocks and bonds – and portfolios of stocks, bonds, and CTAs.

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  • In the above, the gold line is our Commodity Long-Short program’s actual, net of fees composite track record since its September 2013 inception. The dark red line is our Systematic Global Macro program’s actual, net of fees composite track record for the same period. The green line is a hypothetical 50/50 combination of the two programs. (Past performance is not necessarily indicative of future performance.)
  • More importantly than the performance of either strategy over this period, we’d argue the most noteworthy characteristic is the extremely low 0.14 correlation between the two strategies. This is why the combination of the two looks so appealing. (Past performance is not necessarily indicative of future performance.)
  • While our Commodity Long-Short program has produced higher returns, those returns have been accompanied by higher volatility. The latter reality is intentional; we run our CLS program at a higher volatility (“heat”) setting than our SGM program.
  • It is important to remember that, due to the inherent (i.e. free, as opposed to having to pay to borrow to lever up equities) leverage of futures markets, a CTA manager makes a subjective choice as to what level margin-to-equity / volatility / heat setting to operate his or her program – but the level chosen is not, in and of itself, a source of “goodness.”
  • Since the relationship between such characteristics as returns, volatility, and drawdowns for each of our two programs are functions of the subjective decision that we made regarding how much volatility to target with each program, risk-adjusted metrics (i.e. “reward to risk ratios”) must be applied to get an accurate and normalized comparison between the two programs’ performance.
  • While the Sharpe Ratio is the most popular risk-to-reward ratio, as we convey in our white paper, Sortino: A ‘Sharper’ Ratio, the Sortino ratio is a more appropriate measure to use. This is because the Sharpe ratio, by assuming that the returns it is measuring are normally distributed, unfairly and incorrectly penalizes programs whose returns exhibit positive asymmetry (skewness). In reality, investors typically welcome upside volatility and perceive only down-side volatility as actual risk.
  • Note the colored arrows in the above table. It is no wonder our happiest investors are those that have exposure to both of our two programs. By combining the two strategies, the Sharpe ratio increases, the Sortino ratio goes up, the MAR (annualized return / maximum drawdown) increases, and the maximum drawdown decreases. (Past performance is not necessarily indicative of future performance.)

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Why do the two strategies complement each other so well? A few reasons are that they have different return drivers, they trade different portfolios, and they hold positions for different lengths of time.

Which program will likely perform best going forward? We cetainly do not know; spreading one’s bets may be the most advantageous, lowest-risk approach.

Red Rock Capital – Stocks, Bonds, & CTAs

Winton Capital, the largest and undoubtedly one of the best CTAs of all-time, stated that “The long-term historical correlation of CTAs with global stock markets is essentially zero.”

Back in 1983, Harvard professor Dr. John Lintner was onto this and acknowledged how valuable Managed Futures / CTAs could be when he said, “…portfolios…including judicious investments…in managed futures accounts show substantially less risk at every possible level of expected return…than portfolios of stocks (or stocks & bonds) alone.”

The preponderance of the assets under management by CTAs is, and always has been, since the early days of our industry, invested utilizing “trend-following” methodologies generally similar to our Systematic Global Macro program.

While three decades of history and piles of academic analysis has shown that “trend followers” can help add diversification to traditional portfolios of stocks and bonds, we thought we could add significant value for our own capital, and for potential investors, by designing a strategy that would have and maintain a very low correlation to trend following strategies.

Said another way…. we postulated that:

… if Stocks + Bonds + CTA Trend Followers = Good

… then maybe Stocks + Bonds + CTA Trend Followers + CLS = Better?

Red Rock Capital – Stocks, Bonds, CTAs, & Commodity Long-Short

In the below table and via the chart on the following page, we present and analyze the performance of a traditional 60% stocks / 40% bonds portfolio, a hypothetical portfolio made up of 75% of the traditional 60/40 portfolio along with a 25% allocation to our SGM program, and finally a hypothetical portfolio comprised of 75% of the traditional 60/40 but with a 25% allocation to a 50/50 blend of both our SGM and CLS programs. For the period since its inception in September 2013 through March 2016, would our Commodity Long-Short program prove to be a ‘diversifier for diversifiers’?

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  • As most investors know, over this period, the traditional 60/40 portfolio of stocks and bonds has produced impressive results (7.95% annualized returns, 1.13 Sharpe).
  • ‘Proving’ Dr. Lintner correct and as we’d expect, adding a 25% allocation to our Systematic Global Macro program improved the results of the 60/40 baseline portfolio handily. Sharpe and Sortino ratios both went up – as did the annualized return / maximum drawdown metric.
  • The most impressive results were obtained by adding a 50/50 blend of both CLS and SGM programs to the traditional 60/40 portfolio. Both Sharpe and Sortino ratios almost doubled, the maximum drawdown was reduced, and the annualized return / maximum drawdown metric nearly doubled.
  • Both principals of Red Rock Capital continue to keep their personal capital invested at a 50/50 (vol-weighted) exposure to both CLS and SGM programs.

It is important to remember that both of our two investment management programs should be considered as portfolio diversifiers / complements – not as panaceas for improperly diversified and / or over-leveraged investors trying to make a quick buck in the short run.

See full PDF below.