Winter is coming. Let it snow, let it snow, let it snow.
September 26, 2022
August was an outstanding month, as volatility and a renewed bearish sentiment in fixed income and equities drove all our quantitative, short-term, non-trend-following investment programs to strong gains.
Our flagship, the Diversified Program, gained 10.8%, the Smart Alpha Fund gained 4.4%, and the lower volatility Smart Alpha UCITS Fund rose 1.8%. The 5-10 day trade duration Emerald Program rose 12.1%. Total firm assets are $1.04 billion as of 31-August.
The Diversified Program is near the top of all hedge funds in the world with returns of approximately +63% YTD through August 31, after returns of +19% in 2021 and +32% in 2020. Founded in 1993, this program has benefited from its accurate trading of equities and commodities this year, as well as its trading of fixed income and foreign exchange. Our year-to-date returns are the highest ever in this program’s 30-year history, reflecting the outstanding environment for this program’s strategy. Though this fund has a fairly high expected volatility at 16-19%, its strong negative correlation and Beta to equities makes it an interesting vehicle in today’s turbulent times.
Set at an expected 10% annualized volatility, the Smart Alpha Program, which trades only fixed income and foreign exchange and is designed to be zero risk weight under Basel III, is up 23% YTD through August 31. Its UCITS-compliant cousin, the Smart Alpha UCITS Fund is up 11% YTD. The Emerald Program, which trades with a slightly longer 5-10 day duration and is expected to have a 0.4 correlation to Trend Following over time, is up 46% YTD and continues its outstanding 2022.
Sector performance paced by Equities and Fixed Income
Equities: The Diversified and Emerald programs were extremely successful in equities, as large one-day moves first upward early in the month and then downward in the second half of the month gave our short-term models excellent opportunities.
Large one-day equity moves helped the Diversified and Emerald programs in August.
Commodities: Commodity trading was another story, unfortunately. The Diversified and Emerald programs had difficulty here, and dropped just under a percent in energy trading and about ¾ percent in grains, with metals trading posting slight gains.
Fixed Income: All programs profited in the sector, as signals produced a short bias for most of the month following the false rally to start August. Our models quickly profited from the large down days early in the month, and then continued their success with continuing short-biased positions in both US and Europe as the sector trended sharply lower. Contrarian, machine learning and long-term styles contributed to gains in US fixed income. In Europe, machine learning, breakout, momentum and long-term styles were profitable.
US 10Y Note Futures succumbed in August to clear inflation-fighting resolve by the Fed, and our models were extremely successful in the fixed income sector.
FX: In FX, losses in Euro outweighed our gains in Yen, Canadian and Australian Dollar trading, and so we ended the month slightly down in the sector. In Euro, our models had small short positions early in August looking for another leg down, but the Euro instead broke out to the upside to shift our models long.
Trading in $/Euro was more difficult.
The subsequent false breakout and resumption of the down move caught our models leaning the wrong way, followed by an extremely quiet two weeks spent around the 99.80 level to close out the month that didn’t provide any opportunity for our models. Breakout, contrarian and momentum styles had difficulties in the Euro for August.
Investing without a safety net
This year will complete our third full decade of trading for clients at R G Niederhoffer. It is certainly encouraging to have our flagship, the Diversified Program, putting in its best year ever in its 30th year of its track record. Or maybe it’s more than encouraging – it’s not a coincidence.
The biggest change benefiting our strategy in 2022 is the end of the so-called “Fed Put” — the repeated efforts by the Fed and other Central Banks to provide liquidity to markets during large stock market selloffs that began after the stock market crash of October 19, 1987, a day I remember vividly as it happened in only the sixth week of my trading career.
During 2022, I’ve been reminded frequently of 1987 — that inflationary, volatile, formative year for me. In fact, it isn’t lost on me that my entire career in short-term trading has been spent employing — and marketing to clients — a strategy that has been in direct competition with bonds, which have seemed to serve as “crash insurance” ever since Fed Chairman Greenspan lowered rates to save the markets after the Crash of ’87.
Our Diversified (and Smart Alpha and Emerald) Programs are designed to provide a similar goal of positive return and downside protection to what bonds have offered. A couple of years ago, if asked, I might have said that bonds have sometimes done a decent job of providing this protection, but maybe we’ve done a better and more consistent job.
But now, with mounting inflationary pressures, Central Banks can no longer provide liquidity with impunity to save stock markets. Stocks and bonds have become positively correlated assets, it is dubious to think of bonds as diversifying or protective. The safety net of the 60/40 stock/bond portfolio is gone.
A world of pain
This new macro environment may last quite some time. Fed Chair Powell certainly drove that message home in his highly anticipated late-August speech in Jackson Hole. He said, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
Inflation has soared this year to its highest level in 40 years.
This was certainly a departure, for it could be said that every Fed Chair since Alan Greenspan in 1987 has made pain avoidance an integral part of his or her strategy. In fact, the very existence of the so-called “Fed Put” – allowing investors to use Bonds as a positive-return, protective insurance policy on their equity portfolios – was the ultimate in pain management. Under Modern Portfolio Theory, this insurance policy should cost money, not pay you a yield to own it. Diversified portfolios of stocks and bonds have certainly reduced investor pain over the last 35 years.
Simply said, this year, without the safety net of the Fed Put, it’s much scarier in the markets. Our models — which capture the impact of human behavioral biases — have increased their accuracy to record levels.
Uncertainty and volatility remain elevated as we enter the Autumn. We don’t know how much pain the Fed is warning us to expect, at what point they will act, or what they will do should things take a turn for the negative before inflation is tamed.
As far as portfolio construction goes, it is certainly more challenging to find protective strategies in a world in which fixed income no longer provides diversification for equity investors. In addition to our primary focus on strong standalone return, it is my belief that our strategies’ strong emphasis on negative correlation and protection for equity and fixed income investors and their extremely low correlation to trend following represent a particularly useful portfolio construction tool in today’s environment.
It may be useful to examine our performance in the worst drawdowns and best run-ups for the S&P 500 and Barclays Global Agg. Fixed Income to see a demonstration of this.
Drawdown and runup periods are measured as 100 trading days or less. Based on performance dates shown in tables above. Source: RGNCM; S&P 500 – Total Return; Hedge Funds – HFRXGL; CTAs – SG CTA Index. Hypothetical returns have inherent limitations as set forth in the Disclaimers at the end of this material. See such Disclaimers for details regarding time periods showing actual, pro forma, and hypothetical data. In summary, RGNCM data are hypothetical during the following periods: (1) RGN Smart Alpha, through November 15, 2018; (2) RGN UCITS, through July 14, 2020; and (3) RGN Emerald, thru November 38, 2021. PAST PERFORMANCE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
Without the foundational stock/bond diversification that has underpinned portfolio construction for decades, investors are in uncharted territory. Markets have the potential to move in ways that are unprecedented, and unknown risks abound. The pain that has occurred so far may not be over.
It is not too late to add additional diversification to portfolios, and to replace the diversification that fixed income once provided with other types of strategies that still do provide protection and positive return.
We look forward to exciting times ahead, for the rest of 2022 and beyond. If you’d like to schedule some time to exchange ideas on portfolio construction, market conditions, or the macro or quant outlook going forward, it would be my pleasure to schedule some time to chat.
P.S. We have some interesting overlay versions of our strategies that can use parts of your existing portfolio, like US or Global equities, as collateral in some very interesting ways. For example, an overlay of 50% Smart Alpha plus some of your existing S&P 500 exposure can double the return of the S&P 500, with 0.99 correlation to the S&P 500 and less overall volatility. Let me know if you’d like to see this. It works for Bonds and hedge funds too.