Portfolio managers can profit from using derivatives satellite portfolios as portable alpha and beta vehicles in absolute return strategies, according to research done by Edhec Risk and Asset Management Research Center and Eurex.
These portfolios, based on active asset or sector allocation decisions, can be used either as stand-alone absolute return alpha providers, or as overlay portfolios customized to help managers modify the exposure of their portfolios with respect to a variety of sources of risks on which they have no desire to bet, the research shows.
Focusing on the Euro zone, the Edhec Risk and Asset Management Research Centre’s studies report statistically significant evidence of predictability at the 2.5% level in Dow Jones EURO STOXX 50 excess return for the period from July 2000 to June 2003.
These econometric forecasts can be turned into active portfolio decisions and implemented via Eurex index futures to generate absolute return portable alpha benefits based on active asset allocation decisions equal to more than 7% annual return over the period with a low volatility, the study shows. This performance can be further improved by using an option overlay portfolio as a portable beta vehicle.
In particular, the Edhec Risk and Asset Management Research Centre’s work demonstrates that suitably designed option strategies would have added more than 120 basis points of performance for the period without any increase in the portfolio risk.
Finally, the Edhec research teams show that adding active sector rotation decisions makes it possible to significantly lower the volatility of the underlying tactical asset allocation strategies while maintaining the level of average returns due to the benefits of bet diversification.
The benefits of active asset allocation decisions presented in these experiments are not based on the use of any specific econometric model with unusually superior predictive power, the research shows. The approach followed is actually based on a process that consists of selecting at each date a “council” of models to make predictions, as opposed to using a single model, Edhec said. The benefits of active asset allocation decisions actually originate more from the combination of a robust econometric process and an efficient trading of low cost investible products such as Eurex index futures and options, it said.
The conclusion is that most long-short managers could use a similar methodology to enhance the performance of their portfolios, the research shows.