Season Investments

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Staying Flexible

Posted on August 21, 2012

We recently attended the Innovative Alternative Strategies conference in Denver, CO. Events like this afford us some time to step out from behind our computers and spend a couple days just thinking and talking with other like-minded portfolio managers. This particular event did not disappoint. The impressive keynote lineup (Jeffrey Gundlach, John Mauldin, Mark Yusko, and George Will) was second only to the quality of conversation we shared with many of the managers who were there behind the booths showcasing their strategies. We returned from the conference with a short list of viable candidates for possible inclusion in our absolute return allocations, with the Virtus Dynamic AlphaSector fund being one of the more promising options.

The Company

The fund*, offered through Virtus Investment Partners, is sub-advised by an SEC-registered investment advisor out of Newton, MA called F-Squared. Founded in 2006, F-Squared has grown to nearly 40 employees and $8 billion in assets under advisement over the past six years. Citing severe losses during market downturns as “the single greatest threat to investor goals”, the company’s website lays out its unique investment philosophy as follows:

F-Squared’s investment philosophy is clear, simple and groundbreaking. Our strategies are designed to protect investors from severe losses in down markets while providing quality participation in rising markets.

This way of thinking clearly resonates with the core philosophy laid out in our Economics of Loss video, and we are always curious to see how other firms are applying this philosophy in their portfolios.

AlphaSector “Premium” vs “Dynamic”

F-Squared’s core offering is their AlphaSector Premium (“AS Premium”) strategy. The quantitative model underlying AS Premium has been live for over eleven years and was originally developed for use by a family office out of Boston. The strategy invests in the nine primary sectors of the S&P 500 Index via SPDR ETFs as well as cash and cash equivalents.

2012-08-21_AlphaSector_Investment_Universe.png

Each sector is evaluated using a proprietary moving average model to determine whether or not the sector is in an uptrend. If an uptrend is confirmed the strategy will hold an investment in the sector, whereas if an uptrend is not confirmed the strategy will hold cash. Additionally, the windows of time that the moving averages are measured over are adjusted dynamically in response to changes in realized volatility. In short, as the market becomes more volatile AS Premium’s moving average windows become shorter in duration and vice-versa if volatility is falling. As with all effective trend-following approaches, the net results of AS Premium (dating back to April 2001) show less volatility, less downside capture, shallower overall drawdowns and a higher profitable percentage without sacrificing any expected return relative to the static S&P 500 benchmark.

That said, our primary interest has been focused not on AS Premium, but on a slightly altered version of the strategy that F-Squared calls Dynamic AlphaSector (“Dynamic AS”). While AS Premium manages within a net exposure range of 0-100%, Dynamic AS can actually be as high as 130% net long or -50% net short. While the underlying sector models themselves do not change, the portfolio construction methodology is more flexible to take advantage of extreme market environments (see page 3 of this presentation for a description of the ten possible portfolio allocations for the strategy). The table below is a quick comparison of AS Premium and Dynamic AS.

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F-Squared, using their historical AS Premium model as a starting point, has backtested historical results assuming the Dynamic AS portfolio construction rules had been applied. The table below summarizes some of the key findings from our analysis of the backtested results.

2012-08-21_Dynamic_AS_Backtest_Results.png

We always view backtested results with a grain of salt and use them primarily to get a feel for the potential impact of a particular strategy within the context of our overall client portfolios, realizing that the future is going to look a whole lot difference than the past. The fact that F-Squared’s AS Premium model has been live over the entire backtest period is an advantage, and in our opinion the portfolio construction flexibility of the Dynamic AS strategy simply takes what has worked in real time for AS Premium and seeks to exploit it in a slightly altered fashion. Also, given our core belief in the efficacy of trend-following strategies and the fact that we have not yet seen a product applying this approach specifically to sectors, this fund is an attractive candidate for inclusion in our Absolute Return allocations.

Where Does This Fit In?

We are currently in the process of overweighting Absolute Return strategies relative to long-term target allocations. Given the uncertainty of the global macro environment and policy intervention we are reducing our reliance on traditional stocks, commodities and bonds and choosing to increase exposure to a diverse mix of strategies that collectively offer the potential for attractive returns in any market environment.

We consider the Dynamic AS strategy a better Absolute Return candidate than AS Premium due to the fact that it more proactively hedges risk while offering the potential for positive returns even in down markets. It also is a more direct complement to some of our other Absolute Return holdings. The primary risk to this strategy comes in the form of sharp sell offs that occur quickly over short periods of time (ie, 2010’s flash crash or 2011’s US debt downgrade), so holding this fund alongside other investments that are designed to benefit from similar events (XVZ is an example) can create a collective risk/return profile that delivers more consistency and downside protection while offering the potential for mid to high single-digit returns.

As stated in Virtus’s marketing collateral for this fund, A true alternative fund doesn’t always have to maintain low-correlation to the equity market. It just needs to be flexible enough to not be correlated at the right times. We agree completely, and believe this fund improves our ability to achieve that goal.

Contributor: David Houle,CFA

* Shares of the Virtus Dynamic AlphaSector Fund trade under tickers EMNAX, EMNBX, EMNCX, & VIMNX. Prior to 2/6/12, the fund was sub-advised by another manager running a market neutral equity strategy. As such, any track record for this ticker prior to 2/6/12 should be considered as irrelevant to current investors. 

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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.