How diversification and factor neutralisation can help reduce drawdowns and deliver more stable returns


Many sophisticated investors increasingly demand investment products that focus on idiosyncratic alpha. The primary reason for this is an appetite for stable returns and reduced drawdown risk, no matter the market regime. Kvasir’s Market Neutral strategy is designed to appeal to such investors and achieves this through the following two main approaches:


  1. Hedging risk factors: Hedging factor exposure is generally the elimination or significant reduction in exposure to specific risk factors. Often such risk factors are defined by so-called factor models such as the FAMA French factor models but could also be based on sectors or geographies. 


  1. Diversification: Diversification is at the heart of Kvasir’s approach to investment strategy development, and is primarily achieved through the implementation of various different types of strategies that use different data sources and holding frequencies, which are ideally as uncorrelated as possible. Diversification can also be achieved by investing in as many different instruments as possible for instance through geographic expansion.


Markets have seen heightened levels of volatility for the past 3 years with certain events standing out as more violent rotations, leading to significant drawdowns for many L/S hedge funds. 

Some examples of such events are the following:


  • Factor rotations in Q3 2019 

  • Sell-offs and widespread de-grossing of larger hedge fund in March 2020 after lockdown announcements

  • Rotation related to the 1st covid vaccine announcement in Nov 2020


During such periods, hedge funds can experience daily drawdowns that are several multiples of  their expected daily average volatility. Ultimately it is such extreme events that can contribute significantly to widely varying volatility of a funds’ performance over time, which is undesirable for most investors. 


This performance behaviour is often underestimated by both investors and hedge fund managers, while the latter often lack the tools to mitigate such characteristics. Part of the reason for this is that a relative scarcity of historical instances of such extreme events makes it difficult to properly model such behaviour to make reasonably good forecasts of expected drawdowns.


While at Kvasir we use advanced statistical techniques to model such tail behaviour, we are more focussed on minimising our exposure to such tail events in the first place. Risk factor hedging and diversification are the most vital instruments to do so.




 

Neutralising Factor exposure


Neutralising factor exposure can be easier said than done as it is often challenging to estimate forward looking exposures given a portfolio. This is primarily due to the fact that factor related estimates such as factor returns and factor loadings are noisy estimates based on historical data. 

Kvasir uses sophisticated AI techniques to improve its ability to measure factor exposure and is able to significantly reduce its realised exposure doing so, compared to more traditional methods.

 

In addition to factors that come with an economic definition such as the FAMA french factor models, Kvasir also uses machine learning to measure additional “residual” factors that perhaps are more temporary in nature, yet can have a significant impact on portfolio volatility.

Often such factors can be best described as “crowding” and can be challenging to identify.

However, machine learning offers powerful tools to recognise such temporary changes, and provides the ability to model interactions between factors, so they can be viewed in isolation as well as part of the overall contributions they make to the strategy’s volatility over the longer term. And as a result can be more effectively addressed through hedging.


Kvasir’s mission is to continue improving diversification in our overall strategy  whilst isolating idiosyncratic alpha. We believe that this is the best approach to optimise risk adjusted returns for our clients and ultimately offer a product to investors that is so vital during challenging market regimes as we have been experiencing for the past few years.

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