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How Our Investment Models Fared in 2022?

Those who attended our IBF-accredited course on introduction to hedge fund strategies and quantitative investing know we teach 4 different investment strategies that focus on both risks and return. 2022 has been an eventful year and we did a short video update previously on the model performance (see note at the end of the post) for the year. In this post, we provide more color on how these models fared in this tough environment.

A Broad Overview Of The 2022 Performance

The four models or strategies are Risk Parity, Trend Following, Volatility Trading, and Sector Rotation. Let's see how they stack up against the broader US stock market. Our investments focused on the US markets so I will be using the S&P 500 ETF (Ticker: SPY) as the benchmark. It is not the best choice in terms of being apple to apple comparison. But it would be what most people like to reference against.

Strategy Vs S&P 500
Strategy Vs S&P 500

In a nutshell, 3 of our strategies - Risk Parity, Trend Following, and Sector Rotation are in the red this year. Volatility trading, on the other hand, delivered a great performance and is up almost 6% amidst this rough investment climate. When we run all these strategies in a single multi-strategy portfolio, it is down an acceptable 11.8%. In comparison against the performance of the broader US stock market, as represented using S&P 500, most of our strategies are better off.

How Does The Multi-Strategy Look Over A Longer Term?

If we stretch back to look at longer-term model performance since 2006, it seems that 2022 is an outlier year where the multi-strategy trended down together with the US stock market. This comes from a breakdown in the correlation across the assets and strategies which has otherwise been holding up well. In 2022, only the volatility trading strategy managed to buck the trend. But despite, the drop in performance this year, the strategy still did well on an absolute and risk-adjusted basis delivering a CAGR of about 13% and Sharpe of 1.4.

Plot of Multi-Strategy Vs S&P 500
Model Performance (2006-2022)
Model Performance (2006-2022)

* Volatility strategy uses theoretically calculated price data on the traded securities based on VIX futures as an estimated proxy from 2006-2011 because the actual securities used only started trading in 2011.

Let's now take a deeper dive into each of the individual strategies.

Strategy 1 - Risk Parity

Risk parity is an asset-allocation strategy based on the concept of balance. First, a balance across the mix of assets to hold. And second, a balance in the risk across the assets in your portfolio. It is a simple and commonsensical approach to building a robust portfolio. This strategy has its roots based on the well-established Modern Portfolio Theory (MPT). And Ray Dalio, the founder of Bridgewater Associates, one of the largest hedge funds in the world, is instrumental in popularizing this approach. He launched the first hedge fund based on this concept and named it the "All-Weather" fund.

But in 2022, Risk Parity funds across the board delivered a disappointing performance and that included the pioneer risk parity fund aka All-Weather fund.

Risk Parity Funds Performance
AllQuant Risk Parity Model & Other Risk Parity Funds Performance

Now, under most circumstances, Risk Parity portfolios are fairly stable and tend to hold up. Our Risk Parity model navigated through many challenging periods before this e.g. 2008-2009 when the Great Financial Crisis (GFC) landed, 2018 when the US and China tensions flared with central banks turning hawkish, and 2020 when the Covid-19 pandemic hit.

Performance During Challenging Periods
Performance During Challenging Periods

In fact, based on model performance since 2002, the Risk Parity model weathered through without a single down year until 2022. So what led to their dismal performance in 2022? There are 2 main reasons and they are not unexpected.

1. Diversification breaks down and all asset class head south

Soaring inflation in 2022 and a heating labor market with spiraling wages led to aggressive rate hikes from the US Federal Reserve in a bid to cool things off fast. That in turn causes almost all asset classes to go down in tandem. Diversification fails then because there is nowhere to hide. Bonds whose yields are near zero before inflation rose, were especially sensitive to inflation and rising interest rates. And for most risk parity portfolios, unfortunately, bonds are a central part of their portfolio. Even Gold which was a star performer during the stagflationary period in the 70s didn't manage to repeat its feat although it did fare better than most others. The only bastion of safety in 2022 is commodities which are drivers of inflation.

Broad Asset Class Performance in 2022
Broad Asset Class Performance in 2022

2. The use of leverage amplifies losses.

Most risk parity funds use leverage as their risk is deemed to be low under most market conditions. That means they borrow money to amplify their positions and returns. So that translates to larger losses when a bad patch hits.

Risk Parity Outlook

2022 marks a bad year for risk parity portfolios, or for that matter, any long-only portfolio without much exposure to commodities. That, however, does not mean diversification has lost its value and is no longer relevant going forward. The fundamental premise behind diversification and risk parity is still sound. And with inflation abating, rate hikes slowing, recessionary pressures on the horizon, and a much higher bond yield today than a year ago, asset classes' behaviors should start to normalize. There are also ways to strengthen the risk parity portfolio. For example, we can extend diversification to more asset classes such as commodities. We can also employ more advanced techniques such as risk targeting to reduce its risks in uncertain times.

Strategy 2 - Trend Following

Trend following is a well-known trading strategy that has been around for ages. It is essentially a system that comprises technical and risk management rules. The central idea is to ride and profit on price trends for as long as possible. For our model, we only trade in US large-cap stocks and only take the long side of the trade. So to put this simply across, we invest and hold on to stocks whose up trend is in place and closes them out when the trend turns.

This strategy works well in strong steady trending environments. In such an uptrend, it will be able to latch on and take a big bite out of the stocks' returns. And during a strong steady downtrend, it will size down to limit losses. The shortcoming, however, is that it gets whipsawed when the market turns volatile and the trends switch up and down violently.

Trend Following Limit Losses During 2022

Our Trend Following strategy is down slightly over 10% this year. But that is well within expectations since it is only positioned on the long side amidst this bear market. In fact, I would consider it as having done its job given that we run it with leverage and it still loses significantly less than the S&P 500 (S&P 500 lost more than 18%). This is because we have been trimming positions over much of the year to reduce the risk exposure we have to the market. That helped to mitigate the losses.

Number of invested securities in our Trend Following Model
Number of invested securities in our Trend Following Model in 202

This is the defensive side of the Trend Following strategy - size in when things are in favor and size out when they are not. The same thing happened during the GFC in 2008-09 where our Trend Following model flattened out everything and was holding 100% cash at one point in time. At the worst point during the GFC, Trend Following navigated through it with a reduced loss of 23% against S&P 500's 51%.

Trend Following Outlook

After a strong market rally in November 2022, the Trend Following model has plowed back into quite a number of securities. It seems to be positioning for an upturn in the stock market and if the trend did materialize and sustain, we can expect it to size into more securities to capitalize on the price move. But should the market take a turn and trend down, then we will see some interim losses and the model scaling down over time.

Strategy 3 - Volatility Trading

The volatility trading strategy is uncorrelated with all other strategies but runs at a higher risk level than the rest. The main idea behind it boils down to this simple notion - buy volatility when the market is complacent and short volatility when the market is fearful. And because of how volatility behaves as an asset class, this strategy has the potential to make outsized returns when the market gets rough. This makes it a good complement to traditional strategies as it can cushion the losses (not always though) during a bad market. And it has thus far been able to deliver during major crises. But having said that, it is no holy grail as well. This strategy also has a higher chance of encountering tail losses (large losses) if it gets on the wrong side of a bad trade.

Volatility Trading Strategy During Challenging Periods
Volatility Trading Strategy During Challenging Periods

The First Half Of 2022 Was Not Easy. Money Came In Only In The Second Half.

Even though Volatility Trading ended the year on a positive note, it did not come easy as well. There were many trade switches in the first 6 months of 2022, many of which ended up with small losses. But collectively, these pile-up and at its worst point, it was down 14% based on monthly return data. The turnaround only came in the second half of the year. That is when the strategy started to make good returns almost every month till the end of the year.

Volatility Trading Strategy Vs S&P 500 in 2022
Volatility Trading Strategy Vs S&P 500 in 2022

Volatility Trading Outlook

Just like the rest of the strategies, the underlying principle behind the volatility trading strategy is sound and valid. At the moment, it is positioned on the short side of volatility but given its sensitive nature, that can turn around pretty quickly when market sentiments shift.

Strategy 4 - Sector Rotation

Traditional sector rotation relies on forecasting economic and business cycles to determine allocations to the various different sectors. And they are typically held over a longer term until the regime shifts. In our approach, we adopt a more quantitative and systematic way to rotate amongst the stock sectors periodically using a scoring system that picks the best sectors to invest in. That allows it more flexibility to adjust to changing market conditions. In addition, we also run a hedging strategy that size up the risks in the market and allocates part of the capital into US Treasury bonds when required. As an example, when the risk is determined by the system to be high, it will allocate more to Treasuries.

We picked the right sectors, but the hedge underperformed in 2022

The sector rotation positioned itself mostly in the defensive sectors throughout 2022 - consumer staples, healthcare, and utilities. And that was the right pick as many cyclical sectors got hit badly in the market downturn. In particular, consumer discretionary, technology and communications did much worse than the S&P 500. The only outstanding exception is the Energy sector which did spectacularly well as they benefitted from the rise in commodities which is one of the main drivers of escalating prices. Now, even though the Sector Rotation strategy did not pick out Energy as it went for the safer bets, these sectors still did way better than the rest.

Individual Sector Performance in 2022
Individual Sector Performance in 2022

As with all turbulent times, the hedging mechanism in our Sector Rotation strategy came into action in 2022. And because of the hostile market environment, our allocation to the hedge was also higher. Now, in a more typical market crisis, our hedge which is essentially US Treasuries can be expected to cushion losses coming from stocks just like what occurred during the 2008-09 GFC and the more recent Covid-19 pandemic. Unfortunately, in 2022, bonds are also whacked down along with stocks. Longer-term bonds which is what we are using for hedging did even more poorly than stocks. As a result, instead of buffering the losses, the hedge actually dragged the portfolio down significantly more. But overall, the Sector Rotation strategy still outperformed the S&P 500.

The chart below shows you how Sector Rotation would perform with and without the hedge and in the latter case, we park the allocation for the hedge into cash instead.

Sector Rotation Performance With & Without Hedge
Sector Rotation Performance With & Without Hedge
Sector Rotation Outlook

The sector picks remained relatively stable till the end of 2022. Most are still in the more conservative sectors such as staples and healthcare. But the hedge size has been scaled back quite a fair bit. So it is now better positioned for a stock market rebound. We would expect it to lag in the event of a strong rebound as most of our exposures in this strategy are still in the defensive sectors. But should the market take a further dive, we should hold up better as well. And after one of the worst years in history where long-term Treasuries suffered one of their longest and deepest downturn, yields are now hovering near an attractive 4%. With recession expectations rising, its safe haven status should be coming back in place. In fact, we are already seeing some normalizations in their behavior near the end of 2022.


Will 2023 be worse than 2022? Or will the financial markets rally from here? This is a million-dollar question for most investors who are trying to time and position their portfolios. But for us, the more crucial question is whether correlation will continue to break down across the asset classes. Because that reduces the effectiveness of diversification and our hedges. The good news is we are seeing encouraging signs. Asset class behavior is gradually reverting back to the norms. We are also in better shape today than a year ago when markets were still fresh in grappling with uncertainties coming from inflation, Fed, and geopolitical tensions. As of now, inflation is easing, Fed is slowing its hike, the demand-supply imbalances are resolving, bond yields are appealing again, and China is opening up. So let's see what this new year will bring for us.

Note: All performances shown are model performances. Transaction costs are factored in based on Interactive Brokers' estimated cost structure.

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