The case for tactical trading for nonprofits

By: Mark Raskopf, CFA, Head of Tactical Trading Strategies MARCH 2012 Darren Spencer, Director, Alternative Investment Consulting The case for tactical trading for nonprofits Issue: The investment portfolios of nonprofit organizations typically hold a mix of asset classes designed to: 1. achieve a targeted level of diversification and 2. produce risk-adjusted returns over a full market cycle For investors pursuing both goals, hedge funds can be useful portfolio additions. Non-profit institutions, in particular, have been leaders for many years in investing in hedge funds in order to get further portfolio diversification and some potential downside protection. The correlations of multi-strategy and long/short equity hedge funds to other asset classes may move higher during episodes of market volatility and in market downturns. Knowing this, what potential role can investors expect tactical trading to play in a diversified hedge fund strategy? Response: Tactical trading hedge fund strategies can help to offset vulnerabilities and risks in: 1. a portfolio s long investment exposures and 2. in a portfolio s blend of traditional asset classes and hedge fund strategies (e.g., multi-strategy, long/short equity) Adding or increasing exposure to tactical trading hedge funds doesn t require a change in portfolio objectives. In fact, it can be a useful way of recalibrating a portfolio s aim at its existing target objectives i.e., strong risk-adjusted returns and true diversification during difficult market environments. Adding or increasing exposure to tactical trading hedge funds doesn t require a change in portfolio objectives. In fact, it can be a useful way of recalibrating a portfolio s aim at its existing target objectives i.e., strong risk-adjusted returns and true diversification during difficult market environments. Russell Investments // The case for tactical trading for nonprofits

A side benefit of tactical trading strategies is their diversity among two main categories: discretionary macro, and systematic macro (in each of these categories, Russell has identified subcategories). As we will show, not all managers in these categories meet Russell s criteria for tactical trading. But managers that do meet our criteria may produce low correlations with each other, which can add a diversification benefit within the tactical trading allocation. Background It s not the hedge fund category (discretionary or systematic macro) that makes a tactical trading manager, but rather the manager s pursuit of four specific objectives, all of which can be quantified and evaluated: 1. Ultra-high liquidity of underlying investments. Specialist tactical traders build portfolios and positions that can be quickly and easily liquidated or shifted in response to changing market conditions. 2. Generally low beta to traditional asset classes. Most effective tactical traders manage from the top down, a practice which, over a market cycle, tends to help keep beta low and relatively constant. Securities selection usually takes a back seat. 3. Ability to profit in trending or directionless markets. The tactical trading manager is attuned to both directional and relative-value themes and positions. 4. Tight risk-management processes. The tactical trading manager adheres to a goal that many long/short equity hedge funds promised but failed to deliver in 2008: capital preservation in tough times. Tactical managers abide by strict position-level and portfolio-level loss limits. Two main categories of tactical trading 1. Discretionary macro a) Global Diversified b) Currencies c) Emerging Markets d) Commodities 2. Systematic macro a) Managed Futures b) Quantitative Macro It s not the hedge fund category (discretionary or systematic macro) that makes a tactical trading manager, but rather the manager s pursuit of four specific objectives, all of which can be quantified and evaluated. DISCRETIONARY MACRO Discretionary macro managers employ a top-down process for buy/sell decisions, focusing on shifts in government policies and deficits, trade balances and worldwide money flows that may impact valuations. They usually express views through a variety of ultra-liquid asset classes, including government bonds, currencies, commodities, and equity and credit indices. Russell segments discretionary macro manager practices by trading discipline or specialization. Subcategories include: Diversified global macro managers, who typically trade the major asset classes in developed markets on either a value or a technical basis. Some diversified global macro managers construct thematic portfolios or set targets for diversifying their portfolios among markets, instruments and asset classes. Russell Investments // The case for tactical trading for nonprofits / p 2

Currency specialists, who may pair-trade one currency against another or take positions in exchange-rate volatility. They look to understand government policies and intervention as drivers of changing economic relationships. They take positions ahead of expected trend reversals, in situations wherein liquidity could meaningfully change, or when they believe historical volatilities have led to significant underestimation of expected future price action. For currency specialists, carry trades are typically not important. Emerging market (EM) macro managers, who combine the toolkit of the traditional macro manager with their special knowledge of emerging markets. In addition to trading standard macro asset classes, they also may trade emerging market foreign exchange (FX) and interest rates, emerging market sovereign debt, and corporate credit and emerging market equity indices. Fortunately, emerging markets such as China, India and Brazil have developed trading volumes sufficient to satisfy Russell s first criteria for true tactical management: ultra-high liquidity of underlying investments. An interesting appeal of EM macro funds is in their ability to profit from the stronger fundamentals of many emerging economies versus those of more developed economies. Trades can be long-term and thematic within a core discipline of risk management, and can also be short-term and reactionary, based on changing market technicals or events. Commodities specialists, who generally combine directional bullish or bearish trades within individual markets, such as natural gas, copper or corn, with relative-value trades between exchangeable commodities such as gasoil or heating oil. Some of the most attractive tactical trading managers in this category are the nondirectional spread traders who exploit tradable opportunities within futures contract-term structures (i.e., during contango and backwardation). SYSTEMATIC MACRO Systematic macro managers apply models across multiple asset classes and disciplines, such as managed futures/ctas and quantitative macro. Managed futures/ctas strategies use quantitative models to anticipate upward or downward price movements in the spectrum of futures instruments equities, fixed income, currency and commodities. Many of these strategies utilize trend-following or momentum-driven models that vary by time frame short-term, intermediate or long-term. Quantitative macro strategies use quantitative techniques to anticipate price moves (directional or relative) and profit from perceived valuation anomalies. Quant models may be based on valuations, economic fundamentals, shifts in the economic environments, or readings of investor sentiment. These strategies tend to emphasize intermediate- to long-term horizons. How to identify appropriate managers In our ongoing evaluation of hedge fund managers for tactical trading merit in each of the two main categories and subcategories, our analysis focuses on: Manager disciplines for avoiding herd mentality and consensus/crowded trades, which can lead to unintended directional risk. Russell Investments // The case for tactical trading for nonprofits / p 3

Consistent portfolio liquidity standards, plus the manager s willingness to exercise liquidity options by making timely strategy shifts, based on changing conditions and data. Patterns that indicate the manager is following consistent disciplines with profit potential in either up or down markets e.g., commodity spread traders who go long and short on different contract months for the same commodity, or long and short like commodities on different exchanges. Consistently low risk metrics (including beta, standard deviation (STDev) and drawdown) and attractive up-/down-capture ratios that indicate disciplined decision making in difficult markets. It is important here to look beyond the labels. In each of the three main categories, there are managers of merit who don t meet our threshold criteria for consistent tactical trading discipline. The table below suggests a few characteristics that can help to identify the true tactical trading managers among other managers in the same categories. Exhibit 1: Tactical trading managers characteristics Category Identifiers that meet Russell s tactical trading threshold Identifiers that do not meet Russell s tactical trading threshold Discretionary macro Diversified global macro Emerging markets macro Currencies Commodities Systematic Macro Managed Futures/CTA Quantitative Macro Adaptive traders who anticipate and/or react quickly to changes in economic policy or meaningful shifts in market dynamics Top-down focus on government policies and deficits, trade balances and worldwide money flows Liquid, trading-oriented emerging markets managers who go long/short within emerging markets and between emerging and developed markets Currency specialists who focus on economic cycles by country, and by various stages in the inflation/growth mix that put pressure on exchange rates Spread-trading commodity specialists following indices with lower volatility, more diversification, and less directional risk than commodity indices Long-term-trends followers who capture fundamental economic themes Managers who add value by continually assessing what is (and is not) modeled in. Hard-coded, liquidity-minded managers practicing style diversification and stop-loss disciplines Illiquid strategies of any type, or strategies wherein traded instruments do not have pricing transparency Strategies not designed to handle rapidly changing markets or volatility events Long-biased emerging markets strategies Currency or rates traders who focus primarily on carry/income Primarily directional commodity strategies Mean-variance optimization models that are unable to adapt to environments with unstable betas and correlations Value-biased global tactical asset allocation (GTAA) managers Long-only risk parity managers Russell Investments // The case for tactical trading for nonprofits / p 4

(%) Tactical trading: the track record in 10 down-market cases In ten episodes of high-volatility or high-liquidity events since 1990, macro hedge funds (represented by the HFRI Macro [Total] Index) have produced positive returns in six. CTAs (represented by the Newedge Commodity Trading Index) have produced positive returns in five. Historic data suggests that combining both strategies, within a tactical trading portfolio allocation, can help investors preserve their capital during market-stress events. Exhibit 2: Average monthly returns during time of stress (period ending December 31, 2011) 8.00 6.23 4.00 - (4.00) (8.00) (12.00) 2.41 3.01 3.15 2.03 0.74 1.04 0.49 0.63 0.78-0.34 (0.64) (1.32) (1.37) (0.88) (1.97) (1.37) (2.24) (1.72) (2.07) (3.02) (3.08) (4.21) (4.65) (5.63) (5.36) (5.29) (4.77) (9.71) (9.05) (8.67) Russell Global Index Newedge Commodity Trading Index HFRI Macro (Total) Index 60/40 Portfolio 60/40 portfolio: 60% Russell Global Index/40% US Barclays Capital Aggregate Bond Index Average since 2000, 1/1/2000 to 12/31/2011; LTCM Collapse 1998, 7/1/1998 to 9/30/1998; Busting of internet bubble 1 - early 2000, 1/1/2000 to 2/29/2000; Busting of internet bubble 2 - Late 2000, 9/1/2000 to 12/31/2000; September 11th 2001, 9/1/2001 to 9/30/2001; Accounting scandals 2002, 4/1/2002 to 9/30/2002; Global Financial Crisis - 2008/2009, 9/1/2008 to 2/28/2009; August- September 2011, 8/1/2011 to 9/30/2011 Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Three ways to look at correlations To evaluate correlations of hedge fund strategies vs. the broad market, three views are useful: 1. in all markets; 2. in up markets; and 3. in down markets For purposes of identifying true tactical trading strategies, the third way may be most important. Among major hedge fund strategies, macro and commodity strategies have shown the lowest correlations in all three views, as shown below. Macro is the only hedge fund strategy shown with negative correlation in down markets. Russell Investments // The case for tactical trading for nonprofits / p 5

Exhibit 3: Long-short equity ( equity hedge ) exhibits high correlation to long only equities Index correlations vs Russell Global Index HFRI Fund of Funds Composite Index HFRI Equity Hedge (Total) Index HFRI ED: Distressed/Restructuring Index HFRI Macro (Total) Index Newedge Commodity Trading Index 60/40 Portfolio Data from January 1, 2000 to December 31, 2011 (0.30) - 0.30 0.60 0.90 1.20 All market Up Market Down Market Turning risk analysis upside down Most hedge fund analysis focuses primarily on performance across all months, and secondarily on upside capture in months when the broad equity market is positive. To evaluate tactical trading managers, Russell also considers downside capture performance vs. the broad market (Russell 3000, shown below) in down months. A composite portfolio, including tactical traders, has demonstrated the lowest average monthly loss in down months from 1/2000 through 3/2011. Exhibit 4: Up-down average returns participating in the upside & preservation of capital in downturns: Average monthly returns (%) 4.00 3.84 2.44 2.49 2.00 1.36 1.21 1.20 0.300.55 0.280.39-0.00 (2.00) (0.27) (0.87) (2.23) (4.00) (4.12) (6.00) All months Russell Global Index Russell Global Index up months down months Russell Global Index Newedge Commodity Trading Index 60/40 Portfolio HFRI Macro (Total) Index HFRI FoF Composite Index Data from January 2000 to December 2011 60/40 portfolio: 60% Russell Global Index/40% US Barclays Capital Aggregate Bond Index Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell Investments // The case for tactical trading for nonprofits / p 6

Summary Tactical traders can play a valuable role in managing a diversified mix of hedge fund strategies, due to the attractive return opportunities and correlation properties such strategies may offer. As is the case with all active managers, tactical trading managers need to be monitored on an ongoing basis (even the best tactical trading managers can fall into bad habits, such as putting on trades that are within their comfort zones even when attractive opportunities are lacking). We believe the current structural headwinds in the global economic environment, combined with increased macro uncertainty, offer a timely opportunity for investors to consider a tactical trading allocation. Within this allocation, we expect true tactical traders to produce medium to low correlations with each other. Choosing several of these managers, and rebalancing periodically among them, can potentially yield a diversification benefit as an extra increment of portfolio return. Finally, we note that volatility can put a tailwind behind tactical traders by creating new opportunities in commodities, emerging markets, currencies or trend-following strategies. We believe the current structural headwinds in the global economic environment, combined with increased macro uncertainty, offer a timely opportunity for investors to consider a tactical trading allocation. For more information: Call Russell at 800-426-8506 or visit www.russell.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. There is no guarantee that any stated expectations will occur. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Diversification does not assure a profit and does not protect against loss in declining markets. In general, alternative investments involve a high degree of risk, including potential loss of principal; can be highly illiquid and can charge higher fees than other investments. Hedge strategies and private equity investments are not subject to the same regulator requirements as registered investment products. Hedge strategies often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. The trademarks, service marks and copyrights related to the Russell indexes and other materials as noted are the property of their respective owners. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments 2012. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: March 2012 USI-12688-03-14 Russell Investments // The case for tactical trading for nonprofits / p 7