New Jersey index advisory firm MSR Indices views equity hedge funds as not only securing alpha for their investors these days, but that when they do so it is not by intuitive stock picks or insider tips but by intertemporal risk parity (otherwise known as target volatility).
Risk parity is a concept that has received a lot of attention for institutional investors in recent years, but the MSR methodology offers a new way for investors interested in liquid access to complex investment strategies as an alternative to investing directly with CTAs, hedge funds and long-only managers.
The founders’ research indicates that equity hedge funds outperform dollar- weighted indexes by the same amount that target volatility indexes outweigh those dollar-weighted indexes. This means that equity hedge funds and target volatility indexes have virtually identical performance as one another when fees are held equal.
But, having made that discovery, MSR’s founders observed that targeted volatility indexes are transparent and easily implemented, so no one would try to charge “1-and-20” for the index. The conclusion naturally suggested itself that targeted volatility strategies are a promising replacement for equity hedge fund strategies.
In September 2019, the company created the MSR Platform, an institutional investment platform designed to offer investors access to the returns of MSR Investable Indexes through vetted third-party asset managers. MSR is in the liquidity business, and through this platform in particular it provides a liquid alternative, by virtue of the use of futures, to direct investment with a CTA, a hedge fund, or a traditional long-only asset manager. Milliman, the global risk manager, provides centralized portfolio management.
Risk parity and targeting
Explaining MSR’s approach in broad terms, Michael Rulle, founder and CEO of MSR, said in a recent interview with Alternatives Watch, “We think in terms of risk parity and risk targeting, and of three basic trading styles.” The styles he has in mind are: reversal (which he defines further as “short-term counter-trend investing”); trend following, and long-only investing.
Both MSR’s risk parity and trend-following indexes have had positive gains in early 2020. Over the last decade, both indexes have had annualized gains as well with over 5% annualized returns for risk parity and 2% for trend-following. But the tide may be turning in momentum investors’ favor.
MSR clients include other Index providers like S&P that it has partnered with, pension funds, CTAs and hedge funds looking to create a strategy or add to their strategies.
For pension funds the product is a fit for those seeking low cost liquid alt exposure. They have also seen interest from family offices looking to run their own strategies and ETF shops and mutual funds looking to white label their own index/strategy.
Rulle also discussed his high regard for momentum positions, that is, trend following, in a podcast last July, when he said that this strategy “trends to do well when equities do very poorly.” As a consequence, “it kicks in when you really want it to kick in.”
Trend-following involves looking for corrections in the price action of a security, buying a security that has been the objective of an impulsive bearish move or selling one where the impulsive move has been bullish.
Before founding MSR, Rulle was president and CIO of both Graham Capital Management and Hamilton Partners, two multi-strategy alternative investment firms.
“No matter what you do, you’re likely incorporating one of those three styles,” he said. Furthermore, whatever strategy you want to follow, the MSR indices can help you follow it.
MSR has indices for global fixed income, global equity, the S&P 500 futures, global 60/40, risk parity trend following, long-only trend, global macro and an optimal portfolio index. The last of those is a proprietary blend of MSR’s own exposures, which includes market reversal models for global equity, global fixed income, global currency, and various commodity markets.
Of options, tails and cryptos
MSR uses futures to offer access and liquidity. Asked whether in the medium distance MSR might want to include options in the mix, Rulle replied, “We do not use options, but we replicate options.”
He added that he could “see real options going in there, but I don’t like fat left tails.” Options will only be added to the system if that can be done without adopting the picking-up-nickels-in-front-of-a-steamroller style. It’s all fun and games until a steamroller hits. Indeed, Long-Term Capital Management and many of the most spectacular blow-ups since then have arisen because even smart people (even Nobel Prize winners) can learn to ignore the fatness of fat left tails, the possibility of exposure to huge losses in the event of a sudden shift in the value of an underlying. Further, historically options have played a role in the learned ignorance of such smart people.
Asked about the cryptocurrencies, Rulle said that he wouldn’t rule out an eventual indexing of that asset class. He added, “I’m not sure I understand it, but I think it’s trying to replace money. I don’t know what the equilibrium value is going to become because it is still difficult to define its future utility.”