"Crisis Insurance"

Beta comes in different shapes and sizes: plain vanilla and exotic, bull beta and bear beta. Alpha is no different and positive crisis alpha avoids the Achilles’ heel of other varieties: it doesn’t disappear when you most need it.


The Chicago Mercantile Exchange (“CME”) in this new paper defines crisis alpha as performance during equity bear phases, such as late 1998, 2000-2002 and 2008. Unsurprisingly, the two equity hedge fund strategies that avoid long exposure to equities have produced positive crisis alpha: equity short biased and equity market neutral managers. CTAs, which can be long or short equities, are the other only hedge fund strategy that delivered positive crisis alpha – so say the CME. Every other hedge fund strategy, according to the BarclayHedge indices, suffers from negative crisis alpha, as the chart below shows. (Click the chart to enlarge.)

What is more striking is that CTAs actually need crises to generate their returns. Strip out crisis periods and you can cut in half the BarclayHedge CTA index returns, as the graph below illustrates.

And precisely the opposite applies to hedge funds in general: exclude the crisis periods and the returns will double.

You don’t need to be a Nobel prize winner to figure out that CTAs can act as crisis insurance by effectively neutralising the negative periods for the other strategies. That said, Harvard’s 1990 Nobel Prize Winner and “Father of the Capital Asset Pricing Model” John Lintner did make such a case for CTAs as diversifiers long ago in 1983 with this antique typewriter-written paper. (Editor’s Note: Think weird kind of printer with keyboard attached and no wifi…)

Where is the crisis alpha coming from? To answer that, the CME splits investment risk into three categories – price risk, credit risk and liquidity risk – that are normally pretty independent of one another. But in a crisis like 2008, liquidity and credit risk take the driving seat and synchronise investor behaviour which manifests itself in heightened price risk for most investors– but strong trends for some to follow. CTAs, which mostly follow trends, are well positioned to latch onto the big moves, which is why 2008 was their best year since 2002 or 1998, depending on which index you look at.

Some investors, the CME implies, may have overlooked CTAs by focusing on their easily visible price risk and relatively low standalone Sharpe ratios as shown below (to the exclusion of less obvious credit and liquidity risks, which we already discussed on AAA here and here).

The CME argues that CTAs are exposed to more price risk, but less liquidity and credit risk – in fact they reap their greatest rewards during credit crises. Price risk, displayed against crisis alpha below, is measured by the degree of mean reversion in return patterns, liquidity risk by the level of serial or month-to-month correlation in returns, and credit risk by correlation with the gap between swap spreads (which face bank credit risk) and US Treasuries (which have historically had no credit risk notwithstanding Standard and Poors’ negative outlook on the US Government and its substantial ownership of banks).

Cynics might say that as the world’s largest clearer of futures, clipping a small fee on each and every contract traded, the CME has a vested interest in seeing investors allocate more money to CTAs that trade futures – the skeptics might have a point. However, going forward, regulators are migrating all kinds of other derivatives onto exchanges, including credit derivatives, and the CME is not making any special case for credit funds. Besides, not all CTAs have to trade futures: some specialise in currencies, which still trade mainly over the counter and could very well continue to do so.

One point the CME did not make is that synthetic replication approaches may also be to recreate a CTA return profile, and these do not always involve trading futures. One of the oldest replication techniques identified by Fung and Hsieh in this 2001 paper involves owning a basket of look-back straddles (puts and calls both at the money) that would probably be traded OTC bypassing exchanges.  So, the CME is educating investors about the benefits of CTA strategies, but the educated investor also has a menu of vehicles at their disposal to access positive crisis alpha from such strategies.