Investing in up and Down Markets

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such investors also prefer satellite asset returns to be more volatile in up-markets and less volatile in down-markets. These criteria reiterate that satellite assets should benefit our total investments when these assets help insulate our overall returns when markets are hit by extreme and volatile events, whilst providing capture of the market on the upside.

The choice of satellite assets will be based on performance using past data and using such track record to provide insights into the performance of one satellite asset’s risk relative to that of another satellite asset and that of the core portfolio. The analyses of such data would require simple computations that can be easily made using a computer spreadsheet. One can translate the selection criteria into statistical measures of the first moments between core returns and satellite returns and the cross moments between core returns and satellite volatility. In the first moment analysis, investor desire satellite returns to be positive when the market is down. We will coin this situation – downside protection. Further, it is also desirable that satellite returns are positively correlated with the market when the market is up. The satellite funds that provide “downside protection” and “upside capture” satisfy the first moment criteria.

For the cross moment analysis, we examine the volatility of the hedge funds in relation to the returns of the market indices. Investors would prefer the following outcomes. Explicitly, if cross moments are mainly positive for the satellite assets, it means that when the market is down, the volatility of the fund returns is also low and vice versa. When the market is up, increased volatility of the hedge funds’ returns is better tolerated, whilst reduced volatility is desired when markets are down, as investors are unlikely to tolerate increased likelihood of sharp losses in the satellite returns during such times. Funds that reduce volatility when the market is down and vice versa when the market is up satisfy the cross moment criteria. The ideal satellite asset provides “downside protection” and “upside capture,” and to exhibit low volatility under weak market conditions.

We should not lose faith in the basic tenets of financial theory. What the GFC has shown are the shortcomings in its application. We should not throw the baby out with the bath water, but to improve the implementation and asset selection process. Setting clear objectives and clarity in the asset selection criteria will bring about improvements in how our money is managed keeping in mind that investment is about yield enhancement and also about protection against losses.