EIM has been focused on creating innovative solutions to investment problems for 20 years. The Enhanced Convexity Hedge Overlay compartment of the AAA Alternative Fund (ECHO), recognised as the Most Innovative Fund-of-Hedge-Fund (Europe) this year by World Finance, reflects how we apply our extensive expertise in tailor-making hedge fund portfolios, our specialised risk management tools, and our scenario-building capabilities to achieve highly specific investment outcomes. ECHO represents an effective solution to a preoccupation shared by many investors today: how to profit from extreme deflationary or inflationary environments, while limiting the cost of carry until they occur.

The genesis of ECHO
The initial impetus for ECHO came directly from the concerns expressed by our clients in the wake of the 2008 financial crisis. Chief among them was that, historically, unprecedented global monetary expansion would lead to inflation, which in turn would cause their bond holdings to suffer. Second, they realised that the cost of hedging this risk through conventional derivatives was prohibitive and involved taking on significant counterparty risk, because most such protection is provided in the form of over-the-counter swaptions.

The ability of counterparties to provide such derivatives at a reasonable price was, and still is, hampered by their increased cost of capital. Also, because of time decay, an option-based strategy is only likely to be cost-efficient if its implementation incorporates active timing, which, in the case of inflation, is generally extremely difficult.

Most observers tend to agree that fundamental growth-based inflation may transpire sometime in the future, but it is impossible to predict if it will occur in six months, two years or five years from now. Any insurance with embedded time value, as is the case with options, has a high risk of costing more than its eventual profits. However, while no one knows for sure when, or if, significant inflationary conditions will arise, it is possible to describe with confidence what such a scenario would entail. Bond yields would shoot up, cyclical commodities may rise, and if growth follows a calm period, equities should profit, at least initially, from improved sales.

Since 2004, EIM’s development and management of tailored solutions has been driven by a forward-looking, scenario-based framework. Its central premise is that macro-economic scenarios eventually affect financial markets and, as a consequence, alternative strategies as well. By carefully defining these scenarios and working out expected market behaviours in each, EIM and its clients can derive a clear sense of the impact each scenario would have on our clients’ asset and liability mix and which strategies would provide the best diversification.

Capturing trends
As we discussed inflation scenarios and assessed which strategies and methodologies would likely behave best in such an environment, it became apparent that techniques existed that could reliably capture resultant trends.

In its simplest form, a strategy that invests only in cash or short bonds – ie that profits when bond prices go down – would, depending on the existence of an established downtrend in bonds, be more efficient than an options strategy, because it would stay in cash until the scenario actually happens and protection is needed. Strategies aiming to do this typically use price action signals, for instance analysing the behaviour of moving averages of different timeframes relative to current prices, to determine the onset of trends. They then initiate their exposure and start to participate in a trend as it becomes established, rather than maintaining a constant exposure as an option would. This flexibility minimises the cost of waiting, when timing can be off by years.

When we set out to screen the universe for funds doing this, it soon became apparent that the bull market of over 30 years in treasuries and 20 years in bonds had destroyed any inclination to implement a short-bond strategy as a business venture. Managers pursuing ‘pure’ inflation strategies were few and far between. We therefore turned to Commodity Trading Advisors (CTAs) for help. Their core competence is in systematic, computer based, trend-following strategies, which they generally apply simultaneously to a broad set of markets – including equities, commodities and Forex, as well as bonds – in order to smooth their returns through diversification. We identified managers who were willing to explore the setup of trend-following funds based on the inflation scenario we envisaged, and implement the strategy on the LumX managed account platform EIM has helped develop.

Enter deflation
As we were progressing on our inflation project, market and political events starting in 2009 caused investor concerns to broaden. Deflation emerged as a threat just as dangerous to investor portfolios as inflation, leading us to broaden the scope of our solution to include it. Again, while the occurrence and timing of a deflationary scenario are uncertain, the expected impact of deflation on markets is well known: volatility and correlation increase in all asset classes, equity markets fall, bond yields retreat and credit spreads widen. As with the inflation scenarios, we embarked on an exhaustive review of all the strategies that would profit from such an environment.

Protection sellers traditionally cater to the fear of market drops. Contrary to the market for inflation protection, a large number of indices, tail funds and other strategies are available to hedge deflation, covering many asset classes and using many methodologies. The greatest challenge is in fact to identify those that are the most efficient.

Many simple solutions being offered, based on holding long volatility for example, can be very costly, with monthly carry as high as seven percent. We therefore focused on the interesting, structured products that have emerged since 2008, based on more complex implementations of the trend-following techniques described earlier.

Using VIX or VSTOXX equity implied-volatility index futures or variance swaps as underlying instruments, these methodologies vary their exposure to volatility using not just price movements, but also the shape of the futures curve, or other indicators, as signals. With this flexibility, protection can ultimately be achieved at much lower cost.

Short credit strategies also proved interesting. We reviewed dozens of credit methodologies and identified one that was particularly efficient for our purpose. As it did not exist as a fund, we implemented the methodology for ECHO on the LumX managed account platform.

The result of our work was a portfolio structure for ECHO in which two teams of managers each addressed either the inflation or deflation risk, with all strategies selected for inclusion in either team meeting the following imperative criteria:
1. The methodology could be analysed, was understandable, and made sense;
2. The strategy explicitly aimed to minimise the cost of waiting for the payout scenario to develop;
3. Directional exposures were systematic, to guarantee a predictable participation when a trend develops. Strategies with discretionary decisions on exposures were discarded;
4. High liquidity and transparency;
5. Limited counterparty risk.

A word on the critical importance of this last point: because the scenarios we address are quite extreme, it is likely they will create issues for some trading counterparties or providers such as banks. Rather than trying to anticipate which ones might fail, we structurally minimise exposures wherever possible.

For example, funds set up on the LumX platform essentially have all their liquidity with a very solid custodian, leaving only the minimum amount of cash necessary to support trading with clearing brokers or prime brokers. For ETFs, we analyse the collateral portfolio and the payment structure in detail to make sure risk is limited in amount and time, typically to no more than one day’s performance. For swaps we insist on tri-partite collateral agreements and frequent settlement of losses and gains.

Putting it all together
The next step was portfolio construction itself. The two questions we had to answer were: “What is the optimal balance at any time between inflation and deflation protection in the portfolio?” and “How should strategies be weighted within the inflation and deflation components of the product?”

Over years of analysing alternative strategies, EIM has developed a set of robust tools able to handle the skewed distributions, fat tails and unstable correlations typical of such strategies

Weightings of the inflation and deflation components in ECHO are decided by EIM based on our macro analysis and scenario outlook. Both groups of strategies will always be present in the portfolio, with weights ranging from 30 to 70 percent. The current allocation is tilted towards deflation.

Allocating between strategies, and to individual funds within strategies, is more complicated and incorporates advanced risk management. The strategies selected for ECHO are ‘lumpy’ by design as they aim to generate large payouts in certain precise conditions with no better than modest returns until those conditions materialise. Their volatility therefore evolves over time. A long period of very low volatility, when a strategy is essentially in cash, generating returns of perhaps only plus or minus 50 basis points, can suddenly be punctuated by a period of highly volatile returns reaching double digits in a single month. Typical risk measures using average volatility, such as the Sharpe ratio, are therefore useless since the average never occurs. In addition, covariance between the strategies ebbs and flows with their exposures and the behaviour of the underlying instruments they are trading and tracking. Again, average correlation seldom occurs and only describes reality by chance.

Over years of analysing alternative strategies, EIM has developed a set of robust tools able to handle the skewed distributions, fat tails and unstable correlations typical of such strategies. For example, correlations are replaced with copulas that are better able to describe how correlations between instruments or strategies change at certain times.

Monte-Carlo simulation then allows us to examine a large number of possible portfolio outcomes to maintain the optimal balance of strategies in the portfolio over time. An important objective is that no single strategy should on its own either drive returns or generate a significant portion of losses in the portfolio. ECHO is actively rebalanced to maintain this equal-risk strategy profile over time.

ECHO was funded and launched on February 1 2012, after extensive testing that showed the concept to be very robust. Even after generous adjustments for survivorship bias, its behaviour in periods of systemic crisis like 2008 would have been very strong, while the ‘cost of waiting’ during recent lull periods was indeed more favourable than that of holding options.

In conclusion, the ECHO programme reflects EIM’s unique approach to developing targeted investment solutions. Based on a precise description of the client’s required return pattern in specific scenarios, EIM focuses on identifying strategies and funds whose expected behaviours will generate the desired outcomes. This requires detailed knowledge of each strategy and a high level of transparency on how each fund trades. Finally, ECHO’s liquid and transparent nature makes it suitable for all portfolios, including those with stringent regulatory reporting requirements such as Solvency II.

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