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ALTERNATIVE INVESTMENTS


inventories. Momentum generates alpha by identifying the commodity markets that need to create the incentives for market participants to move physical commodities in and out of storage. Chart 5 shows the list of commodities that have shown strong persistency in returns. Momentum strategies are rewarded for taking


price risk in anticipation of future price movements. But market positioning is just an expression of the risk-adjusted market expectations of future returns. Hence, market positioning can be used as a signal for momentum strategies, and investors can also generate alpha by taking price risk as indicated by market positioning data. Momentum can be used as a relative value signal


that generates cross commodity alpha by selecting which commodities to go long – for example, the MLCXAKLE index uses such a strategy by selecting the most “backwardated” or the least “contangoed” commodities to construct a long-only portfolio (see chart 6 for historical performance of the MLCXAKLE and DJUBS indices).


Volatility strategies Volatility strategies provide insurance to market participants and are the quintessential alpha strategies rewarded for taking price risk from market participants who are willing to pay a premium for it. Just as in any other derivatives market, implied volatility in commodity markets serves as the key variable for market participants such as producers, consumers, processors and investors to match supply and demand for options. However, there is often a structural imbalance between buyers and sellers of options in most commodity markets. Market participants’ hedging needs cause- persistent biases in the commodity options markets, offering a source of market-neutral alpha for investors. Investors, like market makers, can benefit from the


imbalances between buyers and sellers of commodity volatility through variance swaps. The payoff of a variance swap depends directly on the difference between implied volatility and the subsequently realized volatility of the underlying asset. Bank of America Merrill Lynch produces the MLCXGVA (Gold) and MLCXCVA (WTI Crude) indices (refer charts 7 and 8) that are designed to exploit the spread between implied and realized volatility as an alpha strategy.


The power of diversification The objective of any alpha portfolio should be to capture the benefits that a diversified portfolio of different sources of alpha can provide. In general, a portfolio’s risk is a function of the number of assets held in the portfolio as well as of the correlation between them. Hence, a portfolio of a few alpha strategies, more or less independent from each other, will generally produce better risk-adjusted returns than any single strategy by itself.


A simple example illustrates the power of


diversification in an alpha portfolio. Suppose alpha strategy A generates returns of 5 per cent and volatility of 2 per cent a year, providing an information ratio of 2.5. At the same time, suppose three uncorrelated strategies B, C and D each generate annual returns of 3 per cent with the same volatility. Despite each of those strategies being far worse than strategy A on an individual basis, it turns out that an equally weighted portfolio of strategies B, C and D produces a better allocation in risk-adjusted terms than an allocation to strategy A. This simple example (below) also suggests an easy


methodology for creating high quality alpha in any asset class. Investors should pursue simple and easy- to-understand strategies that exploit a broad range of sources of alpha. While some of the simpler strategies may not perform as well as some of the more complex strategies on an individual basis, as long as they are uncorrelated with each other, their combination is likely to do so.


Product development Several investment banks are investing substantial resources into developing products to enable their clients to access enhanced beta and alpha products based on commodity markets. Bank of America Merrill Lynch has created a broad suite of indices that track the performance of such strategies. Wholesale investors can gain exposure to those indices through standard wrappers such as OTC options and Notes to suit a wide range of payoff profiles.


5%


THE AVERAGE ROI OF A PORTFOLIO THAT AIMS FOR AN ABSOLUTE RETURN,


IRRESPECTIVE OF MARKET CONDITIONS.


Disclaimer


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A simple example shows the power of combining strategies with different sources of alpha Strategy A


Single B, C, and D Strategies


Returns Vol


Information-ratio Source: Bloomberg, BofA Merrill Lynch FAMILY OFFICE: ASIA TOMORROW 71


5.00% 2.00% 2.50


3.00% 2.00% 1.50


Portfolio of B, C, and D


3.0%


1.15% 2.60


Portfolio of B, C, and D (targeting 2% vol)


5.20% 2.00% 2.60


OPERATIONS


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