Time for something exotic…weekend reading

Perhaps the best part of being a CFA is a ‘free’ (with membership fees) subscription to the Financial Analysts Journal.  This publication can usually be relied upon to have one or two half-wonkish articles directly applicable to everyday portfolios in each issue.

The latest issue came to my door today, and my eyes were immediately drawn to an article by PMs at Kepos Capital and Bob Litterman (famous financial quant): Exotic Beta Revisited.  They construct a portfolio of 9 exotic betas, which have zero equity correlation by design (i.e. they hedge equity exposure to zero on a daily basis):

  1. Equity value – Market Neutral (MN) equity indices, based upon conventional value factors
  2. Bond yields – long an international portfolio of government 10-year bonds; plus MN bond 10-year yield carry
  3. Bond slope – long an international portfolio of government 10-year/2-year bond spreads; plus MN bond spread carry
  4. Commodities – long a basket of commodities (combo of index + equal-risk); plus MN commodity backwardation carry
  5. Real assets – long a basket of REITs
  6. Currency value – MN currency carry
  7. Volatility – short VIX futures, and/or short variance swaps
  8. Credit – short credit protection/long credit risk, through a basket of US/Europe CDS indices
  9. Catastrophe bonds – long catastrophic reinsurance risk (such as hurricanes and earthquake bonds)

Impressive stats from the portfolio they construct, even with reasonable transaction costs assumed, and inability to rebalance too much in things like number 9 above.

A lot of these strategies fall into the Expected Returns overview that Ilmanen wrote years ago.  I’ve come across these strategies in the expensive hedge-fund world, but not many in cheap mutual fund world as of yet.  If any of you hear of these guys starting an accessible fund, let me know.  Otherwise, I’m off to implement some of these trades by myself!

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