Using derivatives: ensure diversifiers don’t cluster together

0

Constructing a diversified portfolio of different managers and strategies requires an understanding of how each relates to the others in different market conditions. Strategies which cluster together, in terms of having a positive correlation, should receive a smaller allocation in a diversified portfolio than those which don’t cluster. Those which help diversification should be allocated accordingly, according to Frontier Advisors.

Clustering analysis is a helpful tool to identify similarities and differences which may otherwise not be easily discerned, the final webinar (on July 30) at this year’s Frontier Advisors conference was told. Michael Sommers, a principal consultant and the head of alternatives and derivatives strategies at Frontier, who chaired the session, said that Frontier was covering a relatively new process in order to adopt a total portfolio perspective on behalf of funds. “We are focusing less on what’s under the hood (of managers’ strategies) and more on what is cluster analysis.”

His colleague Donna Davis, an associate consultant who has a background in quant modelling, said that cluster analyses, which look for similarities and differences within a data set which might not be easily recognised, create order within that data set by establishing groups.

“Cluster analysis is unsupervised,” she said, “in that we don’t tell the computer what we’re looking for. This helps the user to look past grouping biases.” But there still needs to be human interaction to identify which clusters best suit the data from the fund’s or manager’s point of view.

“Cluster analysis is a point-in-time analysis, which looks at what happens to relationships in, say, an equities rally or drawdown,” she said. “We can replicate those market actions and reshuffle the ‘vertical branches’ [which provide the relative distinctions].”

Sommers said that this year’s virtual Frontier conference, held over a three-week period, encompassed about 50 presenters. As with other big conferences, such as the recent CMSF, extending the period of delivery and engagement from a day or two to a couple of weeks, allows for more presenters and easier access by the audience, who don’t have to decide between conflicting breakout sessions. The Frontier conference session recordings will be available within the next week or so on the firm’s website.

– G.B.

Share.