The last 18 months went down in history as one of the most challenging market environments in modern times. Federal Reserve Chairman Ben Bernanke described the financial system as being "at the brink of collapse" immediately after the fall of Lehman Brothers. For many, this was an abnormally candid and clear remark given to a marketplace accustomed to interpreting stealthy and encyclopedic "Greenspan-isms" for 19 years. The good news is that the economy will eventually turn around--and it will probably be stronger and more robust as a result of overcoming turmoil. The bad news is that at least for the time being, finding good and sustainable positive returns in the midst of unprecedented volatility is like finding a needle in the proverbial haystack.
Fortunately, those needles do exist and more often than not they employ strategies which either (a) are neutral to the market's aggressive volatility or (b) take advantage of it. For example, 22-year veteran to quantitative market strategies Bradford Paskewitz of Paskewitz Asset Management trades short and intermediate-term tops and bottom, an approach that has historically thrived during market extremes. PAM has a track record of delivering its target annual returns profile, which is currently at 25% returns per annum and 15% standard deviation. However, past performance does not guarantee future results.
Analysts expect that volatility in the markets will remain high until all remnants of the financial crisis are cleaned up and the fear or post-recovery inflation problems controlled. It is a tricky situation for the government where bad decisions could lead to even more uncertainties. Interesting enough this setup bodes well for Paskewitz, who has historically benefited from high volatility. PAM's CEO, Bradford Paskewitz, remarked, "the strategy works better during a volatile market, which I expect it to remain at these levels for at least another 1-2 years." However, even during one of the lowest volatility periods in recent history in '04/'05, PAM delivered annual returns of 17.3% and 14.05%. During high volatility years from '06 to '08, it posted returns of 38.98%, 39.21% and 32.25%, respectively.
Another of PAM's strengths in today's bearish market is its low to negative correlation with different markets. Historically, declines in equity markets are correlated with higher volatility, which contributes to the diversification potential of investing in PAM (http://www.iasg.com/group/pam/contrarian-sp-500-stock-index). Looking at the two historical analysis of the VIX, the data shows the inverse relationship between volatility and market performance.
A Proper Use of Leverage
Aside from solid performance over time and low correlation with other types of investments, Paskewitz's strategy utilizes leverage. Leverage comes with the caveat that both risk and returns are magnified. For example, the collapse of Long Term Capital Management in 1997 and Bear Stearns can be attributed in large part to their use of extreme leverage (LTCM used up to 100 times leverage iand Bear Stearns's core hedge funds used 35 times). Of course, Paskewitz Contrarian 3X Stock Index Program does not compare to those leverage levels. The most Paskewitz's program uses in leverage is 6X and it occurs rarely (3-4 days per year). According to Bradford Paskewitz, the program averages a leverage ratio of 1.2 times during normal conditions. With proper risk controls, which is regularly practiced by the program, PAM attempts to use leverage to its advantage.
Going forward whether volatility moves higher, stays at current levels, or reverts lower, Paskewitz's program appears to be a Commodity Trading Advisor capable of generating smart returns in difficult times. Their ability to take advantage of volatility and Paskewitz's prudent application of leverage has led to a long track record of stable returns. Nevertheless, while our expectations of PAM may be high, all investors should be aware of the highly speculative nature of investing in an absolute program. As the market fights to find the proper direction and investors hunt for above-average performance, PAM may be a worthwhile addition to any diversified portfolio.
