Spring Valley Asset Management Diversifying For Alpha
Morristown, New Jersey-based quantitative hedge fund Spring Valley Asset Management, a registered CTA, has been trading since 2014 but January marked the one-year anniversary of Brett Palatiello joining the firm and February marks the one-year anniversary of the live trading launch of Spring Valley’s Diversified Alpha product, for which Palatiello is the Portfolio Manager.
Palatiello joined Spring Valley from Naqvi Van Ness Asset Management, where he was a portfolio manager of long short equity strategies. The switch to trading the futures markets came about because Palatiello saw an opportunity to launch a differentiated product in an industry mired in struggles at an existing CTA with the infrastructure to launch the product quickly.
“We [Palatiello and Charles DuBois, a colleague of Palatiello at Naqvi Van Ness] noticed the CTA space – traditionally trend followers and price-based managers – performing poorly, particularly over the last 10 years, so we created a number of futures strategies which we felt would offer something different in the systematic global macro space. We met John [Ryan, Founder of Spring Valley Asset Management] who was interested in our ideas, and he had the infrastructure to get this going quickly, so Chuck and I joined him at Spring Valley. It was a natural fit for us”, says Palatiello.
Palatiello’s background in long/short equities is evident in how he has built Diversified Alpha. As opposed to trend-following – the source of returns of many of the systematic managed futures trading industry - Diversified Alpha allocates half of the risk of the product to technical directional strategies and the other half to fundamental and relative value strategies.
“We’ll rank a market within an asset class based on a fundamental variable and we will go long the ones with the best fundamental characteristic and short the ones with the least favourable characteristics. We’re essentially capturing a spread between baskets of markets, similar to how it’s done in long/short equity”, says Palatiello.
Diversified Alpha trades more than 50 global futures markets across 4 asset classes, has an average holding period of a month, an average margin to equity of 14% contains 52 individual models. Palatiello has a three-pronged approach to modelling the different strategies contained within Diversified Alpha. Firstly, they diversify their models across multiple holding periods and parameters to reduce the luck involved in choosing the correct strategy; they avoid choosing the wrong rebalancing date by rebalancing one twentieth of the portfolio each day when they get a new signal to remove path dependency; and they neutralise certain factors, like momentum, so that they don’t capture additional uncompensated sources of risk. Each model has a volatility target of 15%, something Palatiello says is critical to his overall risk management philosophy.
“We believe our risk management is substantially more comprehensive than what you’ll see in other managed futures products because we explicitly target volatility at the portfolio level. If volatility picks up, we take risk off the table. If it goes lower, we put risk on. We deliberately maintain our volatility level.”
“We believe our risk management is substantially more comprehensive than what you'll see in other managed futures products"
Palatiello has invested in technology to the model which enables him to see how the portfolio is doing in real-time – and perform diagnostics in real-time – making the portfolio management process smoother, and in October the model residualized the inflation factor against 10-year bonds; the evolution of the models is something that Spring Valley shows in the investor deck for Diversified Alpha.
“We thought it was appropriate to remove the risks that were in 10-year bonds from those in inflation-linked bonds, so we can get a raw measure of inflation expectations and the risks in inflation. It’s important to show investors how your processes change, even if they’re relatively minor”, he said.
Capacity-wise, Palatiello says that the capacity of the program can be anywhere between $500mn and $750mn. He’s not one for gathering assets for gathering assets sake.
“We’ve seen a lot of managers with legitimate sources of alpha that got a little too greedy in wanting to raise more assets, which diluted those alphas. We’re more interested in preserving and actually achieving our objectives without having to dilute our alpha”, he said.
“We're more interested in preserving and actually achieving our objectives without having to dilute our alpha"
CTAs promote their lack of – or low, at least – correlation to equity and credit markets, and Palatiello goes a step further by touting his program’s low correlation to other CTAs; Diversified Alpha has a downside correlation of .02 to the BarclayHedge CTA Index. Indeed, he’s quite open about when Diversified Alpha will fare less well than most other CTAs because he believes he’s offering something different.
“CTAs will outperform Diversified Alpha on an absolute return basis when trend following is very strong because we have a very low allocation to trend following. But we’re offering something uncorrelated to CTAs. Investors don’t allocate to us because they want trend following. They allocate to us because they want a diversifying strategy uncorrelated to CTAs where the returns are consistent each year. Our focus on volatility management means that we can deliver that”, he said.
Palatiello has big plans for Spring Valley; he intends to go back to his roots as an equity trader by launching a long/short equity product at some point this year. He has a live track record as he ran the strategy in a private account previously, and Spring Valley also has plans to add people in operations, research and business development. Before that, the focus is continuing to build out Diversified Alpha to ensure it’s a success, and Palatiello is bullish on his chances.
“If we’re meeting our objectives [15% annual returns with 15% volatility] we should be able to raise a decent amount of money, especially in a space that’s relatively homogenous and struggling. We’re very optimistic.”
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