Paraclete- The Quest for Persistent Positive Carry in Global Macro
Paraclete is a Global Macro Fund headquartered in Singapore that deploys a systematic “smart diversification framework” that solves the problem of heightened market volatility by continuously balancing exposures to the right mix of assets that can generate positive expected returns while managing portfolio risk to a constant level. Dennis Mak is one of the co-founders of Paraclete. As of August 2020, Paraclete’s AUM is U$100 million. For the last three years since their founding in 2016, they have had a 31% annualized return, making it one of the world’s best (if not the best) performing quant macro strategies. In this interview, we discuss their approach to risk management and how a strategy like theirs fits into a traditional portfolio. The investment manager is Heritage Capital Management Pte Ltd.
Interview with Dennis Mak, portfolio manager
Tell me your background and evolution of Paraclete. What makes you different than other global macro funds with your Smart Diversification Framework?
We think of the Paraclete investment strategy as a very efficient tool for long-term investors to collect market risk premia, achieve high absolute returns, and control risk exposure to a targeted level. At any given time, investors want to achieve three goals: 1) own assets that have positive expected return, 2) own each of those assets in the right amounts in order to maximize the portfolio’s total return, 3) have a plan to manage risks when dangers arise. Each of those goals is challenging for the investor to achieve. If investors have a less than 50/50 chance of getting each goal correct, (let’s say a 45% probability for each of the three), the simple multiplication rule of statistics suggests that the investor has less than a 10% chance of achieving all three goals simultaneously for the portfolio as a whole. Paraclete solves that problem by doing each of the three well. Paraclete uses a systematic process for selecting attractive assets, constructing an optimal portfolio of those assets in a process that uses our smart diversification framework, and rebalancing the portfolio in order to manage risks as they arise. Smart diversification refers to creating a portfolio that has balanced risk exposures across asset class. As an example, Paraclete’s asset selection framework chose a portfolio that included a large allocation in equities in 2017, which benefited from the new tax and economic policies at the time. In 2020, the strategy selected precious metals and commodities such as wheat that benefited from the COVID pandemic.
I am the co-founder of Paraclete. Prior to Paraclete, I worked in investment positions at Ziff Brothers, Perry Capital, and Credit Suisse.
How does portfolio risk allocation coupled with robust risk controls both on the portfolio level and operation level allow compounding returns to become realized?
The mantra of long-term investors like Warren Buffett has always been to own high-quality assets and own them for a long enough time. We also share this belief. Our approach adds an additional element, which is that we target a constant annualized level of volatility of 30% in all market conditions. We achieve this by varying the amounts of each asset we own by prudently using leverage until the total expected annualized volatility of the portfolio reaches our target. This requires us to have robust risk controls both in the determination of the asset weightings and in managing the live portfolio. An annualized risk of 30% gives us exposure to enough market upside to produce high absolute returns. However, our risk management tools won’t prevent us from experiencing drawdowns. On average about once every 12 months, we can report a decline of approximately 10%. In a very bad month, we could be down approximately 15% or more. In a rare, but severe financial crisis, the strategy could have a drawdown of approximately 30%. Our risk management tools hopefully will keep our downside expectations contained within the expectations of a 30% volatility target. By staying invested in the strategy, investors should benefit from recoveries in the NAV. This should allow the investor’s capital to benefit from compounding at high rates of absolute return.
How does Behavioral Analysis come into factor when it comes to your risk tolerance for short-term and medium-term volatility?
Our edge is analytical and behavioral. On the analytical side, we have described our asset selection and portfolio construction technique using smart diversification. On the behavioral side, our edge comes from our ability to tolerate short and medium term volatility. Most investment managers are attempting to minimize volatility. Some true alpha strategies can produce attractive returns at low volatility, though the scalability and persistence of these strategies have to be questioned. Most managers, in desiring to deliver alpha, conflate it with beta. By optimizing for minimal volatility, they also minimize the returns. Many times, the realized volatility of these managers is much higher than they intended. What is better? A low-vol, low-return strategy that actually delivers high-vol and low-returns? Or a strategy offering constant vol and high returns? We prefer the latter. Put another way, we offer our investors transparency and intellectual honesty. Paraclete’s objective is to deliver high absolute returns over time while targeting a 30% annualized volatility. If we are successful, we expect our long-term reward-to-risk ratio (or Sharpe ratio) to be 1.0 or better. Even though we run a quant strategy that invests in macro assets, our philosophy is similar to that of buy-and-hold-investors who see volatility as an opportunity created by the manic-depressive character named Mr. Market.
How and why can Paraclete benefit the traditional equity bond ratio of 60/40 as developed markets’ real rates are negative given the 30% annualized volatility target?
A 60/40 portfolio held from the beginning of 2007 until late 2019 would have produced an annualized return of 2.95%. By allocating just 5% of such a portfolio to Paraclete with the rest allocated to the 60/40 portfolio, that combined portfolio would have produced an annualized return of 7.4%. $100 would have grown to $244 with the combined portfolio instead of $144 with 60/40 alone. Paraclete can benefit the traditional investor by providing a source of low-correlated return and by improving the reward-to-risk ratio (RRR). With the 60/40 portfolio, the RRR would have been 0.27. With the combined portfolio, the RRR more than doubles to 0.59. It may be a surprise to discover that adding Paraclete to the combined portfolio would not have increased the portfolio’s overall volatility by very much. The annualized volatility during this period would have been 12.6% versus 10.9% under 60/40. The significantly improved return and RRR outweighs the marginal increase in volatility.
Cryptocurrencies alongside gold and other precious metals is the perfect hedge to current geopolitical risk alongside US dollar debasement from QE. How does the rise of cryptocurrencies fit into a global macro portfolio?
We invest in only highly liquid publicly traded assets, such as futures on the S&P500, Nikkei, government bonds, oil, and commodities. We recognize that cryptocurrencies are increasingly attracting the interest of investors for a variety of reasons. We are constantly reviewing our investment universe, monitoring changes in the underlying liquidity to determine whether an instrument should be added or removed. It may be possible down the road for cryptocurrency to be offered as a standardized futures contract, in which case we will review it for inclusion in our investment universe. We currently do not have plans to add cryptocurrencies at this time. Our investment universe however includes precious metals such as gold and silver as well as non-USD currencies, which could be selected to form part of Paraclete’s portfolio.