What should pension fund managers and trustees consider when assessing the merits of adopting an enhanced indexation/ quantitative management strategy?
In search of superior risk control and greater certainty of result, pension fund managers and trustees are increasingly turning to quantitative investment techniques. However, realistically the only thing that is guaranteed in the world of investing is the notion of uncertainty. So what should pension fund managers and pension fund boards be considering when assessing the merits of adopting an enhanced indexing or an active quantitative approach? For the purposes of clarity, we can define enhanced strategies as those that are designed to produce returns of between 50-150bp net of fees, while active quantitative strategies operate in the 2-3% outperformance target bracket.
The first point to consider is for what the strategy is intended, or, in other words, what is its purpose? If, for example, the pension fund has adopted a core/satellite structure in which low risk mandates make up the core in combination with higher risk portfolios, the pension fund managers should be realistic about what most enhanced and active quantitative strategies are designed to achieve. Generally speaking, such approaches are at the lower end of the relative risk spectrum and will be better limited to investments in the core. Allocations premised on the basis of a strong risk budgeting framework should ensure that enhanced and active quant strategies are employed for an appropriate purpose. This should also ensure that the chosen strategy fits in with the other investment selections for the plan. Ideally, the enhanced or active quant portfolio will be uncorrelated to the other investment choices, its contributions to return being directly additive, whereas the additional risk incurred will be diluted by the desirable property of low correlation.
The second issue is the nature or type of enhanced or active quant strategy being employed. Active quant strategies by their very nature are model-driven. However, this type constitutes just one subset of the three main types of enhanced strategy:
o Derivatives-based cash enhancement strategies;
o Strategies based on valuation techniques, either fundamental, analyst-driven or quantitative model-driven; and,
o Strategies aimed at exploiting pricing anomalies, from index additions to convertible or merger arbitrages.
The pension funds must be convinced that there is a genuine source of value added that is being mined, and that the approach is supported by a robust and repeatable investment philosophy. For example, strategies that are derivative-based, cash enhancement techniques by nature will be trying to exploit the relationship that ties futures (and similarly other more exotic instruments) to their underlying instruments:
F + C = E + D
Put simply, the return of the future plus the return available on cash should theoretically be equal to the total return on equities (price return plus dividend income). The notion is that this equilibrium must broadly hold to ensure fair pricing of derivatives and that no arbitrage opportunities will persist. Nevertheless, some enhanced managers will believe that incremental return can be gained from investing the cash in more risky instruments, of a longer duration or of greater credit risk, in return for which the holder should be able to attain a greater return. Pension funds will need to feel completely comfortable that the nature of the risks being taken (bond-like) is appropriate for an equity investment.
Equally, where valuation techniques based on fundamental analyst research are employed to generate alpha, there is some evidence that such insights can be overwhelmed by systematic effects in the highly diversified portfolios that the lower tracking error targets of enhanced strategies require. Similarly, while merger arbitrage techniques have been shown to be very profitable in the hands of quality portfolio managers (enhanced indexers and hedge fund managers), their reliance on corporate activity in the capital markets means that such alpha opportunities are not always available. On this basis, it is possible to make a strong case for the employment of model-driven techniques as a strong foundation for at least part of the investment process.
In addition to getting comfortable that the nature of the risks being taken is appropriate for the purpose of the strategy, and in addition to being reassured that the investment philosophy is valid and sustainable, funds must also reflect on the investment process itself. Some pension fund managers will take comfort from strict objectivity, while others may feel inclined to allow some subjective human overlay to tinker with the process. Some focus on the nature of the risk modelling process being followed will also be appropriate for the savvy trustee. To what extent does the risk model fully capture the risks of the bets in the portfolio, or how closely tied is the risk model to the intended source of value – added? For example, a process that is premised on selecting momentum stocks will be poorly served by a risk model that only captures value, size and country effects. Part of this concern can be alleviated by having the fund manager explain why their chosen risk model (whether fundamental, statistical, or hybrid) is appropriate for their investment process.
Lastly, the pension fund manager should be able to gain comfort from the nature of the portfolio construction and implementation. Is the fund manager able to use the full range of trading techniques (including crossing, agency and principal trades), and do they properly model and incorporate estimates of transaction costs in their portfolio construction? It will be important for the fund manager to have a good understanding of what level of turnover is right for their investment process.
There are many different facets that pension fund managers and boards should explore prior to their deciding to adopt enhanced indexation or active quantitative management styles. Some basic understanding of investing will be an advantage, and the fund managers themselves will need to be able to adequately demonstrate the transparency of their investment process in well understood language and concepts.
Eoin Murray is head of quantitative management – Europe at Northern Trust Global Investments in London