December, 2015 Print
Timothy Atwill, Head of Investment Strategy, Parametric Portfolio Associates.
Timothy Atwill of Parametric Portfolio Associates – a majority owned subsidiary of Eaton Vance – discusses the benefits of “Systematic alpha” and its application to emerging markets
The emerging market equity asset class has seen great growth over the last 25 years, as perceptions of these developing economies has moved from scepticism to a well-established appreciation of their contribution to global economic growth. Accordingly, an asset class which was once considered the realm of the courageous (or foolhardy) is now considered a key part of many investors’ portfolios. However, local government pension schemes are, in aggregate, significantly underweight emerging market equities according to State Street Local Authority League Tables at 31/3/2015, with a mere 6.2% of their total equity exposure to emerging markets, as opposed to 10.4% of the MSCI ACWI Index.
On top of grappling with the asset class itself, investors are quickly learning that they are between a rock and a hard place in terms of selecting active versus passive investing, with active strategies being challenged by high fees, transaction costs and low liquidity, while passive solutions create poorly constructed portfolios which are concentrated in the most developed of the emerging market countries. The “systematic alpha” approach provides a third way, which is distinct from both active and passive: a disciplined, rules-based, engineered approach. With the current focus on asset pooling, this systematic alpha approach could represent a scalable, cost-effective way for larger local government pension scheme pools to obtain diversified exposure to the asset class.
How “systematic alpha” differs from other styles of investing
Asset management has traditionally been split into two arenas: active and passive. With active, a portfolio manager attempts to outperform a given benchmark. Views on individual securities are typically developed through fundamental research or quantitative techniques, and these views are generally reflected in portfolio positions that often deviate from the stated benchmark. In contrast, passive managers attempt to match a benchmark’s performance by holding relatively static positions and minimising transaction and operational costs.
A third style of asset management has become increasingly popular, falling between these two extremes. “Systematic alpha,” as we call it, relies on three basic tenets: 1) outperformance is sought via the structure of a rules-based portfolio; 2) portfolios are built to emphasise diversification with no fundamental views expressed on the individual securities level; and 3) portfolios are constructed in a transparent fashion. Simply put, the aim is to generate alpha by tempering volatility through a combination of portfolio rebalancing and diversification. In addition, our approach may help reduce the impact of market inefficiencies and lower costs – including taxes – by limiting portfolio turnover compared to active strategies.
An approach that does not adopt fundamental security views
Many active managers attempt to add value by doing fundamental, bottom-up analysis and then taking portfolio positions based on these research efforts. Parametric has observed that the capital markets are a relatively efficient pricing forum, and that it’s difficult to consistently outperform through fundamental research.
While portfolios may have a tracking error risk profile similar to that of actively managed portfolios, this approach is not meant to reflect similar views on the expected returns of the individual securities. Instead, it is informed by a total portfolio perspective of seeking to minimise volatility through diversification and systematic rebalancing. Specifically, systematic alpha strategies seek to take advantage of the historical volatility and correlation properties of the underlying securities when constructing portfolios. As a result of this process, strategies may exhibit material deviations from the benchmark composition, but these deviations are not based on any assessment of the future performance of the individual securities held.
A rules-based approach to portfolio construction
The systematic alpha approach to portfolio construction is very different from that of both active and passive managers. Active managers pursue outperformance by dynamically assuming portfolio positions versus the stated benchmark, whereas passive managers try to match a benchmark’s return by holding fairly static positions similar to those of the benchmark. However, a benchmark may have attributes that make it an ineffective way of gaining exposure to an asset class. For example, even though many mainstream indices try to broadly define an investable universe, in fact, they frequently contain significant unintended concentrations. Emerging-market indices, in particular, tend to be concentrated in only a handful of countries.
Systematic alpha uses a rules-based approach which bears some resemblance to standard index construction rules, but has diversification and rebalancing as its driving principles. The rules differ from asset class to asset class, but the overarching goal of each systematic alpha strategy is the same – to outperform a prescribed benchmark by achieving a more optimal risk/return balance through relatively static positions. As an asset class evolves, portfolio construction rules are allowed to evolve as well, to adapt to the new market realities.
In essence, the approach is based on the core belief that a disciplined focus on diversification and rebalancing can add value across multiple asset classes. The resulting outperformance we may achieve is not derived from an ever-changing set of relative value judgements, but is the product of more thoughtful exposure to an asset class than is available through most passive indexing strategies.
Systematic alpha strategies have enhanced portfolio transparency versus other strategies
Systematic alpha strategies demonstrate a heightened transparency compared to most active managers due to the rules-based portfolio construction techniques. The explicit nature of a top-down investment style gives investors a clear picture of how the strategy is positioned relative to its benchmark. These biases in positioning versus the benchmark are persistent and change only slowly as the market environment changes. Ideally, this transparency is designed to ensure that portfolio performance does not come as a surprise to our investors. By building a transparent exposure to an asset class based on straightforward and reliable portfolio guidelines, a systematic alpha strategy attempts to deliver outperformance in a less dynamic fashion than active management and without the arbitrage issues of passive management.
The systematic alpha approach in emerging markets
This systematic approach in emerging markets follows a top-down, three-part process to build and maintain investment exposure in these markets. Beginning with the broadest investable country universe – up to 50 emerging markets, including a large number of frontier markets – each country is assigned to one of four tiers, the largest countries to Tier I and the smallest to Tier IV, based primarily on market capitalisation and liquidity. This four-tier structure seeks to offer greater exposure to smaller markets for enhanced portfolio diversification and return potential, while avoiding the concentrations of capitalisation-weighted indices. Additional screens are also run for access and investability, as well as for currency and valuation risk. This country structure allows risk and and volatility to be managed in a better way by exploiting emerging markets’ unique cross-correlation and standard deviation characteristics. Country weightings are then systematically rebalanced to prevent concentrations and to capture the alpha that may arise from the interaction of assets with high volatility and low cross-correlations.
The sell discipline in a systematic alpha approach
A key element in a sell discipline is systematic rebalancing when a country’s weighting in the portfolio reaches its specified trigger point. This disciplined rebalancing means trying to buy into market weakness, and generally seeking to sell into market strength. A country will typically be removed from the portfolio in the event that it gets added to a developed markets index, or if a major constituent becomes nationalised or political activity in a country substantially curtails shareholder rights.
The benefits of a systematic alpha approach to emerging markets
We believe the emerging markets asset class lends itself to investment strategies that employ systematic portfolio rebalancing. A systematic alpha approach seeks to provide increased diversification versus traditional active portfolios, while steering clear of the severe country concentrations found in capitalisation-weighted indices. By design, a systematic alpha approach underweights the largest capitalised countries and overweights the smallest. At the same time, it seeks to take advantage of the high country-specific volatility and low crosscorrelations prevalent in emerging and frontier markets.
Systematic alpha offers a third approach to asset management, distinct from the traditional styles of passive and active. It also provides a more transparent source of potential outperformance than active management and is not predicated on being consistently “smarter than the market.” At the same time, it presents a more nuanced and thoughtful exposure to an asset class than pure passive management. Through a disciplined, rules-based construction process, systematic alpha seeks to preserve the predictable performance qualities of a passive mandate, while still offering the potential for outperformance versus a benchmark. These ideas are transferrable across many different asset classes, and Parametric’s construction rules change to reflect the unique characteristics of each asset class. However, the general theme underlying each systematic alpha strategy is an attempt to outperform through a combination of rebalancing, lowering volatility through diversification, and reducing frictional costs and market inefficiencies.
Parametric can provide UK local government pension schemes with unique, innovative solutions to managing equity risk; the portfolio managers work in a team-based environment as “investment engineers” who design processes that can succeed without relying on repeated tactical insights into valuations or market direction – something that points to the potential for Parametric strategies as a complement to other active and passive asset managers.