Asset managers worldwide face the new market reality: significantly decreased global economic growth, the lowest interest rates and inflation, an increase in asset cross-correlation due to accelerated globalization and spikes of event driven volatility, high assets valuation levels.
In response to market changes the new approaches to asset management have been developed: risk based asset allocation and factor investing. In this introductory document we briefly cover historical evolution of asset management from traditional methods to alternative beta and “pure” alpha strategies. Then we describe each category and analyze it based on our own examples. At the end we outline the new trends and future fields of research in modern asset management and alpha generating strategies.
1. What global portfolio investors are looking for from their asset managers?
- High equity like return.
- Bond like low volatility.
- Avoidance of large drawdowns (recessionary peak to trough drop in assets value)
- Diversification from their currently owned assets (own business or real estate for individuals, current investment exposure for institutional investors).
In other words investors in general seek the greatest possible efficiency in terms of return/risk ratio where the risk is uncertainty of investment outcomes.
2. New market reality:
- Decreasing global economic growth.
- Interest rates and inflation are at the lowest levels.
- Risk premiums depressed across all major traditional asset classes due to high valuation levels.
- Speed of information distribution and globalization make event driving volatility much bigger.
- Diversification potential is reduced: traditional asset classes are limited in number and became highly cross-correlated due to accelerated globalization.
- Growth risk (equity beta) still dominates investment portfolios worldwide.
These factors make traditional asset allocation along with popular nowadays risk parity portfolios not effective anymore. Estimated 10 year looking forward Sharpe ratios for these portfolios are well below historical mean values for the last thirty years (see page 14).
3. Adapting to new conditions: historical evolution of asset management
The figure below shows historical evolution of asset management techniques from traditional approach which is based on Modern Portfolio Theory (MPT) and Efficient Market Hypothesis (EMH) to factor based investing. The concept of a risk factor stems from the belief that the returns on an asset can be broken down or split up into distinct sub-components that each contribute to the overall return and risk characteristics of the asset. Extending this into portfolio management, Podkaminer (2013) likened risk factors to atoms and assets to molecules. For example, the return earned on a corporate bond can be broken down according to the risks to which the bond holder is exposed, including duration, inflation and credit risks.
Factor based approach gives the following advantages (among others):
- An increased ability to understand, predict and explain the drivers of performance over different time horizons and regimes.
- Factors pairwise correlation is much lower than traditional asset classes even during turbulent times, robust portfolio mean-variance optimization is possible1
- Gives an ability to unwind from undesired risk exposure and consistently exploit various forms of market inefficiency (alternative beta).
However “pure” factor investing has several practical impediments. The main problem is effective factor capturing and its investability given investment policy determined constraints and liquidity requirements. Most popular nowadays smart beta indexes have unlevered long only exposure. That leads to residual undesired risk exposure (traditional beta), reduce diversification and factor’s performance potential.
4. We divide asset management approaches into the three main categories:
1. Traditional asset management.
2. Factor based investing.
3. “Pure” alpha strategies.
The third category is “pure” alpha consistently derived by several top hedge funds like Renaissance Technologies, Bridgewater Pure Alpha, Two Sigma, AQR Capital, Millennium (they closed for new investors long time ago and very costly for old clients - fee structure 3/30+) from the following sources:
1. Idiosyncratic risk exposure: security selection based on superior information or analytical skill
2. Market and factor timing models (volatility, return and correlation forecasts)
4. Event-driven strategies, arbitrage and ultra high frequency trading
5. Value creation (top private equity funds or activist strategies in public markets)
The main idea of active management is to determine and combine as many independent alpha sources as possible in order to generate high and stable investment results uncorrelated to traditional assets.
5. The future of active factor based asset management lies in the following fields:
- Determined global investable factor universe database that includes popular traditional, alternative and not widely known pure alpha generating factors.
- Effective factor exposure via ranking approach which is superior to popular alternative indexes weighting methods.
- Robust factor timing models.
- Robust portfolio optimization schemes.
- Goal seeking theme investing (theme is a combination of factors with a special purpose).
- Diversified absolute return pure alpha multi-strategy portfolios at low cost.
Source: SSRN Introduction into Multi-Factor Investing by Yury Polyakov, May 2016