Matthew van der Weide Communicating with Impact ... · Communicating with impact: Illustrating...

Communicating with Impact:Illustrating (semi)active returns

Copyright © 2017 FactSet Research Systems Inc. All rights reserved. Confidential: Do not forward.

Matthew van der Weide

[email protected]

Ian Hissey

[email protected]

Current themes in the industry

3Copyright © 2016 FactSet Research Systems Inc. All rights reserved. Confidential: Do not forward.

Implications for (semi) active management

Rise of Passive Investing

Clients are getting more sophisticated

Pressure on fees &Increased need for justification

Low RateEnvironment

Smart Beta is a driving force in passive investing

Low rate environment catalyst in scrutinizing of cost

Factor Awareness increases client demands as cheap alternatives exist

• Active Managers need to pivot offerings to service changing client demand

Challenging Environment Communicate value-add effectively

Smart Beta: The end of active management?

• Nothing new, increased granularity in Beta

• Early index innovation– Cap Weighted indices and ETFs

• Fama French – Small, mid, large benchmarks and ETFs– Value / Growth benchmarks and ETFs

• Smart Beta– Risk Premia, Smart Beta, Factor benchmarks and ETFs


Beat Benchmark instead of absolute return

Beat Style Benchmark instead

Beat Smart Beta (Benchmark) instead

Assume a manager has skill

• This is an oversimplification:

– Skill is in selecting stocks• Whether fundamental stock picker or orthogonal quant alpha

– Skill in selecting “factors” in the broadest sense• Styles, Sectors, Regions, Asset Classes


Show Alpha is idiosyncratic and/or factor tilts are intentional

Show alpha is in the selected factors

Increased factor awareness leads to better portfolio construction:Unintended exposures eat Alpha for breakfast

Communicating with impact

• In order to justify active fees highlight the value add of active manager

• Key items to address when marketing the strategy

• Agenda:– Focus on Horizon– Incorporating risk into the process– Factor Awareness & Risk Based Performance Attribution


Focus on Horizon


Horizon and … money chases returns

• Long term horizon vs short term performance

• Ironically Risk Premia / Smart Beta strategies are a perfect example– Most marketing is focused on excess return (over a conveniently selected period)– They sustain long periods of drawdown

• Similarly there can be “mean reversion” in fund performance

• Emphasize the process– Show historical situations that were similar– When there are consistent style tilts, use factor performance to illustrate this

Historical illustration

• Tech Bubble

• Sectors / Finance Sector

• Momentum


Factor as illustration

• Use factor returns to illustrate factors are long term positive but show drawdowns

• Size factor Northfield Global Equity Model 1990 - Current




• Value/Growth factor Northfield Global Equity Model 1990 - Current


Style performance in different regimes


Incorporating risk into the process


Incorporating risk into the process

• Good idiosyncratic alpha can be eaten away by poor portfolio construction

• Be aware of factor exposures and contributions to risk

• Aligning bets to risk contributions and vice versa, two dimensions:– Across securities and groups of securities– Across factors

• Stress testing– Look at plausible market scenarios– More importantly test conviction

• Bets might be on external / macro factors• See what happens when the scenario enfolds, and when it doesn’t


Aligning: Positioning vs risk contributions

• Active weight <> Active Risk

• Benefit: – Independent of Factor definitions– Portfolio can be grouped in any way the manager thinks or the portfolio is constructed

• Challenge: – It might not highlight the sources or risk and/or diversification


Sectors vs. Risk

• Most active sector weights are in line with risk contributions except for IT & Consumer Discretionary


Relatively large contribution: Primarily Mith Group

IT proportionally low contribution to risk

% of Tracking Error % Active Weight

Regions vs. Risk

• Despite large underweight in Japan, most risk in Asia ex Japan



Most risk in Asia

Underweight Japan

Buy / Sell recommendations vs. Risk


Overweight Buy Recommendation and largest contributor


• Alignment to the investment process

Aligning: Factor exposures vs. risk contributions

• Benefit: – Multi factor approach that takes into account correlations

• Challenge:– Definitions pre-specified by the risk model

• Answer to Challenge:– Combine positioning and exposures


Aligning: Factor exposures vs. risk contributions


Aligning: Positioning and Risk contributions

• Combined traditional security exposures with factor contributions uncover new insights


Again 40% of risk in Consumer Discretionary

Of which 6.5% Region Risk

But mainly 27%Stock Specific Risk

Of which half comes from Minth Group

Stress Testing

• Stress Testing allows one to look at the impact of potential scenarios on a portfolio

• Historical Events– Limited number of examples– Likelihood of repeating

• Factor Shocks– Allow for hypothetical scenarios

– Look at plausible market scenarios– More importantly test conviction

• Bets might be on external / macro factors• See what happens when the scenario enfolds, and when it doesn’t


Stress Testing Example

• Minth Group Ltd. is engaged in the design, manufacture and sales of trims, decorative, body structural and other related auto parts. Its products include trims, decorative parts, body structural parts, seat frame systems, roof racks, and other components. The company was founded by Chin Jong Hwa in 1992 and is headquartered in Ningbo, China.

• Company is doing well, but has dependency on several factors– Consumer spending & Auto industry – 40% of Revenue derived outside the home market– Clients include the likes of GM, Ford, Volkswagen…


Stress Testing: Contribution

• Factor Shock: MSCI APAC Automobiles & Components 20% down and up


Stress Testing: Standalone Return

• Identifying safe havens and vulnerabilities


Utilities most sensitive, but only on the portfolio side:-18% vs. -9%

Similarly Healthcare least sensitive on benchmark side: -11% and -8%

Factor Awareness


Factor Awareness: Risk based performance attribution

• Regardless of style show that performance is driven by the decisions made, whether factor or selection

• Brinson Attribution describes return as Allocation and Selection

• Why Risk Based Performance Attribution?


Risk Based Performance Attribution

• Multi Factor Attribution

• Classical View• (Active) Exposure * Factor Return = Factor Impact

29PRESENTATION FROM FACTSET RESEARCH SYSTEMS

𝒓𝒓 − 𝒃𝒃 = �𝒊𝒊=1

𝒏𝒏

𝒆𝒆𝒑𝒑𝒊𝒊 − 𝒆𝒆𝑏𝑏𝒊𝒊 × 𝑹𝑹𝒊𝒊 + 𝒆𝒆𝒓𝒓𝒓𝒓𝒆𝒆𝒓𝒓

Comparison

Brinson

• Allocation & Selection Effect• De Facto Standard• Straight forward calculation• Single Dimension• Flexibility in grouping

Risk Based

• Risk Factors & Stock Specific Effect• Increasingly used• Need to understand units and risk model• Simultaneous Tilts• Traditionally at the portfolio level


Risk-Based Performance Attribution Should

• Fully explain relative performance

• Decompose down to individual securities

• Allow users to customize reports to match the investment process



𝒏𝒏

𝒆𝒆𝒃𝒃𝒊𝒊 − 𝒆𝒆𝒊𝒊 × 𝑹𝑹𝒊𝒊 + error

Risk-Based Performance Attribution Should

• Fully explain relative performance

• Decompose down to individual securities

• Allow users to customize reports to match the investment process



𝒏𝒏

𝒆𝒆𝒃𝒃𝒊𝒊 − 𝒆𝒆𝒊𝒊 × 𝑹𝑹𝒊𝒊 + Stock Selection

Brinson vs. Risk Based Attribution

• Risk Based tells a different story than traditional Brinson


Brinson vs. Risk Based Attribution

• Regrouping the portfolio by sector results in different selection effect for Brinson, but not for Risk Based Attribution


Risk Based Attribution – Factor Impact

• The logical next question is, what factors have contributed?

• Despite relatively small risk contributions, substantial effect on performance


Currency

Fundamental

Sectors

Conclusion

• With the rise of Smart beta we have evolved from a single to multiple beta world. This beta is available increasingly lower cost

• To succeed in active management and justify active fees, one has to show skill above and beyond factors tilts

• When communicating the value add of active management, highlight the importance of horizon and investment style. Factors payoffs can highlight the importance of horizon

• Show the importance of due diligence and incorporate risk into the investment process, highlighting the deliberateness of decisions

• Risk based performance attribution is a powerful method to describe active returns and manager skill, whether factor selection, security selection or the combination


Matthew van der Weide Communicating with Impact ... · Communicating with impact: Illustrating...

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