Curbing investment risks: Quantitative Investment Strategies
Like other industries, the investment sector is quickly developing new ways for technology to augment the performance of people. While talented portfolio managers still manage much of the world's investment assets, quantitative investment strategies (strategies applying systematic rules to investment contents) have been shown to generate robust investment returns, using techniques that are both systematic and scalable.
The first type of these quantitative-based strategies was "smart beta" ("Beta" QIS) which has gradually developed as an alternative to long-only equity investment since being launched in the 1970s. The second type, "risk premia" (broader use of systematic rules to global markets, to design alpha-type strategies)", which we will focus on, has evolved over the past five years, and is an alternative to long-short hedge funds, spanning all asset classes ("Alpha" QIS). Systematic strategies are also used not for investing, but hedging portfolios ("Hedging" QIS).
In a world where the future of investment returns seems uncertain, risk premia or "Alpha" QIS are in demand. Today's ever lower interest rates, expensive security prices, high corporate leverage and geopolitical uncertainty are challenging for traditional investment strategies. By contrast, QIS exploit identifiable inefficiencies in securities markets to engineer strategies designed to perform whether mainstream markets rise or fall.
Because they rise or fall independently of markets, QIS diversify portfolios of equities and bonds. Banks such as Societe Generale with leading derivatives structuring expertise can exploit market inefficiencies (see box: seven risk premia) at generally lower cost than active asset managers. They do so in a way that is also transparent and systematic.
Far from competing with the mainstream asset management industry, QIS strategies complement it. "The business of QIS will evolve," explains Jean François Mastrangelo, Head of Pricing & QIS EMEA for SGCIB.
"We used to provide a basket of 10-20 strategies for pension funds seeking funds of hedge fund replication. But in the future it could be more and more in-house experts or asset managers intermediating, who will go to banks for sophisticated single strategies and will be quite advanced. And there will remain smaller actors that still request full basket allocation from banks".
How are they used?
As Asset managers and Pension Funds come under increasing pressure to reduce costs, so they are likely to select single-strategy QIS as building blocks for portfolios. They will choose the best QIS from a range of banks that have the scale, market intelligence and engineering expertise to manufacture them at low cost.
Historically, though, QIS have mainly been bought as a basket of strategies, or for hedging, rather than bought as single strategies. Typically, they have been used in one of three ways:
Taking clever risks
Like smart beta, Risk Premia arise from market inefficiencies, also known as factors. The difference is that smart beta strategies are based on academic theory, while these "Alpha" QIS strategies arise from quantifiable arbitrages or behaviours present in derivatives markets.
In QIS investing, risk management is a top priority. In other words, we design strategies that try to avoid markets' greatest risks (equity downturn, sharp rates moves etc.)."We discuss with our investors the strategies that are most immune to those factors," notes Mastrangelo, referring to the factors that make future investment returns so uncertain. "For example, we favour interest rate carry strategies that are independent of the interest rate level. You can't do that with cash bonds, only through derivatives."
At any one time, market conditions lead to windows of opportunity. For example, Societe Generale's "rates volatility strategy" currently allows investors to buy interest rate volatility cheaply. This anomaly arises because many people are effectively selling market volatility, or buying callable products, which has distorted the shape of the interest rate yield curve. For investors, the strategy gives a positive return based on the carry or spread between rates at different maturities on the yield curve.
But "Alpha" QIS strategies are not entirely risk free. "When you look at a systematic arbitrage you have to understand that this does not come for free," notes Mastrangelo. "It comes because there is a skewed market. There are some unwinding effects that can be harmful. But we are very mindful of the capacity of the market for absorbing money from these strategies. So, if we see a shift we can tell our clients to exit."
QIS are attracting assets fast. We currently estimate USD 300bn in "Alpha" type of QIS, which compares with over USD 1trn in the longer established smart beta. According to Coalition Societe Generale* has over 6% of the market in QIS, at about USD 20bn, and we are leveraging our derivatives expertise to provide clients with innovative solutions.
Concludes Mastrangelo: "We are an innovative solutions house, not a bank that just uses its scale, known as a "flow monster." We can become unique in the QIS market – leveraging our well-known derivatives expertise across asset classes Our target is to follow closely the tier1 players in QIS: Goldman Sachs, JP Morgan, DB but there is a strong competition. QIS strategies are likely to play a strong part in the evolution of investment as a key building block of the future of market activities.
Seven types of "alpha" QIS
Buying high-yielding fixed income securities and selling low-yielding can generate a positive return.
Buying cheap assets, selling expensive ones.
Buying outperformers, selling expensive ones.
Buying absolute positive performers, selling short absolute negative performers.
Buying high-quality securities, selling low-quality securities.
Trading the arbitrage between implied and realised volatility.
7. Tail risk
Buying investments that will perform well if market volatility increases.