The hunt for alpha, or outperformance corrected for risk, is the heart and soul of every investment strategy, and today we are taking a look at how alpha is attained at the intersection between factor investing and structured products, the 'endless possibilities' it breeds, and the investment process of the future.
It all starts with risk and the hedging of risk via diversification, an area of focus for Hannes Du Plessis, a classical musician-cum-risk strategist at Barclays Africa Group.
Du Plessis has thoroughly researched the South African equities market over the past 20 years, and has identified that the local risk premiums are largely in line with the traditional global rankings. Momentum carries the biggest risk, followed closely by volatility and value, or the overestimation of 'cheap-for-a-reason' risk.
Risk premia has long been the subject of exhaustive studies, and, while the traditionally established risk factors are relatively well understood, there are also others, less obvious and harder to quantify risks, of which investors should beware. "One of the many hidden risks that some investors are unaware of is misestimating the degree of concentration in markets, especially during bad times," said Du Plessis. "The problem is that we can't measure dependence very accurately, and hidden dependence can be very costly in times of trouble."
If all assets in a certain portfolio tend to move in one broad direction when pressured by a factor, the hidden dependence can accentuate the consolidation and increase dependence in a dangerous self-fuelling spiral.
Du Plessis says that the optimisation of diversification does not get enough attention, and many markets indeed exhibit a tendency of having assets more concentrated in trying times.
One of the problems is that the concept of diversification itself was not properly defined until very recently. The industry experienced a bit of an 'emperor has no clothes' moment in 2011, when only the first operationally applicable definition of diversification came to be, according to Du Plessis.
The mean variance concept of diversification, however, tends to favour the consolidation of funds and create dangerous dependence.
"We need better definitions," Du Plessis conceded.
"The concept that I like to use is diversification measured by the number of independent bets within a portfolio," he said. "One doesn't necessarily need a much diversified portfolio, but you always need to be aware of the true level of diversification so that you can optimise your exposure."
Structured products, and the ability to specifically design the payoff distribution, provide enormous value to asset managers, and ultimately to investors, according to Du Plessis. "Most of factor investing is in portfolio weighting, which is effective in itself, but structured products add a designed payoff layer on top of that for superior customisation and, ultimately, performance," he said.
The most obvious benefit of structured products is that the underlyings can be fitted with rules-based methodologies that can be easily hedged. Designing products that explicitly lower the volatility risk on any one specific factor portfolio will make it cheaper to hedge, and all sorts of structuring possibilities emerge from this, according to Du Plessis. "If most asset management products had this one simple ingredient of installing payoff asymmetry into the payoff distribution, the world would be a better place," said Du Plessis. "There's a great intersection between factor investing and structured products, and we are definitely looking at that." Barclays will soon be launching structured products on factor investing strategies, according to Du Plessis.
Divide your risky asset portfolio in a series of systematic factors and then impose formal diversification, says Du Plessis. Investment planning should start on the payoff distribution: how to actually get there, how to structure a portfolio that is cheapest to get there, and how do you start combining the pieces systematically.
"That's something that is missing from the typical investment process," he said.
"You start with 'I want the house to look like this', instead of sourcing the materials first, and leaving the house to build itself," he said. "The investment process should be more about shaping the outcome and then engineering our way there, than buying assets and hoping for the best."
Besides structured products, few investment options exist that fit the concept of 'engineering' the outcome of an investment. Smart beta, while offering a powerful tool for portfolio construction, or rather underlying basket construction, is still in the realm of vanilla exposure. Still, smart beta has 'a lot of good stuff' can definitely go in the right direction, according to Du Plessis.
However, the perennial 'passive versus active management' debate is taking away much attention from where it should be focused on, which is harvesting the risk premia as efficiently as possible and shaping the payoff to do it at the lowest possible cost, according to Du Plessis.
The first SRP Africa Structured Products & Alternative Investments conference 2016 will be held at the Hyatt Regency Hotel in Johannesburg between 16-18 November 2016. See link for details.
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