The Curious Case of the Rise of Hybrid Investing

Active investors' objective function: To maximum excess returns on a risk adjusted basis with fewer periods of under-performance.

There are various styles of investing which an active manager adopts and all styles have certain merits. These styles could be value investing, growth/moat investing or momentum/technical investing. Investors align themselves to a particular style based on their mandate, learning preference and past success. However, no style works forever and some style would work better than the other at a given point of time. Investors who follow one strategy do suffer from under-performance from time to time if their style is out of favour. That’s absolutely fine as long as an investor’s mandate allows the space for periodic under-performance in the pursuit of attaining the larger mandate. In that sense, investors should always be disciplined to follow their preferred investing style as that increases their odds of success.

While knowing one's own game and sticking to it makes sense, does it mean that it is the optimal strategy/style? Perhaps not!

For an analogy, there are stark similarities between religious beliefs and investing styles. In religion, the ultimate mantra is to attain salvation/nirvana. There are various beliefs and practices on how to attain that objective which the devouts would practice with utmost dedication. In investing, the ultimate objective is to attain superior and sustainable alpha. For that most investors follow a particular style which could be a value style or technical analysis and strive to become an expert in that.

Everyone believes that their religion is superior and closer to the truth. But in reality, there is much to learn from all religions and if one is open about assessing others' belief system, then one can find various virtues in those systems. In investing too, investors become biased towards styles which they follow and over time loose flexibility to appreciate the virtues of other styles. However, this notion of focusing on single factor or style investing is now being challenged.

According to an analysis published in FT, only two in every 100 global active equity funds have outperformed the S&P Global 1200 since 2006. Almost 97 per cent of active EM funds have under-performed. Indeed, conventional active fund management styles have struggled to outperform and that have shaken the faith of their investors.

What could be possible reason behind the under-performance of the best and brightest in the industry? One possible reason could be high fixation with a particular style of investing and the lack of flexibility to appreciate and embrace other styles!

The Greek philosopher Aristotle observed that the whole is greater than the sum of its parts. This phrase aptly defines the modern concept of synergy across disciplines and investing is no different.

One way to reduce periods of under-performance and at the same time attain higher alpha could be through "Hybrid investing". This would require an investor to be open about taking the best from all the various styles/disciplines and to weave them together to generate diversified alpha generating tools. Globally, there has been a growing evidence of the merits of rule based factor driven investing.

In fact, there is a relatively new breed of investing called smart beta investing (mainly ETFs), a simplified form of hybrid investing which has become an over US$ 500 billion industry in the US with the AUM growing at 30% over the past 5 years.

Any strategy works to an extent you can front run everyone’s expectations changes. Smart and hybrid strategies have the potential to not only diversify a style risk but at the same time add that extra alpha on a consistent basis which most active investors strive to achieve.

To illustrate how a basic hybrid strategy looks like consider two factors; value and momentum. Both are contrasting in nature and very seldom an investor would be applying a combination of fundamental value criterion along with certain technical criterion such as relative strength. However, a systematic active framework encompassing the simple factors like low valuation and rising momentum could generate a pool of stocks which outperform the benchmark index. While there could be umpteen number of possible combination, in essence, a combination of improving fundamentals, acceptable valuations and favorable momentum shortlists a pool of securities that tend to outperform the market under all kinds of market conditions.

Strong case for Hybrid Investing in India:

To give credit to Indian equity mutual fund managers, they have fared far better than their global counterparts over the long term. However, adjusting for fees and other risks taken into consideration there potentially remains significant scope to improve. Further, there has been massive rotation in terms of styles in India and therefore the performance leadership both in terms of stocks as well as funds keeps changing.

In India the concept of hybrid investing could be far novel as compared to the US where there are as many as 480 known factors at work for smart beta strategies. However, two things which are required for hybrid strategy to work are timely and detailed company performance disclosures as well as some market inefficiencies to exploit. Both are present in India. Indian markets are relatively less efficient and at the same time company performance disclosure requirements are high. Therefore, it's a very fertile ground for the system based hybrid strategies which would be extremely effective in front running the expectations.

The toughest part is to be open about other streams of investing. If that humility is there, then one will be able to steal from all those different disciplines, take little pieces that work and combine them into an approach that works better than any single approach. There are other considerations like liquidity, size, sectoral concentration, etc which an investor can keep in mind while devising a smart quantitative approach. Early days but that could be way to the future investing. A smart and humble way to front run others expectation with a well defined rule based framework!

Hybrid Investing Framework: A simple yet powerful concept