Systematic Equity Factor Analysis in order to implement a Completion Strategy

SYSTEMATIC EQUITY FACTOR ANALYSIS IN ORDER TO IMPLEMENT A COMPLETION STRATEGY TO MITIGATE AGAINST FACTOR BIASES IN YOUR CONSOLIDATED EQUITY PORTFOLIO

More than 20 years of dealing with Boards of Trustees and other Fund selectors has reaffirmed for me the risks of unsophisticated manager selection, influenced largely by brand pulling power, performance recency bias (particularly the classic 3 & 5 year peer relative quartile rankings) and other qualitative selection factors.

On numerous occasions I have witnessed clients’ funds inappropriately skewed through selection biases. These are frequently caused by:

1.     A cohort of top performing managers having been selected, who coincidentally are philosophically aligned to the latest business, economic and investment cycle and demonstrating 1st quartile performance over 3 and 5 years;

2.     Inexperienced institutional manager selectors being prone to the same qualitative and quantitative selection biases as retail investors (Buy High, Sell Low), just with larger denominations of money;

3.     Asset allocators awarding investment mandates with tightly defined mandate parameters, in particular Tracking Error constraints and Peer Relative performance evaluation criteria which precipitates manager “clustering” and a high concentration and commonality of top 20 stocks.

My experience is that investment manager hiring and firing processes tend to lag business and investment cycles by up to 3 years. Ie, a new manager may only get appointed once the Board or asset allocator is satisfied with their 3 year performance track record. Similarly, a top performing manager may only get fired after 3 years of underperformance (of benchmarks and peers), unless there is some business “catastrophe” such as key personnel departures etc.

So a client’s portfolio may be well synchronised with a business and investment cycle for a period of time, but when the cycle rotates, the client’s portfolio will experience a substantial re-set with associated losses.

Fig 1 below illustrates the following:

a)     Radar graph showing the 6 classic Systematic Equity Factors prevalent in most equity markets;

b)     The Red radar represents a theoretical perfectly neutral portfolio with equal exposure to all factors;

c)     The Green radar represents an illustrative MSCI ACWI reflecting how a Market Cap Weighted Index can have overweight and underweight exposures to certain of the 6 factors;

d)     The Blue radar represents a client’s consolidated equity portfolio. Irrespective of whether the client is invested in multi-asset strategies or custom equity-only mandates – by taking the consolidated portfolio and interrogating its exposure to the various factors will produce an interesting diagnostic showing where the fund is overweight or underweight certain factors on a consolidated basis.

In Fig 1 we can see the following:

       i.           The MSCI ACWI (illustrative data) reflecting overweight exposures to Momentum, Low Volatility, Size and Quality, with underweight exposures to Value and Dividend Yield;

     ii.           The client’s consolidated equity portfolio showing a benchmark overweight exposure to Momentum, Low Volatility, Size and Quality; a neutral exposure to Dividend Yield and a meaningful underweight to Value.

Although some Factor Exposure bets may be intended, it is highly likely that the full magnitude thereof is not fully appreciated nor the consequences thereof fully understood.

It is therefore prudent to perform a Systematic Factor Analysis on the consolidated equity portfolio, so that the factor exposures can be measured and objectively assessed against mandate and Fund strategy goals and risk parameters.

To the extent that any of the factor exposures have drifted outside “tolerance limits”, it would then be appropriate to contemplate the introduction of a “Completion Mandate” in order to harmonize the total portfolio’s exposure to equity factors.

Fig 2 below illustrates what a possible “Completion Strategy” mandate might look like.

Bear in mind, a “Completion Strategy” is not intended to render an active equity strategy into a passive index tracking strategy. That would be defeating the purpose of the exercise, as the client may in that case just terminate all their active mandates and hand over the assets to one of the global titan passive managers.

The objective is to harmonize the consolidated portfolio in such a way that some of the extreme positions are moderated, thus still accommodating a fully active framework, with active style and factor bets/tilts, but in a controlled fashion.

Effectively the Client would hand over the consolidated equity “book” of assets run by all their active managers. This consolidated book of equities is then subjected to quantitative factor screening analysis using one of the many factor analysis tools/programs. Once the consolidated portfolio is interrogated and the factor exposures determined, various adjustments can be run, in order to optimise the total portfolio – essentially one would be seeking two outcomes:

1)     Improve total returns;

2)     Reduce portfolio volatility, thus improving the total return per unit of risk.

Once the optimisation is run, a new “Completion Strategy” mandate can be proposed and awarded, as illustrated in Fig 2 – showing a more concentrated allocation to Smaller/Medium Cap, Lower Dividend Yielding stocks and those exhibiting Value factors. The mandate parameters should be written in a completely open manner, so as to accommodate future flexibility and changes to whichever factors are required as the business and investment cycle, and the dynamics of the clients’ main equity portfolio changes. Ideally the completion strategy mandate should be evaluated for effectiveness quarterly.

In Fig 3 we illustrate what the “new” composite client mandate looks like, now having integrated the “Completion Strategy” mandate. 

As is immediately apparent, the client has retained certain Index active outcomes but has mitigated two of the more extreme legacy bets on Value and Size.

PM me if you would like to discuss further on how you can optimise your equity strategy in terms of the systematic factors.

Disclaimer: The above article is a hypothetical case study and does not intend to represent real data or performance or equity style/factor exposures in any index or client portfolio. This article is written for general information purposes only and must not be construed as investment advice by any person or entity. Seek professional advice always.