Irish Pensions Magazine Autumn 2013
18
Expert Opinions
Fixed Income instruments, for long considered ‘safe
haven’ assets, have recently lost this privileged
position. The asset class faces yet another concern
as interest rate rises are a matter of “when” rather than
“if”. On the other hand, boom bust cycles have been
the norm for the last few years and has led investors to
value true uncorrelated performance across multiple
assets. As the majority of asset classes exhibit highly
unstable correlations, the real challenge for a portfolio
manager is to be able to find pure alpha by investing
actively in these asset classes. The final performance
of these products has to be uncorrelated to major
asset classes whilst limiting drawdowns. This pure
alpha feature is even more important when we deal
with an absolute return product.
The main challenge facing a pure alpha producer
is to be able to repeat successful performance (risk
adjusted or not). We will label this repeatability
feature as ‘’sustainable alpha’’. A manager must then
have processes in place that leverage on the skill of
the participating investment professionals to produce
this alpha. The processes should clearly contribute to
alpha production either through (1) efficient use of the
available risk, (2) effective managing of correlation
across different components of the portfolio, and (3)
embedded asymmetry designed to limit the impact
of drawdowns if success does not materialise. These
processes, driven by risk management, have to be
done in a way that promotes risk taken rather than risk
avoidance.
Within Pioneer Investments Portfolio Construction
and Risk Budgeting play a fundamental role when
combining investment ideas and strategies. To support
the combination of different strategies in a single
portfolio and to effectively monitor the risk contribution
of each strategy, Pioneer Investments has developed
a proprietary risk budgeting system supported by a
dedicated team: the Portfolio Construction team. The
key to sustained successful performance is ensuring
that ‘’alpha generation’’ is repeatable and drives each
step of the investment process. We believe that there
are four major families of ingredients that increase the
chance of reaching these objectives.
Stable and well-articulated performance en-
gine
The first and primary challenge in defining the alpha
sources is actually the separation of the active part
of the portfolio from the non-active part. Although
appearing simple, this separation is crucial to define all
the bets and risks in place from investments that need
systematic hedges. Succeeding in this separation is
half the battle. In general, the non-active component
should be market neutral. It can be managed in
a quantitative way. For example, a well-designed
indexation process will help replicate the performance
of the benchmark within a sovereign bond fund. For an
absolute return fund, investing in a carefully selected
portfolio of short term bonds can help realise the index
performance. Once this indexed component has been
designed and executed, the active component can be
implemented in a clear fashion, and derivatives are
used to achieve the type of risk the investor wants to
be rewarded for.
In a more volatile market, alpha generators should
keep all options open to find additional sources of
performance. It’s important to have some alpha
producers aiming to generate performance from
market normalisation after dislocation, whilst others
should be trying to bet on the realisation of these
market dislocations. This example illustrates the
concept of diversification as being much more than a
question of correlation management.
However one must guard against the possibility of
lower risk adjusted returns as a consequence of this
diversity of alpha sources. The more specialised
and experienced an investment professional should
address this concern.
Appropriate sizing of positions
In a framework where every investment represents a
view on specific market segments and is formulated
independently, measuring the risk level appropriately
is key to determining the size of positions. This risk
measure should provide a way to convert the chosen
metric (i.e. percentage weight, DV01) into a unique
and comparable indication of position size.
Comparing the measures of different investment
ideas should then indicate whether the relative size
of all the positions is appropriate enough to avoid (1)
concentration and (2) offsetting.
Concentration may materialise through one investment
idea becoming a dominating factor in performance.
The second way that concentration materialises is
through an increased level of correlation between
different investment strategies pushing performance
in one direction or another.
Sustainable alpha: construct your portfolio towards repeating
your successes
by Dave Santry
