investors
Dave Bradfield
The market for innovative investment products has grown in the past few years, but innovations in the area of statistical, or quantitative, analysis of these products (and investment funds in general) remain comparatively unknown.
With investments, the valuable information is more deeply hidden (it would cease to be valuable if everyone had access to it). One has to scratch harder and harder beneath the surface to unlock the value.
Forecasts of returns would be the first prize, but analysts concede that return forecasting holds little promise of success. Innovation has centred on risk management.
In the past, portfolio managers simply constructed portfolios loaded with stocks promising high returns (stock-picking) without considering their impact on the portfolio’s exposure to risk. Modern managers now consider the extent to which stocks move together, or apart, and use this information to reduce portfolio risk.
The only accurate decision fund managers can make is how much risk they are prepared to carry. They have no choice but to manage risk appropriately. Risk management innovations have led to more rigorous fund management, and have enabled fund owners to refine the mandates given to managers.
Earlier mandates such as “don’t steal any money” progressed to “don’t lose any money”. They’re now far more specific: “Aim for a 2% outperformance relative to the specified benchmark with a maximum tracking error of 6%.”
What are the components of risk and who bears them?
The owner (of the pension fund, unit trust or wrap fund) bears the benchmark risk. In lay terms, the benchmark risk is observed in the volatility of the benchmark returns. Benchmark returns are the typical returns for a particular investment profile, such as the general equity category of unit trusts.
The owner accepts this risk when appointing a manager to invest the funds according to a particular investment mandate (such as “mining and resources”).
For typical unit trusts and pension funds this is the dominant component of risk (accounting for some 94% of the total risk, on average, in the general equity category of unit trusts).
The fund manager, on the other hand, is responsible for the stock-picking risk, the risk of holding a different mix of components to that of the benchmark in an attempt to outperform it.
Additionally, if the manager’s mandate allows timing bets, the manager will also be responsible for the risk of these bets (timing bets are most frequently implemented by shifting the ratio of cash to equity).
Finally, the investor bears the “total risk” of the portfolio, comprising all the above-mentioned risk components. Interestingly, the risk the fund manager is responsible for contains no penalty for losing money (so long as the fund loses no more money than the benchmark). Investors, in contrast, are concerned about losing money, since they bear total risk.
Another innovation can run “diagnostics” on funds. Much as a machine hooked up to your car gives information on potential problems, so this approach diagnoses poor fund performance. It can even identify a target portfolio for restructuring the fund.
A third innovation actually enables the separation of luck and skill when measuring fund managers’ selection and timing ability.
Such analyses can have an immediate and significant impact on fund management. Innovations in the field are likely to grow as quickly as does the market for and variety of investment products.
Dave Bradfield, a former University of Cape Town professor of statistical sciences researching financial markets, now heads the quantitative research division of the Cadiz Group