Broadening the opportunity set of investment strategies is a critical first step to meeting an institutional investor’s performance objectives.
By John L. Krieg and Laura Lawson
Do investors still care how performance is created? Or are we in an age where institutional investors need to reach excess return targets within a mandate regardless of strategy? A decade ago, strategy preference was often a core investment tenet and implementation decisions tended to center around active versus passive management. Today, there is a proliferation of investment strategies, such as enhanced index and quantitative active, residing between passive and active management. As a result, the decision of how to implement an asset allocation and choose the most efficient strategy has become more complex.
“With the proliferation of investment strategies, the decision of how to implement an asset allocation and choose efficient asset class exposure has become more complex.”
— John L. Krieg
CFA, director of product management, Northern Trust
An increasingly common sentiment among institutional investors is that every basis point of excess return is needed. The first step – and one of the most critical – to meeting an institutional investor’s performance objectives is to broaden the opportunity set of investment strategies. Selecting the appropriate product mix depends on identifying the target excess return needed within a given risk budget but not overpaying for it.
Excess return has become more difficult to generate as financial information is increasingly transparent and capital flow is widespread. Some could argue that because of these changes, the financial industry has become more creative with the ways in which excess return is created. This, in turn, has led to the development of multiple new strategies.
Others feel that the expected low equity return environment has forced the industry to invent new strategies because passive index returns are just not enough. Regardless, we seem to be in an era of creative investment products and strategies, and there are proven success cases in each. These new strategies cover a set of mostly quantitative-based products that are marketed as enhanced index – both stock-based and derivatives-based – or quantitative active. (A comparison of a few of these strategies is summarized in “Strategies for Large Cap Equity Exposure,” page 14.)
Implementing an asset allocation and gaining S&P 500 exposure, for example, can be achieved through any of the strategies shown in “Strategies for Large Cap Equity Exposure” on page 14. Each has a unique investment process. However, when compared across common factors such as performance objective, risk and fees, meaningful overlap can be found.
Several common performance analysis measures can be used to evaluate the relative success and efficiency of an investment product, including excess return, tracking error and Information Ratio. (See “Measures of Investment Efficiency,” page 15.) The Information Ratio has been a popular measurement tool with institutional investors as it encompasses both risk and return into a single measure. In a pure academic sense, the strategy with the highest Information Ratio should be the most efficient.
When comparing performance across multiple strategies with differing excess return targets, however, the Information Ratio lacks clarity – offering no indication of how much excess return is created. Conceptually, the Information Ratio needs to be adjusted by the amount of actual excess return the strategy is creating. Looking solely at the Information Ratio can be misleading – it’s only one measure and should be evaluated in conjunction with other measurements for a true assessment of the strategy.
In addition, investment management fees need to be incorporated into product evaluation as certain strategies have higher fees than others. The management fee for any strategy should be consistent with its target excess return. As multiple strategies have emerged between passive indexing and fundamental active, excess return and fees have taken on a linear relationship. Typically, the more excess return the strategy has produced, the more investors have paid in fees. Comparing Net-of-Fee Information Ratios can help gauge the efficiency of the different strategies. But again, focusing on this measure in isolation can be misleading.
An example can help place the relationship between these measures in perspective. As “Risk/Reward Analysis of Three Large-Cap Equity Strategies,” page 17, shows, a hypothetical investor’s goal is to generate 100 basis points in excess return over the return of the S&P 500 and is presented with three different methods for achieving this:
Which strategy is most appropriate for an investor with an objective of 100 basis points of excess return after fees? In our example, Index Plus has the highest Information Ratio of 1.00 and is presumably the most efficient. Even after fees, Index Plus seems to be the best choice with an Information Ratio of 0.80. However, while the Index Plus strategy is efficient, it does not meet the investor’s excess return goal of 100 basis points.
The Index Plus strategy only creates 40 basis points of excess return after fees are deducted, which is 40% of the investor’s performance goal. We believe adjusting the Information Ratio down to take into account both the strategy’s excess return and the investor’s performance goal creates a better comparison across strategies. In the example, similar adjustments need to be made to the Enhanced Index and Fundamental Active strategies.
By comparing the strategies’ Adjusted Information Ratios, there appears to be no clear winner. Each strategy has its trade-offs – either not enough excess return or increased risk as evidenced by higher tracking error:
So what conclusions can we draw from this example? Today, investors have options not only in strategies to reach a target excess return goal but also in implementation of those strategies. Individually or combined, each of the five strategies shown in the “Strategies for Large Cap Equity Exposure” chart on page 14 has the potential to meet an investor’s return objective. Investors should have an idea of the excess return desired to meet financial goals or funding requirements, but searches should not be based solely on that absolute target.
Structuring a mandate to consider a broad spectrum of strategies can provide multiple options to achieve investment needs. Doing so also diversifies the sources of alpha because the excess return in each strategy is created so differently. For example, the excess return created from an active strategy has a low correlation to the excess return created from a derivative-enhanced strategy. Investors can use a combination of strategies to reach their target, while in the process creating a more diversified aggregate large cap exposure with less active risk.
Needing a large amount of excess return from an asset class does not always require selecting a high excess return strategy or a combination of strategies. Typically, there is a positive relationship between excess return and tracking error, with higher excess return strategies having lower Information Ratios.
With leverage and derivatives becoming more mainstream and accessible, excess return goals can be met by using risk-controlled strategies. Leverage can be employed to increase the excess return from any strategy and derivatives used to remove unwanted equity exposure. A creative solution for the investor in our example needing 100 basis points of excess return would be to lever up the highly efficient Index Plus strategy three times. Leverage and derivatives create the ability to financially engineer excess return within a certain risk budget.
“Investors need to look beyond the traditional ‘siloed’ investment manager searches and compare strategies across the broad spectrum of approaches available today.”
— Laura Lawson
product manager, Northern Trust
Excess return is not guaranteed in today’s market, and it has become challenging for institutional investors to find managers and strategies that can create the desired return. As a result, investors need to look beyond the traditional “siloed” investment manager searches and compare strategies across the broad spectrum of approaches available today. This means selection should not be made on the basis of any one performance measure. Despite the current popularity of the Information Ratio, investors can’t spend the ratio. Instead, investors need to consider an array of performance measures when evaluating across strategies.
Expanding the opportunity set so that different strategies within a single asset class can be compared provides choices in implementing asset class exposure within a risk budget. Investors can select a single strategy, use a combination of strategies or engineer solutions through leverage to create efficient asset class exposure.