Macquarie Professional Series. a non-random walk down. Arrowstreet. Macquarie Professional Series. Arrowstreet Global Equity Fund

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1 Macquarie Professional Series a non-random walk down Arrowstreet Macquarie Professional Series Arrowstreet Global Equity Fund 1

2 2 Clockwise from top left: Bruce Clarke, Jim Thames and Peter Rathjens.

3 A non random walk down Arrowstreet In its nine-year history, specialist global equity manager Arrowstreet Capital has built up a solid following from institutional investors around the world. The Boston-based group now manages over US$20 billion and may be accessed by retail investors in Australia through the Macquarie Professional Series. Bruce Madden and Simon Jenkins report. The advantage of using quantitative tools is that those insights can be applied in a highly disciplined, repeatable manner, across a much larger universe of investment opportunities. Arrowstreet is not an easy firm to categorise. On the surface at least they are a quantitative, or quant, manager. Broadly speaking, that means they don t spend their time analysing individual companies, and they don t make investment decisions one at a time, based on whether or not they believe the management team has grasped the subtleties of maximising shareholder return. Rather, they analyse market data to identify signals that can reliably indicate something about the future direction of stock prices. When they have identified a signal that works, they incorporate it into a computer-based trading model. Essentially, the model then does the buying and selling on their behalf. The benefit of using a model is that it s ruthlessly efficient and can analyse more companies in an hour or two than most fundamental managers will get through in a year. That means any insights you ve gleaned can be applied across an almost limitless universe of investment opportunities. Despite the different approaches, however, when you scratch the surface, it becomes apparent that Arrowstreet have a lot more in common with fundamental managers than they do with some of their quantitative peers. The main reason for this is that, like most strategies, quantitative investing has its pitfalls, and Arrowstreet are keener than most not to fall into them. One of the biggest problems with looking for patterns in very large amounts of data is that you re going to find them, regardless of whether there is any causal relationship. If you incorporate such signals into a model, you ll soon be disappointed to learn that it doesn t perform as well on live data as it did on historical data, because the random relationships don t hold up. All quantitative managers take steps to minimise the impact of these random patterns, but Arrowstreet have gone a step further and almost entirely eradicated their influence. They have done this simply by not using the data as a starting point. Instead, Arrowstreet start where most fundamental managers do, with good old investment insight and intuition. They use their experience of markets and investor behaviour to formulate ideas and then use historical data to test them out. If an idea holds up to rigorous back testing and various other forms of analysis, it will eventually be incorporated into the model. The critical point is that the data is used as a verification tool, not a source of ideas. 3

4 Stepping behind the name Almost a decade since its launch, the Arrowstreet name has become associated with serious investment grunt. The firm is considered one of the leading lights in the world of quantitative investment management. Peter Rathjens, who founded the business, along with Bruce Clarke and John Campbell in 1999, explains that Arrowstreet s philosophy is firmly based on investment beliefs and insights about investor behaviour. We believe that investment decisions should be based on investment insights, rather than the potentially spurious output of pattern recognition software. Quantitative tools are a useful way to provide diagnostics for those insights, a management tool for those insights, and a discipline tool for those insights, Rathjens says. But all of the insights come from our understanding about investor behaviour. Importantly, Arrowstreet does not claim that its insights are all the product of its own research. Indeed, according to Rathjens, some of the core ideas can be traced back as far as the 1930s, when researchers first began exploring the concept of value investing. Out of those early investigations came the classic notion that a lot of investors let their heart rule their head. As Rathjens points out, if you can identify a mechanism that allows you not to, you might be able to profit from it. What has changed since the 1930s is the sheer scale of market information available, and with the incredible growth in computing power comes an increased opportunity for skilled managers to separate the gambler s heart from the investor s head. Streets ahead One of the key advantages of using quantitative tools is that one s investment beliefs can be implemented in a highly-disciplined and repeatable manner. Because of these behavioural biases, Arrowstreet has a core belief that markets are inefficient and that there are signals or information about individual stocks that are meaningful to prices which are not reflected very quickly - or at least not so quickly that you can t exploit them profitably. Rathjens says while those insights may not always originate with Arrowstreet, the ways in which they are applied are unique to the firm. We look at many of the insights that thoughtful, active managers have looked at for many years. The fact that an insight is shared by many people does not mean that it has no value, but one should be aware of the fact that it would be better still if it was unique to you, he says. 4

5 A non random walk down Arrowstreet Our investment process is a combination of insights that we would think of as being, broadly speaking, in the public domain, as well as insights that are quite unique to Arrowstreet. Jim Thames, a partner of the firm and one of the senior executives on the group s portfolio management team, backs up that statement. One of the key advantages of using quantitative tools is that one s investment beliefs can be implemented in a highly-disciplined and repeatable manner. Once the stock forecasts have been created, they are combined with portfolio position limits, risk estimates and transaction costs, to produce a final portfolio of stocks with optimal forecast performance for a given level of risk. The overall structure might sound straightforward but, as Thames explains, in practice the Arrowstreet model is anything but simplistic. For instance, comparing valuation measures across stocks in different countries, with different accounting standards and tax regimes, clearly adds The result is that highly refined investment concepts can be applied across a much broader universe of securities than could be covered using manual techniques. For example, in its core global equities fund, Arrowstreet applies its process to over 25,000 stocks, before narrowing this down to a portfolio of between individual equities. Arrowstreet s investment process can be broadly broken down into two stages. Firstly, the insights contained in the model are applied to every stock in the available universe, to produce a return forecast. This indicates whether each stock is expected to outperform or underperform the index, and by how much. The various inputs, or signals, that make up the stock forecasting model are complex and diverse, but they have their roots in areas that would be familiar to most fundamental managers, including value, earnings and momentum. The signals are also evaluated across countries and sectors, as well as individual stocks. Again, like many fundamental managers, this allows Arrowstreet to incorporate a top-down view into their forecasts, and acts as an important differentiator between them and many other quant processes that have traditionally been focused solely on stock specific data. to the complexity. Some opportunities, however, will result precisely because of that complexity. Unlike many other quants that try to apply the same discipline across several different asset classes, Thames says another of Arrowstreet s strengths is that it remains firmly committed to operating in equity markets. He says by focusing its intellectual and operational power on shares - as opposed to fixed income or commodities - the firm is able to make best use of its quantitative tools. Behind the signals As with most types of active management, Arrowstreet s methods can be applied to large cap developed stocks as well as small cap and emerging markets stocks all of which Macquarie investors are exposed to through the Arrowstreet Global Equity Fund. As Thames explains however, Arrowstreet are aware that it s important not to accept market definitions at face value in these areas. Thames gives the example of Korean firms LG and Samsung which generally fall under the emerging market banner. 5

6 Yet these companies are as big as virtually 95 to 97 per cent of the other developed market companies around the world, he says. Both LG and Samsung export most of their production, and accordingly their success is tied to the economic cycles of developed nations such as Japan and the US, rather than other emerging markets. As a result, we ve developed a strategy in which we recognise that instead of assets being discretely categorised as either developed or emerging and nothing in between, we acknowledge there are shades of grey When it comes to the finer details of Arrowstreet s investment process however, neither Thames nor Rathjens will give away too many of Arrowstreet s secrets: success in the quant world is predicated on acting quickly and keeping a close guard on intellectual property. Other than saying that we recognise it s important that we have novel or innovative ideas, we don t talk about the details of them very much because to do so would cause them to no longer be innovative or novel, Rathjens says. As Thames points out, funds management is an incredibly competitive industry where good investment ideas tend to spread easily and can quickly lose their edge. He uses the analogy of running up a down escalator to describe the dilemma facing quantitative investment managers. To stand still in this industry is to move backwards Thames says. You will soon find yourself back at the bottom of the escalator. In order to avoid that inglorious fate, Arrowstreet has invested heavily in its intellectual capability and depends much on academic firepower to stay one step ahead of rivals. 6

7 A non random walk down Arrowstreet The engine room Since its inception, Arrowstreet has recognised the importance of an intellectual engine room as being key to its success. Indeed, one of the firm s three founding partners, John Campbell, is a full time professor of economics at Harvard University. Campbell spends one day a week in Arrowstreet s offices and exerts much intellectual influence over the firm s staff. In a world where staying ahead of the pack depends largely on the quality of your strategies and is fully committed to closing the doors to new money long before the point where the level of assets could jeopardize their ability to continue adding value. Thames credits the small company culture and the fact that Arrowstreet is fully employee owned for these decisions. We understand the perils and pitfalls of active management. We understand the degree to which it s a zero sum game. Somebody else has to be losing value for us to be adding value, he says. We ve done a good job in understanding the importance of that dynamic problem and in creating We believe that investment decisions should be based on investment insights, rather than the potentially spurious output of pattern recognition software. research, Campbell is invaluable to Arrowstreet for his insight into the latest academic thinking around active investment management. Thames also notes Campbell s ability to synthesise new investment strategies. He s an exceptionally bright, out-of-the-box kind of thinker when it comes to blending together ideas, and figuring out ways of combining different theories in order to maximise their collective effectiveness, Thames says. According to Thames the high-powered think-tank environment means everyone has to bring their A-game to every meeting, Thames says. I enjoy working here because every week you re going through a process of in-depth analysis and learning something new, he adds. Rathjens also knows the firm must remain true to its principles as well as being open to change because what worked 10 years ago won t work 10 years from now. That s the quandary all quants must deal with. Arrowstreet has made an explicit policy to align its interest with its clients. For example, Arrowstreet has set conservative capacity limits for each of its a firm that can do the kind of dynamic research that allows us to thrive in today s market and will continue to thrive in the future. It also helps that Arrowstreet has a clear sense of where it stands in the world of funds management. As Rathjens puts it there are two models for investment management firms in this world. One is to focus on distribution with a little bit of investment management on the side. And the other is to focus on investment management with a little bit of marketing on the side. We re the latter. Australian financial advisers can access the Arrowstreet Global Equity Fund through the Macquarie Professional Series of managed funds. For further information about the Fund, speak to your Business Development Manager or visit our website 7

8 Investments in the Arrowstreet Global Equity Fund are offered by Macquarie Investment Management Limited ABN AFSL No ( MIML ). Investments in the fund can only be made by completing the Arrowstreet Global Equity Fund (fund) application form that accompanies the fund s PDS. Investments in the fund are not deposits with or other liabilities of Macquarie Bank Limited ABN or of any Macquarie Group company and are subject to investment risk, including possible delays in repayment and loss of income or principal invested. Neither Macquarie Bank Limited, MIML nor any other member company of the Macquarie Group guarantees the performance of the fund or the repayment of capital from the fund or any particular rate of return. The information in this presentation is general advice only and does not take into account your individual financial situation, investment objectives or needs, which you should have regard to in deciding whether this information is appropriate. Before making a decision to invest in the fund you should obtain and consider a copy of the fund s PDS, which is available on our website: Macquarie Group Limited, MIML, other Macquarie Group companies or their associates, officers or employees, may have interests in the financial products referred to in this information by acting in various roles. They may buy or sell the financial products as principal or agent, may effect transactions that are not consistent with this information and may receive, fees, brokerage or commissions for acting in these other capacities. Past performance is not a reliable indicator of future performance. You should not base your decision to invest solely upon past performance information. OTH /08