FOR PROFESSIONAL INVESTORS ONLY Quantitative Management vs. Traditional Management February 2014
Quantitative Management vs. Traditional Management I 24/02/2014 I 2 Quantitative investment in asset management Introduction Today almost all investment processes make use of quantitative methods in order to address at least two fundamentals needs to control risks to explain performances One special feature of quantitative management is that it automates investment decisions through quantitative methods. This is called systematic management Investment decisions then result from the use of market-data-based quantitative tools; they follow a model a Quantitative management is not an asset An investment process that applies to all asset classes in both class alternative and traditional investment Quantitative management is not a black box The quantitative manager is at the core of this investment process. method without human intervention He is in charge of implementing it operationally and making all the decisions It is, first of all, the result of a disciplined shift in traditional portfolio management
Quantitative Management vs. Traditional Management I 24/02/2014 I 3 A gradual integration of quantitative methods in asset management Quantitative methods to first address fundamental needs In recent decades the gradual integration of quantitative tools in the investment process has involved Risk control To identify and quantify risks thoroughly, objectively and in a standardised manner Particularly to comply with regulatory restrictions Performance analysis and explanation To measure the impact of investment decisions on portfolio performance Use of linear regressions to separate alpha from beta Beta quantifies the impact of market fluctuations that all investment strategies are inevitably exposed to Alpha captures the independent component of market fluctuations directly related to the know-how involved in each investment strategy Possibility to identify actual good management Performance analysis then becomes inseparable from risk analysis.
Quantitative Management vs. Traditional Management I 24/02/2014 I 4 A gradual integration of quantitative methods in asset management Quantitative methods on increasingly complex markets The perpetual changes in financial markets and their heightened complexity in recent years have led to the integration of increasingly sophisticated technologies Market growth and globalisation New asset classes Have moved investment processes up to a new level (especially in asset allocation) Interactions have spread, creating new sources of performance and risk Led to the emergence of increasingly specialised quantitative methods A growing mass of data Due to the size and robust expansion in markets, combined with technological progress (emergence of data providers) Portfolio management companies use quantitative screening tools to rapidly short-list instruments Tail risks Systemic risk Promoted by the use of leverage and encapsulation of financial instruments Force portfolio management companies to use increasingly sophisticated methods to quantify and manage them Derivatives The growing sophistication of quantitative methods has promoted the creation of new derivatives through the development of quantitative pricing tools for these products
Quantitative Management vs. Traditional Management I 24/02/2014 I 5 Quantitative management A disciplined evolution in traditional portfolio management It is based on the objective of systematically streamlining all investment decisions, in order to force managers to make transparent and explainable decisions No black box Meanwhile, the development of broad-based, comprehensive and long-dated databases (going back to 1930), combined with the advent of new technology, has led to an expansion in academic research aiming to prove or disprove the efficiency of financial markets Financial engineers use these findings to implement quantitative strategies through IT platforms that reconcile academic principles with market operational constraints in real time Since then, quantitative management has been based on close cooperation between managers, engineers and academics Investment decisions are transparent and explainable They are based on statistical analysis and not conviction
Quantitative Management vs. Traditional Management I 24/02/2014 I 6 Quantitative management 1 Streamlined investment decisions Decisions are based on thorough statistical analyses of the markets that help confirm sources of risk premiums and market behaviour anomalies (alpha) 2 A systematic investment process based on quantified items Accounting ratios, balance sheet data, risks and interactions (volatilities and correlations), etc. Quantitative tools use these data to build up portfolios that comply with operational constraints 3 Investment models designed in close cooperation with financial engineering and academic research 4 The manager is at the heart of the investment process Upstream, he is proactive in designing strategies In response to market trends and clients needs, he sponsors research and development work He takes part in designing each component of the strategy Downstream, he is responsible for fund performance He assess market conditions on a permanent basis and intervenes as soon as an event is likely to undermine a model s effectiveness He assesses the effectiveness of strategies in real time
Quantitative Management vs. Traditional Management I 24/02/2014 I 7 Implementing a quant strategy: example of a multi-factor equity strategy at THEAM An investment process in three fundamental stages Academic research Uncovering sources of alpha Academic research has found that strategies outperform the market in the medium and long terms through exposure to factor risk premiums These sustainable sources of returns are due to structural market inefficiencies, which are caused, in turn, by investor behaviour Financial engineering Search for a technology to exploit opportunities Management team Implementation with operational constraints Using mathematical tools, financial engineering offers a technology for efficient exposure to these risk premiums within the limits of precisely calibrated risk A research article (BNPP IP Financial Engineering) detailing all these processes has just been accepted for publication by the Journal of Asset Management. This technology is implemented systematically by the THEAM Quant Equity Management team by constructing portfolios adjusted for operating constraints of the market and its clients
Quantitative Management vs. Traditional Management I 24/02/2014 I 8 Implementing a quant strategy: example of a multi-factor equity strategy at THEAM Quant intervenes at four levels It first uncovers the importance of risk premiums by researching historical data and analysing performances It selects and defines four sources of risk premiums individually (i.e., value, profitability, momentum & low volatility) by identifying the most relevant quantitative criteria that make it possible to capture their outperformance potential Financial engineering designs a multi-alpha assembly engine that includes a precise calibration of the risk incurred by each factor Operational implementation by a quantitative management team with integration of investment process constraints Optimising costs by reducing portfolio turnover and the number of portfolio holdings Managing exclusion lists, in compliance with requests from the client and the portfolio management company At each decision-making level of such an investment process, sufficient quant expertise is essential to ensuring quality in the final result
Quantitative Management vs. Traditional Management I 24/02/2014 I 9 Quant strategies in practice: example of the low volatility equity strategy Philosophy / objectives Exploit the low volatility anomaly to offer better risk-adjusted returns than traditional indices over the long term Avoid structural biases induced by other risk-based strategies Construct a robust low volatility portfolio: diversified across sectors with a controlled beta of 0.8 Key Quant steps of the process Calculation of stock betas, volatilities, cross correlations Screening of the low volatility universe Portfolio allocation: stock selection among low volatility stocks processed by a numerical optimization Specific behavior In falling markets, calibrated portfolio beta of 0.8 provides a defensive feature In rising markets and on a mid-term basis: capturing the low volatility alpha offsets part of the contribution of the defensive beta Average strategy behavior (Monthly returns, back-test and live) Back-test (Jan 1995 Mar 2011) 6% 4% 2% 0% -2% -4% -6% -8% 6% 4% 2% 0% -2% -4% -6% -8% Sharply falling Sharply falling Moderately falling Live (Apr 2011 Dec 2013) Moderately falling Calibrated beta of 0.8 provides a defensive feature Average Average Moderately rising Sharply rising MSCI World Index EUR Parvest Equity World Low Volatility EUR Moderately rising Sharply rising Low volatility alpha offsets part of the contribution of defensive beta Source: BNPP IP, MSCI, Exshare, Gross of fees, in EUR, as of December 31, 2013. The figures above are backtest results. Past performance is not an indicator of future performance.
Quantitative Management vs. Traditional Management I 24/02/2014 I 10 Quant strategies in practice: example of the systematic Guru stock picking Philosophy / objectives Based on convictions that have proven effective for many GURU investors for almost a century: companies with strong fundamentals are virtually certain to grow in value Objective: select companies with a sound business model, positive perspectives and an attractive valuation Key Quant steps of the process Quantification of a stock s quality: calculation of a score based on companies fundamentals Selection based on a screening: ranking of scores and selection of stocks with the best ones Specific behavior (world universe) Outperformance over the index in the long run Difficulties in phases of pronounced market stress, where stock prices tend to de-correlate from their economic performances Back-test strategy index performance (until 06/2011) Live fund performance, with monthly returns (07/2011 01/2014) 800 700 600 500 400 300 200 100 MSCI AC World daily TR Net USD BNPP Guru Equity All Country Long TR Volcap 32% USD index 0 2001 2002 2003 2003 2004 2005 2006 2007 2008 2009 2010 2011 8% 6% Monthly return Cumulated performance 4% 120 2% 100 80 0% 60-2% 40-4% MSCI AC World daily TR Net USD Parworld Quant Equity Wolrd Guru USD 20-6% 0 07/2012 10/2012 01/2013 04/2013 07/2013 10/2013 01/2014 160 140 Source: Bloomberg, BNP Paribas, as of 31 January 2013. Strategy index performance: total return, in USD. Back-test figures from 01/03/2001 to 30/06/2011, historical performance from then onwards. Past performance is not an indicator of future performance. Live fund performance: gross of fees, in USD.
Quantitative Management vs. Traditional Management I 24/02/2014 I 11 Quantitative management A management strategy with a bright future ahead of it Advantages for portfolio management companies and investors Extension of the investment universe, greater diversification Better risk management (Precise calibration of parameters, no hidden risks ) Capacity to review how strategies have done in historical scenarios A response to the challenges of the industry In response to the competition In response to clients Style constancy, reproducibility and predictability Transparency in the process, reduction of operating risk Personalisation of portfolios: access to new investment opportunities Optimisation of costs Markets constantly offer opportunities (alpha). Having the means to spot and capture them before everyone else is decisive for the performance of strategies Narrower margins are leading portfolio management companies to cut costs by streamlining their processes to a greater degree Quant s flexibility (one strategy = one model) makes it possible to adapt more easily to the client s needs As with any investment process, there are good and bad strategies. Quantitative management has proven itself in terms of risk control The main challenge is to adapt to market conditions (factor turnover and macroeconomic shifts) On top of a mere disciplined evolution in traditional investment, quantitative management opens new investment horizons, such as multi-factor approaches.
Quantitative Management vs. Traditional Management I 24/02/2014 I 12 Disclaimer This material is issued and has been prepared by THEAM* a member of BNP Paribas Investment Partners (BNPP IP)**. This material is produced for information purposes only and does not constitute: 1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever or 2. any investment advice. This material makes reference to certain financial instruments (the Financial Instrument(s) ) authorised and regulated in its/their jurisdiction(s) of incorporation. No action has been taken which would permit the public offering of the Financial Instrument(s) in any other jurisdiction, except as indicated in the most recent prospectus, offering document or any other information material, as applicable, of the relevant Financial Instrument(s) where such action would be required, in particular, in the United States, to US persons (as such term is defined in Regulation S of the United States Securities Act of 1933). Prior to any subscription in a country in which such Financial Instrument(s) is/are registered, investors should verify any legal constraints or restrictions there may be in connection with the subscription, purchase, possession or sale of the Financial Instrument(s). Investors considering subscribing for the Financial Instrument(s) should read carefully the most recent prospectus, offering document or other information material and consult the Financial Instrument(s) most recent financial reports. The prospectus, offering document or other information of the Financial Instrument(s) are available from your local BNPP IP correspondents, if any, or from the entities marketing the Financial Instrument(s). Opinions included in this material constitute the judgment of THEAM at the time specified and may be subject to change without notice. THEAM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Given the economic and market risks, there can be no assurance that the Financial Instrument(s) will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. Past performance is not a guide to future performance and the value of the investments in Financial Instrument(s) may go down as well as up. Investors may not get back the amount they originally invested. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes. *THEAM is an investment manager registered with the Autorité des marchés financiers in France under number 04000048, a simplified joint stock company with a capital of 8.317.840 Euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris 428 753 214 and is member of the Association Française de la Gestion Financière (AFG), a professional body for thirdparty asset management in France. www.theamfunds.com ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.