The investor crystal ball is not working anymore
When speaking to professionals – investors and managers alike – one thing is clear: no one has a real edge in predicting 2020’s market environment, and everyone is willing to admit it.
“As I always say, I am trying to design strategies that don’t depend on that answer,” says Jesse Barnes, managing partner and internal systematic portfolio manager at HighVista Strategies, an asset manager pursuing endowment-style investing.
But in the event that answer does end up materialising into a dismal market environment, institutional investors are likely to look to their systematic allocations to perform, with a few cautions.
The systematic advantage
Traditionally uncorrelated to equity markets and tasked with diversification, systematic strategies also carry a major advantage in the way they are constructed to be risk-managed.
“It’s not just that they’re better able to be risk-managed, but they’re better able to be targeted to meet an investor’s needs for customisation,” says Barnes, who works with institutional clients in what he calls portfolio engineering.
“These strategies can fill holes in a very useful way to create whatever exposure you want.”
According to Barnes, that customisation and flexibility are the two most critical roles investment firm HighVista plays in the portfolios of its investors, with a total of $3.6bn in institutional assets.
“If you do that well, they can protect you in periods of time when other things are going to do poorly,” he adds.
So with uncertainty heading into 2020, are institutional investors allocating more heavily to these strategies in preparation of doomsday?
Not exactly, says Barnes.
While he has seen an increase in institutional allocators trying to better understand systematic strategies and the role they can play in a downturn, an uptick in allocations has not necessarily followed.
“In my experience investors are really excellent at preparing for downturns a few months after they happen,” he says.
“I don’t see a lot of people that, right now, while the sun is shining, are shopping for umbrellas.”
So while the possibility of market upheaval doesn’t dictate automatic allocation changes or reviews in a portfolio, instead it emphasises the importance of uncorrelated strategies and highlights those that should, historically, perform, according to Steven Wilson, senior portfolio manager for stable value hedge funds at the Teacher Retirement System of Texas.
“We have a very thorough and long investment process,” says Wilson of the largest public retirement system in Texas, managing approximately $160bn in assets.
In his role, he oversees the $7bn Stable Value hedge fund portfolio, of which 33% is invested in quantitative strategies.
“In the beginnings of a market downturn, I don’t think we would change a lot. Instead, we just have investments in places that we expect to respond to that environment,” Wilson says.
“CTAs are the most obvious thing to mention. We don’t have any managers in our portfolio where if the market sells off for three months, we’re sure they’re going to be negative. But we expect the most punchy returns in that scenario to come from CTAs and macro.”
Wilson and his team spend plenty of time evaluating CTAs as the Texas pension’s quant carve-out is half split between CTAs and other systematic strategies, predominantly quant equity.
And while there haven’t been significant changes in the percentage of systematic allocations, the composition of those allocations have materially changed over the last five years, specifically on the CTA side.
Five years ago, Texas Teachers was almost exclusively invested in futures trend-following. Today, the vast majority of their exposure is in esoteric market CTAs, Wilson notes.
Similarly, Joe Marenda, managing director and hedge fund specialist at Cambridge Associates, is seeing a trend in institutional interest toward new opportunities, one not necessarily reflected by a change in an overall quantitative allocation percentage or reaction to a market downturn.
“We’re not changing manager or strategy allocation based off of something that might happen,” says Marenda, of Cambridge’s $37.3bn discretionary OCIO business, which manages the portfolios of endowments, foundations, pensions and private clients.
On average, Marenda sees CA’s institutional clients allocating anywhere from 10% to 25% of their assets into hedge funds. Within that, around one-third is dedicated to quant strategies.
“But we are seeing opportunities to deploy capital into new areas that clients previously weren’t terribly active in,” he says, highlighting emerging markets-focused strategies.
“When I’m thinking about making changes to the portfolio, it’s adding new strategies that are basically different from anything that’s previously available, not positioning for a market correction, because I’ve already built the allocation for that.”
Barnes and HighVista also spend time looking for new strategies. As an opportunistic manager they’re focused on adding value through US micro-cap and emerging market small cap strategies. Their flexibility as a systematic manager means that they can use capacity constraints to their advantage in creating value for their investors.
“As you worry ‘how am I going to win this arms race of PhDs and data and assets?’ Well – one way is just to stay away from where those people are able to play,” says Barnes, adding that HighVista takes an opportunistic approach, looking at smaller markets among other things.
Heading into 2020, conversations surrounding systematic strategies and their downside protection have increased, alongside some cautionary notes.
Like any investment, systematic strategies come with their own risks. But as more and more data is released at unprecedented speed, experts worry now more than ever about overcrowding and rapid model degradation.
“Every alpha strategy has a finite life, and people will approach the end of their ability to generate [that],” says Wilson of the main reason Texas Teachers drops managers.
“Either because what they’re doing is being commoditised or the rest of the industry has caught up.”
As a quant specialist, Barnes echoes the same concern over the commoditisation of an industry based on exploitation.
“How does a quant add value? You’re seeking to capture something that someone else has not figured out yet,” says Barnes. “And it’s not that no one’s figured it out, but maybe not enough capital has figured it out.”
But the biggest growing trend of concern allocators and managers are seeing heading into the next year is just that: growth.
“As we say in Texas, ‘don’t water down the whiskey.’ Every hedge fund on the planet ought to be half the size that they are currently,” says Wilson.
And while he doesn’t want Texas Teachers’ allocations to be shaved, he thinks managers need to be more conservative with the money they bring in and less enticed by increased management fee revenues.
“Even some of the best managers think they can take on more assets,” he adds.
“And the hard thing is that you don’t know it’s too much until there’s a discrete market event where the firm size can’t hold up.”
From the manager’s perspective, Barnes understands this and stresses the importance of raising money only from investors who truly comprehend the strategy, especially headed into a year of economic uncertainty.
“If you’ve raised money from someone who doesn’t fundamentally understand what you do, they’re only going to be with you as long as things are good,” he says.
Included in HighVista’s capital-raising mission is a substantial education process to explain strategy expectations.
“Here’s when we’re going to win. Here’s what losing looks like. These are the drawdowns we have,” he uses as examples.
“Our approach is very intuitive, where we feel like we can educate investors to understand what we’re doing, why we’re doing it, and hopefully then they’ll stick with us.”
As HighVista educates investors on expectations for their 10-plus systematic strategies (managing $1bn assets total), Marenda at Cambridge highlights an opportunity to educate investors on the industry as a whole heading into the new year.
Marenda voices a major concern in the way investors have constructed certain quantitative expectations based upon historical precedents.
“It’s a mistake to think of something that is uncorrelated or very lowly correlated as negatively correlated,” says Marenda of one misperception systematic strategies encounter.
“That’s one of the fundamental behavioral mistakes that people make. They think, ‘Oh quants are going to go up when the markets go down.’
“And I’m like, no – they’re uncorrelated. You can’t count on that. But people do. It’s a false expectation built around strategies that are designed to be actually highly diversifying to the total portfolio.”
Marenda highlights this behavioural creation of false relationships as a major caution heading into 2020.
“The global financial crisis is not the way to think about how a strategy should be used in a portfolio,” he adds.