Monday, July 27, 2015

Active trading vs Passive Investing

Even in normal times, individual and institutional investors alike have a hard time figuring out where to invest and in what. Should one invest more in advanced or emerging economies? And which ones? How does one decide when, and in what way, to rebalance one’s portfolio? 

Obviously, these choices become harder still in abnormal times, when major global changes occur and central banks follow unconventional policies. But a new, low-cost approach promises to ease the challenge confronting investors in normal and abnormal times alike. 

In the asset management industry, there have traditionally been two types of investment strategies: passive and active. The passive approach includes investment in indices that track specific benchmarks, say, the S&P 500 for the United States or an index of advanced economies or emerging-market equities. In effect, one buys the index of the market. 

Passivity is a low-cost approach – tracking a benchmark requires no work. But it yields only the sum of the good, the bad, and the ugly, because it cannot tell you whether to buy advanced economies or emerging markets, and which countries within each group will do better. You invest in a basket of all countries or specific regions, and what you get is referred to as “beta” – the average market return. 

By contrast, the active approach entrusts investment to a professional portfolio manager. The idea is that a professional manager who chooses assets and markets in which to invest can outperform the average return of buying the whole market. These funds are supposed to get you “alpha”: absolute superior returns, rather than the market “beta.” 

The problems with this approach are many. Professionally managed investment funds are expensive, because managers trade a lot and are paid hefty fees. Moreover, most active managers – indeed, 95% of them – underperform their investment benchmarks, and their returns are volatile and risky. Moreover, superior investment managers change over time, so that past performance is no guarantee of future performance. And some of these managers – like hedge funds – are not available to average investors. 

As a result, actively managed funds typically do worse than passive funds, with returns after fees even lower and riskier. Indeed, not only are active “alpha” strategies often worse than beta ones; some are actually disguised beta strategies (because they follow market trends) – just with more leverage and thus more risk and volatility. 

But a third investment approach, known as “smart” (or “enhanced”) beta, has become more popular recently. Suppose that you could follow quantitative rules that allowed you to weed out the bad apples, say, the countries likely to perform badly and thus have low stock returns over time. If you weed out most of the bad and the ugly, you end up picking more of the good apples – and do better than average. 

To keep costs low, smart beta strategies need to be passive. Thus, adherence to specific rules replaces an expensive manager in choosing the good apples and avoiding the bad and ugly ones. For example, my economic research firm has a quantitative model, updated every three months, that ranks 174 countries on more than 200 economic, financial, political, and other factors to derive a measure or score of these countries’ medium-term attractiveness to investors. This approach provides strong signals concerning which countries will perform poorly or experience crises and which will achieve superior economic and financial results. 

Weeding out the bad and the ugly based on these scores, and thus picking more of the good apples, has been shown to provide higher returns with lower risk than actively managed alpha or passive beta funds. And, as the rankings change over time to reflect countries’ improving or worsening fundamentals, the equity markets that “smart beta” investors choose change accordingly.
With better returns than passive beta funds at a lower cost than actively managed funds, smart beta vehicles are increasingly available and becoming more popular. (Full disclosure: my firm, together with a large global financial institution, is launching a series of tradable equity indices for stock markets of advanced economies and emerging markets, using a smart beta approach). 

Given that this strategy can be applied to stocks, bonds, currencies, and many other asset classes, smart beta could be the future of asset management. Whether one is investing in normal or abnormal times, applying a scientific, low-cost approach to get a basket with a higher-than-average share of good apples does seem like a sensible approach.

via Project Syndicate

Monday, July 20, 2015

Roubini partners with Barclays bank to launch equity indices

London-based bank Barclays has partnered with economist Nouriel Roubini and his Roubini Global Economics research firm to launch a suite of smart beta equity indices: the Roubini Barclays Country Insights Indices. As tradeable strategy indices, the suite is ideally suited to underlie index-linked investment products such as exchange-traded funds.

The engine behind the new indices is Roubini’s “Country Insights” model, which measures country risks and opportunities via a systematic rules-based approach. The model ranks countries based on four key pillars – external adjustment capacity, institutional robustness, growth potential and social inclusion – and incorporates some 200 distinct variables. Input data come from a variety of sources, including the Bank for International Settlements, the International Monetary Fund, the World Bank, the World Economic Forum and Gallup Polls.

The model aims for a granular assessment of each country across a variety of metrics and is designed to derive a country’s “Investment Attractiveness Score”. Inputs include a country’s ability to innovate, its demographic make-up, the quality of education and availability of healthcare. The model not only takes into consideration a country’s macroeconomic performance, but also other factors directly relevant to a nation’s growth potential in areas such as policy and political risk.

It is worth noting that, of the Eurozone countries, the model consistently ranked Greece, Portugal, Italy and Spain in the bottom four in terms of their investment attractiveness as far back as September 2005, clearly identifying them as countries with elevated levels of risk and low growth prospects. At this time, the Roubini Barclays indices would have significantly underweighted or avoided these countries entirely.

“The majority of investors would not invest in a company without first assessing its assets, liabilities and ownership structure. Investors may wish to perform a similar analysis when looking at the economic attractiveness of a country”, said Paul Domjan, Managing Director at Roubini Global Economics.

“The Roubini Barclays Country Insights Indices aim to do this. Instead of focusing entirely on a country’s ‘income statement’ – namely its short-term economic performance – the indices use current data attempting to understand the investment risk and benefits of a particular country or region. These data include factors that impact a country’s ‘balance sheet’, including the health of the banking system, the total debt of the economy, the age of the population and its ability to innovate, along with social factors including inequality and education.”

The indices are currently available in All-World, Developed Markets, Developed Markets ex-North America and Emerging Markets versions and use as their basis the MSCI AC World, the MSCI World, the MSCI EAFE, the FTSE Emerging indices, respectively, with country allocations re-weighted or excluded according their Investment Attractiveness Score, as calculated by the model. The indices are re-balanced quarterly.

Based on back-tested data, each of the indices has produced superior Sharpe ratios (before fees, trading costs and expenses) since October 2005 relative to their parent index. Specifically, the Roubini Barclays Country Insights Developed Markets Equity Index has delivered a Sharpe ratio of 0.36 compared to 0.27 for the MSCI World Index; similarly, 0.29 for the Developed Markets ex North America Index versus 0.16 for the MSCI EAFE Index; 0.30 for the Emerging Markets Equity Index versus 0.24 for the MSCI EAFE Index; and 0.33 for the All-World Equity Index versus to 0.26 for the MSCI AC World Index.

With these kinds of track records, albeit simulated, coupled with the allure of the Roubini brand, the indices are likely to draw the attention of product development executives at ETF providers. Indeed, Barclays is thought to be in early-stage talks with a number of firms.

Monday, July 13, 2015

What will Greece do next ?

Now that the Greek people have overwhelmingly rejected the terms of the creditors’ proposed cash-for-reforms deal, either a new (short-term) deal will be reached by July 20 (when Greece is due to pay off €3.5 billion in bonds to the ECB) or the government will default on another key institution, dramatically raising the odds of "Grexit" once again.