Passive management doesn’t add up for mathematical investor

Investors in a low returns environment may be looking to lower their risk and costs through passive investing, but self-described mathematical investor, INTECH Investment Management, has steadfastly argued that the case for passive management doesn’t add up.

David Schofield (pictured), INTECH’s international division president, says that investors who look at passive investment as a way of minimising their risk are not fully appreciating the opportunity cost of forgoing the chance of excess returns.

“What a lot of people overlook is the lost opportunity cost of identifying a skilled manager,” Schofield says.

“It might be cheap going passive, but you are not really reducing your total risk. Whether it be market cap indexing, fundamental indexing, or some of these other more efficient indexes, the absolute volatility of these indices is not substantially different.”

While acknowledging that there are low volatility indexes and low volatility equity investment strategies, Schofield says they are different in their risk/return objectives from those offered by active managers.

“The desire to reduce risk is a bit of a specious argument for going passive; there is perhaps career risk involved because you shouldn’t underperform, but you are giving up the risk of outperforming, which is another risk in itself,” he says.

“It is also not necessarily cheaper because, even though you might be paying low fees, if you are able to identify a skilled manager who does outperform you have given up a lot.”

Schofield points to the track record of INTECH, which across its suite of products has delivered between 100 and 600 basis points of excess return before fees per year over its 24 years in the market, as indicative of the potential opportunity cost of going passive.

Schofield describes the recent market tumbles in July and August as having a minimal effect on the firm.

“July and August were pretty normal for us,” he says.

Schofield says potential short-termism among investors, which either look to scale back their equity exposure or move to passive in the belief they are in a low returns environment, risks further compounding underperformance in the largest proportion of their portfolio, typically large-cap equity holdings.

INTECH has been investing for the past 24 years using a virtually unchanged process developed by founder and chief investment officer Robert Fernholz.

Fernholz developed his theorem through academic research into stock price movements, while teaching at Princeton University in the early 1980s.

The theorem and subsequent investment strategy he developed are designed to capture volatility using the application of a proprietary maths formula that Fernholz invented.

Instead of trying to predict the future direction of stock prices, the strategy is based on analysing how stocks move relative to the index and attempting to identify stocks with high relative volatility and low correlation.

A portfolio identifying the target weightings of each stock based on relative volatility and correlation can then be constructed.

As market movements begin moving stock weightings away from INTECH’s set targets, is to sell some of the stocks that have moved up in price, in order to maintain weightings, and buy some more of the stocks that have fallen in price.

The portfolio is rebalanced weekly, and target weightings are also revisited.

“Volatility is the fuel to our investment process and we have spent many years trying to understand and estimate volatilities and correlations, and these are the key tools we use to build our portfolios,” Schofield says.

“Many people misunderstand the fact that volatility itself acts as a drag on long-term growth of returns, and if you reduce that drag you can, obviously, increase long-term returns. So controlling the volatility of your portfolio is crucial. Compounding works best when it is consistent.”

The mathematicians at INTECH study their benchmark index with the aim of improving upon that structure to get a slightly higher return with the same or lower risk.

Central to the investment strategy is the focus on the information ratio. This ratio is typically defined as the excess return divided by the tracking error of the portfolio. Schofield says it essentially measures the excess return and the volatility of that excess return.

“We are targeting information ratios of between 0.8 and 1, which is very high, and if you achieve an information ratio of 1 you will expect to outperform approximately five years out of six,” he says.

Schofield argues that achieving these consistent low-risk excess returns of 1-2 per cent in large-cap holdings has a far greater effect on overall performance than using active management in asset classes that make up a relatively minor part of a portfolio.

“We are trying to target modest but consistent returns over and above the market,” he says.

“If you can achieve consistent 2 per cent returns above the market consistently over the long run, that will put you in the upper echelons of the competitors’ universe.”

“Outperforming by between 1.5 and 2 per cent in US large caps over the long term, for example, makes you the top manager, which is what we have been able to do.”