Magic of maths: harnessing the excess growth from portfolio volatility

In the aftermath of the global financial crisis, some investors are questioning the true diversification in their global equity portfolios and the appropriateness of standard benchmarks. GREG BRIGHT spoke with Adrian Banner, co-chief investment officer at INTECH Investment Management, about these and other issues.

With strong ties to academia the Princeton-based global manager INTECH is well equipped to debate the pros and cons of traditional cap-weighted indices. In fact, the firm encourages this and related discussions in the true spirit of its academic connections.

Adrian Banner, who was promoted to co-chief investment officer this year, still teaches part-time at Princeton University – mainly calculus – and is one of five senior management with a PhD in either mathematics or physics. A new recruit, Ioannis Karatzas, who was formerly a consultant to INTECH, remains a professor of applied probability in Columbia University’s mathematics department.

INTECH has developed its product to be benchmark centric and has what it terms a “mathematical” style which captures the volatility within a broad market portfolio.
The problem with cap-weighted indices is that it is difficult, without considerable discipline, to avoid being caught up in a stock market bubble. Most fund managers use at least an element of momentum style in their process to avoid underperforming for potentially long periods. When the bubble bursts, their clients lose out.

“Cap-weighted indices may go in and out of fashion but it is still the only viable (index) that doesn’t require much rebalancing,” Banner says.

There is no theoretical impediment to adapting the firm’s process to non cap-weighted indices and preliminary tests have shown that there is some potential for similar performance compared with non-traditional indices too.

The firm is also looking at other asset classes, such as bonds and currencies, to which its mathematic process may be applied, depending on things such as liquidity and market breadth.

The firm’s process is derived from a landmark study by one of its founders, Bob Fernholz, who published a paper in 1982 called: “Stochastic Portfolio Theory and Stock Market Equilibrium”. Fernholz remains co-chief investment officer.

Looking at work by Harry Markowitz from the time, Fernholz observed that the geometric return rate of a portfolio was significantly greater than the average for each stock in the portfolio, which he termed “excess growth”. This meant that any benchmark of volatile instruments would perform better than the average of the instruments themselves because there is a chance that some of the stocks will fall out of the index. In US large caps, for instance, the excess growth of the index over time is about 3-4 per cent a year.

Fernholz also observed that if someone can pick stocks which will outperform or avoid ones which will perform poorly then you can ignore the volatility component of returns. However, it is difficult to consistently pick stocks to beat the market, especially in developed large-cap markets.

Fernholz launched the company, with Robert Garvy, who remains chief executive, in 1987, after five years of research on the process. The firm is now about 90 per cent owned by the Janus Capital Group.

The process aims to capture some of the volatility of stocks relative to each other. The managers study variances and co-variances rather than the growth rates of the stocks themselves.

In its simplest form the process goes like this: if there are two stocks in a portfolio priced at $100 each and they are inversely correlated, if one moves up to $125 the other will move down to $80 (four-fifths being the inverse of five-fourths).
The portfolio will make money over time because of the asymmetry, without the investor having to know in advance which stock will go up and which will go down.

INTECH does not attempt to capture all the volatility because this would result in an unpalatable tracking error. It has three levels of aggression in most of its products, with the middle ground generally targeting a return of 2 per cent above benchmark with a 2 per cent tracking error.

“We stay only in the sweet spot of higher information ratios,” Banner says.

With some big developing countries decoupling from the West’s (lack of) growth in the past two years, particularly China and India, investors have also questioned the appropriateness of the MSCI World as a core benchmark for global equities, rather than one with more emerging markets exposure.

Banner says the firm’s style is not a pure volatility play, because that adds to the risk as well as return.

“There’s an equal if not greater weight given to risk control,” he says.
In emerging markets, for instance, there is more scope for picking stocks because of their greater volatility, but if a manager is not a stockpicker, there is more randomness in the outcome.

“It looks like the information ratio (in emerging markets) could be lower even though they are more volatile,” Banner says. “It’s a question of whether the trends are more dominant than the volatility.”

INTECH will provide, if a client requires, a strategy benchmarked to the All Countries World Index, which has about 10 per cent exposure to emerging markets, but has not marketed this as a product. For such a mandate the manager will use a purely passive approach for emerging markets.