The stochastic advantage: volatility creates opportunity

Robert Garvy, chief executive officer of Florida-based INTECH Investment Management, talks to Kristen Paech about the benefits of mathematical investing, and the blurring of the line between passive and active investing.

Pension funds are flocking to passive management amid the global market volatility. A survey of 100 Asian institutional investors, carried out by Greenwich Associates, found passive mandates are becoming increasingly popular, while a recent move by the A$28 billion AustralianSuper to terminate 20 of its 30 active equities managers and direct most of the freed-up capital to passive exposures is further evidence of this trend.

However some strategies attempt to get the best of both worlds, offering pension funds above-benchmark returns for index-type risk.

One such approach is that of “mathematical investing”, which is based on Stochastic Portfolio Theory and is an extension of quantitative investing.

The approach was developed by Dr E Robert Fernholz, founder of INTECH Investment Management (previously known as Enhanced Investment Technologies) and seeks long-term outperformance by taking advantage of the
volatility of large cap stocks. Rather than tracking the index, the mathematical approach calculates the volatility of individual stocks and takes overweight positions in stocks with above-average volatility.

Importantly, the approach does not simply try to maximise the return available by capitalising on excess volatility, but instead seeks to do this within a controlled risk framework.

Robert Garvy, chief executive of Florida-based INTECH Investment Management, says institutional investors have shifted focus from return to risk.

“Two of the strongest human motivators are fear and greed,” he says.

“When we go through a period of ebullience advancing markets, people are very much interested in the return they’re achieving. They often can lose sight that there is a risk associated with that embracing of the market, but it’s not been expressed in up-markets. When we go through a period like we’ve experienced over the past 18 months or so, and we have these tremendous upheavals and negative bear markets, a fear and the awareness of
risk that’s embedded in any investment comes to the fore. We see a lot of interest in risk-managed strategies where these markets exist.”

As investors embrace alternatives to traditional cap-weighted indices, such as fundamental indexation, Garvy says the demarcation between active and passive is blurring.

“We have seen a very substantially increased movement into passive strategies as active managers have suffered relative underperformance to benchmarks during the current market meltdown,” he says.

“Classically passive investing was a capitalisation-weighted index. Now there is fundamental indexing; is that passive investing? It’s  perceived as an intersection between active and passive, and mathematical falls into that category as well.

“I think the landscape is changing and people are beginning to look at active versus passive in terms of how far away from the classical capitalisation-weighted benchmark might a particular strategy wander? If it’s a risk budget or risk management issue in which the constraints in the portfolio keep it quite close to the benchmark – the benchmark being the cap-weighted index – often the parameters will allow for limited risk strategies within a
passive benchmark.”

While Modern Portfolio Theory and quantitative investing use financial theory to optimise investment outcomes, mathematical investing does not.

As Garvy explains, the mathematical approach does not take into account classic income statement and balance sheet items when making determinations. In fact, it does not even forecast the future rates of returns of stocks.

“We don’t try to identify winners and losers,” Garvy says. ‘What we’ve found is that as people express their views by buying and selling stocks, they create volatility and just using that volatility itself, which is a natural component of markets, we can generate a return that’s higher than the return of the market, without having any more risk than the market itself.”

Modern Portfolio Theory, established by Harry Markowitz in 1952, is based on the idea that the efficient frontier, which considers a universe of risky investments and explores what might be an optimal portfolio based upon those possible investments, was the combination of securities that had the lowest standard deviation or variance for a given rate of return.

Garvy believes a portfolio that is constructed by taking a group of securities with lower correlation to each other, reducing the volatility of the entire portfolio for a given rate of return, is more efficient than a portfolio that does not.

“The classic index fund where the stocks are weighted based on the capitalisation has no consideration of the correlation among the securities, so it’s extremely unlikely that a portfolio constructed that way is
efficient in a Markowitz mean variance fashion,” he adds.

“We’re trying to create a portfolio that’s slightly more efficient in considering the variance and covariance among these securities than would be the case in an index portfolio.”