Capturing Alpha Around Constraints | Chief Investment Officer

Whether it’s long-only or derivative-free, constraints on a portfolio don't matter that much in achieving alpha--as long as it's risk-weighted and built strategically, according to a new whitepaper.

(November 15, 2012) – Let’s be realistic: Many asset owners are not free to build their equity portfolios any way they want to.

Still, while investors have myriad individual restrictions—from short-selling or investing in tobacco companies—they all have a common goal: alpha.

With that in mind, three quants from BNP Paribas set out to create and test various approaches for constructing equity portfolios around constraints, and model the alpha each returned. Raul Leote de Carvalho (head of quantities strategies), Pierre Moulin (head of financial engineering), and Xiao Lu (quantitative analyst) recently published their findings in a whitepaper, titled “Multi-Alpha Equity Portfolios: An Integrated Risk Budgeting Approach for Robust Constrained Portfolios.”

The authors conclude that moderate restrictions do not, in general, reduce a portfolio’s exposure to systematic risk. This is both good news and bad news. Constraints on portfolio construction do not shield funds from certain risks as they’re intended to. But, constructed thoughtfully, a constrained portfolio can capture similar levels of alpha to its free-investing counterparts.

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They built a number of model portfolios with various constraints, in isolation and combination:

1) A long-only constraint, which makes it impossible to sell-short stocks.

2) Liquidity constraints, which is particularly relevant for larger investors who may find it difficult to invest at all in some stocks Stock exclusion list constraints, where investing in some stocks is not authorized due to, for instance, environmental, social and governance (ESG) investing mandates.

3) Restricted access to derivatives instruments, in particular over-the-counter derivatives In one model portfolio of global equities, the authors run scenario analyses using three different risk-budgeting strategies, including mean variance, maximum diversification, and equal-risk weighting.

Moulin, de Carvalho, and Lu tested each of these individually-risk budgeted portfolios at three different levels of restrictions: none; long-only plus liquidity constraints; and long-only, liquidity constrains, plus a capped number of total stocks.

The best performer was in fact the most constrained portfolio, constructed through a mean-variance risk budget. When back-tested against historical data, the portfolio returned 5.9% above the MSCI World Index.

“We show that constrained portfolios built from the stock implied returns of the unconstrained allocation retain much the same exposures to systematic risk factors than the unconstrained portfolio,” Moulin, de Carvalho, and Lu explain in their whitepaper. “The constrained portfolio remains very close to the unconstrained target portfolio when constraints are not too binding. When constraints are too binding, the risk-adjusted returns of the constrained portfolio can be too low to justify taking active risk.”

Read the entire paper here.

(November 12, 2012) — London’s local authority pension funds are being inadequately managed, leaving a ‘time-bomb’ for tax payers to diffuse, leading academics have claimed.

The Pensions Institute at London’s Cass Business School said fundamental flaws in the investment governance of the 34 pension funds in the capital threatened their sustainability without a tax-payer bailout. The United Kingdom’s capital city is divided up into boroughs, each of which has a governing authority and a defined benefit (DB) pension fund for its employees.

“As the evidence in our report reveals, it is not an exaggeration to suggest that the London Local Government Pension Schemes (LGPS) in aggregate represent a ticking time-bomb – however well managed some of the individual schemes might be,” the report claimed. “The extent to which the liabilities in the schemes are being understated and the recovery periods continually extended into the future will sooner or later become transparent.”

The authors of the report – Professor David Blake, a former aiCIO columnist, and Dr Debbie Harrison – identified several key areas where the pension funds were failing.

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They said unless these problems were addressed urgently, the bill for the shortfall in pension provision would fall to those paying tax in the UK capital.

Blake and Harrison said trustees of these pension funds did not challenge the advice they received from their consultants and actuaries and relied on training from their existing asset managers, rather than from independent firms.

The authors also said pension funds were “shopping around” for discount rates and actuarial assumptions which would give a more favourable figure for funding statuses. They also said that recovery plans for under-funded schemes were repeatedly extended, which meant there was no actual recovery.

Blake said: “The London schemes are particularly at risk because they are so small, with funds worth less than £1 billion at the last valuation, and less than £0.5 billion in 50% of cases. This denies them the opportunities conferred by scale, which is enjoyed by many of the non-London schemes.”

One pension fund in the capital was spared the professors’ criticism. The London Pension Funds Authority, which runs investments and administration for several local authority funds, was praised in the report for efficiency and efforts to create a pooled pension system within the capital. This would mean smaller pension funds would benefit from economies of scale and potentially more-experienced staff offering better governance.

The authors criticized the national government department that is responsible for local authority pension funds, the Department for Local Government and Communities, claiming weak oversight on investment governance on its part.

Blake issued a stark warning: “The government has a choice: sort out investment governance and regulation in LGPS or make further reforms to the pensions provided by these schemes, bearing in mind that in the private sector DB has gone for good.”

To read the complete report, click here.