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Patent in the wings for new performance attribution method
(pictured: Adrian Banner)
Portfolio rebalancing has long been recognised as a way to add long-term value and maintain or improve diversification. However, it has always been difficult to measure its impact. Now, a US-based quant manager has applied to patent its algorithm for better performance attribution.
Enhanced Investment Technologies (known as INTECH outside of Australia), an affiliate of Janus Capital Group, has been using the algorithm for its own strategies and has recently applied them to those of its clients. It is used on factor-based investing or smart-beta strategies.
According to Adrian Banner, the Princeton-based chief executive and CIO, it’s a new tool – akin to version 1.0 – which remains an area of active research for the firm, but has become mature enough to use with clients.
The Australian-born Banner was visiting Australia earlier this month to deliver a lecture at the University of NSW’s business school. It was about performance attribution for smart beta and measuring the trading profit of rebalancing. He said: “Our view from our work, which is not always agreed to by others, is that rebalancing is a major contributor to the performance of alternative weighting systems [such as in smart-beta strategies].”
He said: “Investors know that cap weightings are not optimal. For example the S&P has been skewed towards a few big-name tech stocks. Just about every alternative weighting scheme seems to outperform cap-weighted index.”
The main reasons that rebalancing works are that most stock movements reflect natural volatility rather than a trend and, in order to maintain a diversified portfolio, you are required to sell winners and buy losers. This means that the trading associated with rebalancing has a “buy low and sell high character”, Banner said.
If an investor does not trade a diversified portfolio then, over time, it is likely to become less diversified. INTECH sought to find out, then, whether the diversification benefit of a portfolio could be explained by the trading. Rather than use the holdings in its performance attribution, which is the traditional way, it used trading data.
For rebalancing to be of benefit, it needs the whole market to mean revert, but not necessarily individual stocks. In developed markets capital distribution tends to be stable, with no one group of stocks dominating others over the long term. This was strongly supported by the academic literature, Banner said.
Therefore, rebalancing will not be of benefit during trending markets, but these tend to be relatively short-lived. Over time, smaller stocks tend to outperform larger stocks and equal-weighted portfolios outperform cap weighted.
In terms of styles, INTECH says the performance attribution works for value and size, but not so well with the different characteristics of momentum strategies, which aim to capture trends.
“There will be more insights to come for rebalancing portfolios, such as with equal weightings, and for factor-based portfolios,” Banner said.
With its work on value strategies there was a vindication for those deep-value managers which had strategies of five-or-more years. This was because the trading profit for the value factor was largely driven by annual trade matches up to five years apart.
– Greg Bright
