Alain Bokobza, head of the global asset allocation strategy team at SGCIB in Paris
The range of index-strategy products based on algorithmic models has expanded dramatically in recent years. What used to be mainly the preserve of the equity derivatives department has now moved cross asset into commodities, foreign exchange and fixed income. Writer Michael Marray
The problems across the hedge fund industry during 2008 and 2009 presented investment banks with an opportunity to win market share for a wide range of algorithm based products that automatically reallocate between asset classes.
Many hedge funds failed to perform as promised during the financial crisis. In addition to outright losses, many temporarily blocked investors from taking their money out. The investment banks identified liquidity as a key concern, and have had considerable success offering institutional investors products designed to produce stable returns in a wide variety of market environments.
Index-strategy products are typically allocated under the alternatives bucket of big institutional investors, such as pension funds and insurance companies. Some are making up for reduced hedge-fund allocations, but index products are also gaining their own increased allocations, as the overall alternatives bucket grows in size at many institutions.
Most products are producing alpha exposure, which is the out performance of the benchmark in a given asset class owing to either the skill of the manager or the efficiency of an automated strategy. But there are also beta products on offer, which simply give an investor market-risk exposure to a group of asset classes.
Controlling volatility
Multi-asset strategies use algorithms to control overall volatility by automatically re-allocating as markets send out valuation signals. A key element of the market is that investors do not want black boxes, but instead a clear set of rules and triggers that can be studied and back-tested before buying the product.
“We have had a lot of investor interest for several years in the SGI Global Alpha Index, which is a quantitative index designed to capture alpha across asset classes including
equities, volatility, fixed income, foreign exchange [FX] and commodities,” says Yannick Daniel, head of SG Index at Société Générale Corporate & Investment Banking (SGCIB) in Paris.
“More recently we have launched the SGI Diversified Alpha [DIVA] index, which is allocated to a diverse group of SGI indices, with each building block designed to generate alpha with a high Sharpe [excess return per unit] ratio, and also importantly with high liquidity,” he adds.
DIVA is based on five underlying indices; long-short equity, equity volatility based on the S&P 500, long-short commodities, short-term interest rates, and long-term interest rates.
“The low-volatility high-return characteristics of DIVA have generated a lot of investor interest, including in Asia, and we are looking at different wrappers to suit investors, including a UCITS-compliant version in Europe,” Mr Daniel explains.
The SGCIB marketing strategy is to focus on offering a limited number of indices where it sees investor interest, such as the Optimum Euro Equity product, which uses mean variance measures to optimise Eurostoxx weightings and so create more return and less risk.
Calculating risk
SGCIB does not compute the indices itself, but outsources this daily calculation process to third parties such as Standard & Poor’s, Markit, STOXX and Dow Jones.
The 80-strong research department is independent from the rest of the bank, but investors can gain access to products based on the discretionary asset allocation recommendations
of the global research group. One of the flagship indices on the beta side gives investors exposure to the global asset allocations recommendations of the multi asset portfolio.
“We have a global multi-asset research presence, and we start with the umbrella economic scenario,” says Alain Bokobza, head of the global asset allocation strategy team at SGCIB in Paris. “We then take a bottom-up approach to look at the asset class story, where it is very important to be close to the local markets. We also use long-term valuation
tools to assess whether an asset class is cheap or expensive. And finally, we enter into the portfolio construction stage, adding several risk-control instruments.
“The strong multi-asset focus includes looking at the correlations between different asset classes. For example, the historic correlation between the value of the US dollar and the performance of emerging markets equities, which allows us to move quickly to reallocate between asset classes,” says Mr Bokobza.
Multiple options
The competition is fierce, since many other major investment banks are offering a range of single asset and multi-asset products. Thus traditional strengths such as product distribution capabilities are important as well as product engineering – especially since transparency demands that banks reveal the workings of their algorithmic models.
Barclays Capital is active in the sector, and under the control of the cross-asset universe of BarCap alpha strategies it recently launched Barclays Fusion. This is a combination of a group of liquid strategies across a range of asset classes, including equities, FX, commodities rates and alternatives. This includes extracting alpha from one of three key sources: fundamental value, market trends, and carries that exploit inconsistencies along the yield curve or across currencies. For example, the FX component of
Antti Suhonen, head of origination, equity and funds structured markets at Barclays Capital in London
Fusion includes fundamental FX value and intelligent carry-trade components.
“Following the financial crisis, we have seen an increase in allocations from institutions, and also other types of asset allocators such as funds of hedge funds, who increasingly look at algorithmic strategies as part of their investment portfolios,” says Antti Suhonen, head of origination, equity and funds structured markets at Barclays Capital in London.
“Investors want exposure to transparent trading strategies, and we are seeing interest in single asset classes as well as strategy rotation products, such as the Barclays Capital Fusion Index, where strategies across five asset classes are combined to create a portfolio which will seek to perform under different market conditions,” he adds.
“Many large institutions have increased their alternatives allocations, and putting index strategies into the alternatives portfolio, often alongside hedge-fund exposure, is a good way to increase the overall liquidity of the portfolio.”
Yannick Daniel, head of SG Index at Société Générale Corporate & Investment Banking in Paris
First-mover advantages
BNP Paribas has also been one of the first movers in the market segment, and over the past three years has seen a lot of investor demand for its Millennium Master Series index, which dynamically allocates long andshort positions to a wide range of assets, including developed market equities, Chinese equities, real estate, FX and commodities. The defensive assets are government bonds and gold. And another product, Flex-Invest, uses several moving averages (from one month to one year) to assess equity market trends and systematically reallocate to government bonds when necessary.
“In the past, it was often possible to hold equities for a five-year period and make good returns, but financial cycles are becoming shorter and more intense. In today’s markets, investors need to be able to reallocate very dynamically from one asset class to another,” says Matthew Yandle, BNP Paribas’s head of global equity and commodity derivatives structured products design.
“It is not enough to make small portfolio adjustments, for example, from 60:40 equities versus bonds to 55:45,” he adds. “The most successful managers can rapidly move allocations from zero to 100%.
“We need to be able to deliver absolute return, which is something that everyone is looking for, but also with high liquidity,” says Mr Yandle. “Clearly it is easier to deliver alpha when it is not liquid, but what we are promoting is liquid alpha.”
In response to the growing demand for algorithmic strategies as part of alternative investment portfolios, UBS has created a global Liquid Alpha platform, which offers products such as the UBS Diversified Strategy Index linked to the full range of asset classes, including rates, credit, equities, currencies and commodities.
‘Glass Box’ strategies
The UBS approach is driven by a combination of qualitative and quantitative research. The strategies it devises are fully transparent and based on a clear set of rules, which has earned them the sobriquet of being ‘glass box’ strategies.
It has also had success with FX exposure. “We launched an algorithmic FX carry-trade product under the name V10 back in 2007, which uses a volatility filter to try to anticipate
periods where there is likely to be a correction in the carry trade, and make adjustments by taking long and short positions within the G10 group of currencies,” says Jonathan Roberts, executive director of strategy indices at UBS in London.
“Investors want a transparent model, and they ask for a lot of detail, for example, over what would have happened to returns if the parameters of the model had been changed slightly,” says Mr Roberts. “They also want to see a real track record, rather than just back testing, and the V10 product picked up the severe moves of the financial crisis and the subsequent market reversal in March 2009 very nicely.”
The retail market is getting more sophisticated, and is gaining access to strategies that used to be the preserve of institutional investors. For example, exchange traded commodities based on the UBS V10 strategy have at times been among the top five most traded certificates on the SIX Scoach Swiss Exchange.
The increasing interest in these products has in part been brought about by the poor performance of the hedge fund industry during the crisis, and the disillusionment with the very high level of the hedge fund industry’s standard fees – 2% of assets plus 20% of all gains. These fees were standard in good times, only for investors to find many funds unable to cope with the markets in crisis.
If the new generation of strategy indices can deliver the stable returns that they promise, arrangers will be well-placed to win some very large institutional mandates in the coming years.
