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Make Diversification your Beta

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Yves Choueifaty, President and Founder of TOBAM

Yves Choueifaty, President and Founder of TOBAM

This article is sponsored by TOBAM.

Yves Choueifaty, President and Founder of TOBAM, explains why concepts such as “smart beta” or “neutral portfolio” require clear definitions and how the Maximum Diversification® approach answers the need for beta.

What is your definition of Smart Beta? What makes a beta smart?
TOBAM is one of the founders of what has been called by the industry the “Smart Beta” movement since 2005. I do not like the expression smart beta since it lacks clear definition and, as a mathematician, I do not like undefined terminology.

So, what is smart beta? Originally, beta is a measure of how much you access the systematic risk premium available in a given market. Secondly, what is the systematic risk premium? It is the return of the undiversifiable portfolio.

Most of the smart beta approaches emerged from the observation that the current representation of beta by the industry, which is the market capitalisation-weighted benchmark, is failing to achieve two objectives. The first objective is to be close the efficient frontier ex-post, and the second is to be truly diversified.

The market cap-weighted benchmark has failed to meet those two criteria and, as a result, there is a growing demand for a smarter way to access the equity risk premium.

The common thread of mainstream smart beta approaches and their providers is the recognition that market cap-weighted indices are not the optimal solution for investors. In that sense, “Smart beta” approaches are smart or at least “smarter” than the traditional benchmarks.

What defines truly a smart beta approach, I believe, is its capacity to deliver an equilibrium portfolio.

Risk Factor investing, for example, is contradictory with the notion of equilibrium since betting on a factor for pricing or strategic reasons remains an arbitrage. This is as far as the similarities go in the smart beta world.

TOBAM is the founder and unique provider of the Maximum Diversification® approach and Anti-Benchmark® strategy. What makes your approach unique?
The core investment philosophy of TOBAM is to harness diversification to optimally capture risk premium of an asset class. At TOBAM we don’t know if we are “smart” but we believe that we provide the Beta.

Our conviction is that the inefficiency of the market cap-weighted strategy arises from insufficient diversification. TOBAM’s patented Maximum Diversification® approach is designed to maximise the degree of diversification when selecting the weighting of assets in the portfolio allocation process. TOBAM’s proprietary measure of diversification, the Diversification Ratio®, is maximized to produce a portfolio designed to access risk premium evenly from all the independent risk factors available in the market at any given time.

The Anti-Benchmark® portfolios generated by this approach aim at providing greater returns than market cap-weighted benchmarks over a market cycle, while these portfolios typically also have significantly lower volatilities than the market cap-weighted benchmarks.

What is your position in the current debate about the passive versus active management?
“Passive”… “management.” This is the perfect example of an oxymoron. How can you be passive and manage? How can you manage and be passive?

In my mind passive has nothing to do with asset management, it is literally a custody job.

The passive/active dilemma is hiding another much more crucial dilemma. We often tend to assume that a passive portfolio (i.e., following the benchmark) is a neutral portfolio. This is absolutely false. You can be passive, but you definitely are not neutral, implementing a neutral risk allocation. The market cap-weighted benchmarks are hugely biased and completely failing to allocate their risk neutrally across the risk drivers.

Smart beta approaches are active by design. To remain the Most Diversified Portfolio®, for instance, you need to stay active, in order to remain neutral. Being a systematic asset manager, we are systematically active.

Does that mean that the end is near for traditional benchmarks?
I believe that benchmarks have a role to play in the asset management industry. They are representative of the market; they are the sum of all speculation and, as such, provide information for asset managers and investors. They are a very useful tool for the finance industry but they need to remain an output.

The tendency over the last 20 years to use market cap-weighted benchmarks as inputs that some asset managers take as a strategy reference to follow is highly inefficient and potentially destructive for the global economy, as it diverts core asset managers from their fundamental role in the latter.

How would you then define the role of core asset managers for the global economy?
The job of core asset managers within the overall wealth creation process is to re-invest savings into the economy to create wealth for investors through growth and development. Importantly, the real source of wealth is not the “skills” of portfolio managers, but the “skills” of employees working in the companies in which savings are invested, labour, in other words. It is labour, through improved innovation, productivity and corporate governance, that creates wealth for the investor. This is especially true in the case of equity holdings.

The fundamental role of core asset managers is to act as a link between savings and labour and ensure the risks savers are taking are rewarded as well as possible. To achieve this as purely as possible, it is critical to protect investors’ core portfolios against all kinds of speculation.

By definition, a Maximum Diversification® approach intrinsically promotes firms that stand out in terms of innovation, efficiency and strong governance. It is these characteristics that progressively contribute to the creation of growth, wealth and improve the overall well-being of society.

For more information
TOBAM is an asset management company offering innovative investment capabilities whose aim is to maximize diversification. TOBAM’s flagship Anti-Benchmark® strategies, supported by original research and a mathematical definition of diversification, provides clients with diversified core equity exposure, both globally and in domestic markets. As at March 2015, the company manages about $9 billion via its Anti-Benchmark strategies for clients worldwide. Its team includes 36 financial professionals. For more information, please visit www.tobam.fr

Disclaimer:
This material is based on sources considered to be reliable as of the date shown, but the completeness or accuracy of any information or opinions expressed are not warranted by TOBAM. TOBAM reserves the right of revision or change without notice of the information and opinions expressed in this material. TOBAM accepts no liability whatsoever, whether direct or indirect, that may arise from the use of information or opinions contained in this material.

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How Does Geopolitics Affect Financial Markets?

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This article is sponsored by State Street Global Advisors.

In Alexandre Dumas’s 1844 novel The Count of Monte Cristo, news of an impending cross-border revolution in Spain leads to financial panic among French investors. Some investors end up selling Spanish bonds at a great loss, only to see the price bounce back after the news proves to be erroneous.

Geopolitics matters to markets in the real world too and has been a major theme in 2018, as the post-war global order is dismantled and protectionism takes hold. But, as in Dumas’ tale, it can be hard for investors to know how to react to such uncertainty. In this paper, we examine attempts to assess the impact of geopolitics on markets and conduct our own analysis on how it plays out over different time periods. Our hope is that investors can use this analysis when considering how best to respond to future geopolitical events, in terms of both the risks and opportunities they may present.

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By clicking on the link to view the report, you acknowledge you are an institutional investor or other accredited investor.

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Through the looking glass

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This article is sponsored by Dominion.

The decision taken by the British Government to require the 14 British Overseas Territories (BOTs) to establish Public registers of the beneficial owners of Companies registered in these territories has so far created a divided reaction. The BOTs, have generally taken the view that it is grossly unfair for the UK Government to use ancient Constitutional rights to impose the new legislation whereas the Crown Dependencies who are not affected by this decision have unsurprisingly provided a more measured response. This is reflected by Deputy Gavin St Pier in statements very similar to those issued by Politicians in Jersey stating that ‘Guernsey will introduce a public register if that becomes the agreed global standard.’

Gavin St Pier’s words have I am sure been chosen carefully since the body that has the necessary authority to end this debate is The Global Forum on Transparency and Exchange of Information for Tax Purposes (Global Forum) that has been the multinational framework within which work in the area of transparency and exchange of information has been carried out by both OECD and non-OECD economies since 2000. The Global Forum is the only international body endorsed by the G20 on issues of transparency and Exchange of Information for tax purposes.

So what does the Global Forum have to say on this issue. Well, paragraph 14 of the report of the Plenary Meeting of the Global Forum held in Cameroon in November 2017 states ‘The second round of peer reviews launched in 2016 reflects the latest developments in international tax transparency, including the requirement to have beneficial ownership information which strengthens the fight against anonymous shell companies and the use of legal arrangements to conceal ownership of identity.’ So reasonably one might expect, this issue should already have been dealt with. Unfortunately not it seems. The information sharing framework created by the Global Forum is designed as an exchange of information programme between Governments. Information exchanged is not available to the Public. So therein lies the problem. Public disclosure of beneficial ownership, despite what paragraph 14 might say, does not appear to have been clarified by the Global Forum, leaving it to Governments, pressure groups and other Organisations around the World to set the Public Agenda on this thorny subject.

Hopefully at this years Plenary Meeting of the Global Forum guidance will be provided on this issue that will feed through into legislation in all Countries that have adopted CRS. In the Plenary Meeting in Cameroon it was noted that ‘Some Members expressed concern that the ongoing EU listing process (referring to a proposed blacklisting of certain jurisdictions by the EU) is occurring outside the framework of the Global Forum… Statements like this would not I imagine encourage the Crown Dependencies to make further comment on this issue or to take any specific action as the Global Forum is clearly through these remarks reinforcing it’s mandate granted to it by the G20. The direction of travel, if one considers EU anti-money laundering Directives and bodies such as the EITI of which the UK is an important Member, would appear to favour a new regime creating a framework for Public Disclosure but when and in what form all stakeholders in this process will just have to wait and see what develops and whether the Global Forum will opine and then issue model legislation on this important issue.

To read more on this subject please visit: expertsinwealth.com/globalregisters

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How Do Public Pension Funds Invest?

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This article is sponsored by State Street.

Public Pension Funds (PPFs) are highly idiosyncratic and distinct from other types of institutional investors. The universe of investors that fall within our definition of a PPF is numerous and varied. We count 115 institutions in 70 jurisdictions, diverse in geography and economic development. For the purposes of our study, we examined the top 16 funds whose assets constitute just over two-thirds of the total universe. Despite all the idiosyncrasies of PPFs, we have found some shared characteristics in the evolution of their asset allocation over the past decade.

According to our definition, PPFs held around $5.9 trillion in total assets of 2016 and over 4% of all publicly traded assets, making them a significant global investor group. In particular, given their preferences for specific asset classes, their share is disproportionate in some segments. For example, we estimate that by year-end 2016, PPFs owned over 7% of global tradeable fixed income assets (including 8% government bonds and over 13% of inflation-linked bonds) and over 3% of listed public equities.

Similar to other asset owners, PPFs have undertaken a major reallocation of assets over the past decade. However, the motivating driver has not only been the low yield environment, but also changing regulatory and macro policy settings, which either permitted or encouraged greater diversification along asset classes and geographical exposure.

In detail, the most dominant trend has been the move away from holding domestic (local currency) bonds; in their place, PPFs have redeployed assets towards equities and alternatives, with a small share also diverted into foreign bonds. These allocation trends have been almost universal despite a huge diversity of geography and economic development.

It is important to acknowledge how much this investor group has changed over the past decade, with the asset pool growing by over 40% in dollar terms, and even more if measured in local currencies. While some funds are still predominantly captive buyers of government debt, the bulk of PPFs have been transforming into financial institutions with independent firepower and income-generating capacity. The long-term trend towards more diversified fixed income portfolios is likely to continue, as is the shift towards taking on more risk via equity allocations, subject as ever to changes in market cycles. In this context, we expect most PPFs to not only continue taking on more risk overall, but to further internationalise their portfolios.

Finally, one consideration is that maturing funds catering for aging populations will have to make further adjustments to their asset allocations to account for changing cash flow directions and seek greater contributions and investment returns to bridge any funding gaps.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.

Tracking Code: 2172159.1.1.GBL.RTL

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By clicking on the link to view the report, you acknowledge you are an institutional investor or other accredited investor.

Authors
Elliot Hentov, Ph.D. Head of Policy and Research, Official Institutions Group Elliot_Hentov@ssga.com
Alexander Petrov Policy and Research, Official Institutions Group Alexander_Petrov@ssga.com
Sejal Odedra Business Analyst, Client Strategy, Official Institutions Group Sejal_Odedra@ssga.com

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