Using Crowdsourcing to Dowse for Dollars

With a little effort and creativity, global tactical asset allocation can boost a fund’s returns.

Asset mangers often use global tactical asset allocation (GTAA) strategies to increase returns by taking advantage of shifting market conditions. However, many of these strategies trade assets that could potentially increase a fund’s risk because they are not in their strategic asset allocation.

But by crowdsourcing best ideas from strategic partners to create a unique GTAA, fund managers can boost returns while also significantly enhancing risk management.

“It is crucial for asset owners and asset managers to realize the importance of building a portfolio that is flexible and resilient enough to endure different macroeconomic and capital market environments,” Joy Xu, Verizon Investment Management Corp.’s director of strategic asset allocation and fixed income, told CIO, “and at the same time maintain certain liquidity level to be able to take advantage of any opportunities presented by the markets.”

In a recently published research paper, Xu and Arun Muralidhar, founder of M-cube Investment Technologies, demonstrate how they were able to create a unique GTAA through crowdsourcing, and then adapt the model into a futures-based dynamic beta overlay.

“Asset owners need to be creative and see how they can raise overall returns while lowering portfolio risk,” they wrote. “The futures-based overlay is a much more cash-efficient strategy for the asset owner.”

Xu and Muralidhar say the process they adopted can be easily adapted by other asset owners to whatever strategic asset allocation they use, and that it can allow them to capture untapped alpha built into their portfolio structure.

“With a little effort and creativity, asset owners could get paid to manage risk and generate additional cash for their funds,” they wrote.

Verizon Investment Management Corp. (VIMCO), in developing a GTAA, crowdsourced best ideas from its strategic partners, which included Mellon Capital, Invesco, Goldman Sachs Asset Management, and Morgan Stanley Investment Management, among others. In exchange for a mandate from asset owners, asset managers were required to share their best research ideas to help VIMCO manage its fund.

The GTAA portfolio was established as a tiered decision tree representing 10 different key decisions, such as tactically allocating between global equity and global fixed income, or allocating between global bonds and cash, or US equities vs. international equities. The result gave investment officers at VIMCO a clear recommendation for each of the 10 decisions.

“Many funds have discussed controlling costs and improving returns (as expectations of returns have declined),” Muralidhar told CIO, “and a dynamic beta overlay is probably the lowest-cost way to have the biggest impact on the fund, while also improving risk management.”

So far, the GTAA strategy has been effective for VIMCO. Xu says it has added approximately 50 basis points per year, with 30 basis points of risk, which indicate a Sharpe Ratio of 1.6. Sharpe ratios that are higher than 1 indicate the asset manager is generating a return above the additional risk they’re taking on.

For a pension fund manager looking to incorporate this strategy, Muralidhar says there are three key steps to get started:

  1. Good governance to ensure that staff are empowered to make decisions without fear of negative consequences when the strategy underperforms—it usually will underperform in 40% of the months.
  2. Identify a specific individual in the organization with the requisite skills and enthusiasm to “own” the model construction, and
  3. Provide them with sufficient resources/support internally and convey this clearly to the strategic partners so that they know that the partnership will be judged by the quality of the ideas shared with the asset owner.

The technology was developed by Arun’s M-cube Investment Technologies using its proprietary AlphaEngine software, which the company licenses to clients. However, the client owns the process and the models, which are unique to each client.

Muralidhar said the San Bernardino County Employees’ Retirement Association has also been successfully employing dynamic beta overlay, and that the strategy has added more than $800 million to the fund over the past 12 years.

“If you look at the added value as a multiple of total costs, it is well in excess of 200 times, something no other investment strategy has delivered,” Muralidhar told CIO. “I expect many more asset and pension managers will have an interest in this strategy. However, it is much easier for a pension manager to crowdsource ideas than asset managers as they have many more diverse relationships to leverage.”

Tags: , , ,