Monday, April 29, 2019

Applying AI to Traditional Industries

Image by sujin soman from Pixabay 

By Kurt Wiese, Guest Contributor

When people think of artificial intelligence, or AI, and machine learning, images of autonomous driving, virtual reality, and other high-tech, start-up–dominated fields that didn’t exist a decade ago typically come to mind.

However, in our continuous search for durable growth drivers, we are finding that AI has open-ended potential across many areas, including those that currently depend on labor- and time-intensive research and development processes. Companies with technology platforms that can solve for challenges across multiple applications are interesting in any industry. One such company is Codexis, a leader in protein engineering.

At the recent William Blair CONNECTIVITY conference, John Nicols, president and CEO of Codexis, described how companies are using technology to tackle previously insurmountable research and development (R&D) challenges in the food and pharmaceuticals industries.

Faster, Cheaper, Sweeter

Stevia, a sweetener extracted from the leaves of a plant native to South America, has gained some popularity as a sugar-alternative because it’s non-caloric and natural. But many consumers experience a bitter aftertaste, which limited its historical market acceptance.

Codexis collaborated with a U.K.-based food ingredient company to engineer an enzyme process that eliminates the bitter aftertaste by extracting 95% pure Reb M glycoside, as opposed to the bitter but higher-yielding Reb A.

Researchers have known what part of the plant they needed for years, but until recently, the time and labor required to develop the extraction process had not been economically viable.

New machine-learning platforms allow for this by processing information faster than we could previously imagine. Projects that once took about 20 scientists and up to two years of labor to complete now can take a few scientists a matter of months.

Bending the Healthcare Cost Curve Downward

The healthcare sector faces many risks and uncertainties, including pressure to reduce drug pricing. As a healthcare analyst, I’m especially interested in companies that can maintain healthy margins and robust R&D pipelines in the face of lower prices.

We believe that AI is already ushering in a new era of innovation in the healthcare industry. By dramatically streamlining the drug development and testing process, AI tools have the potential to yield tremendous benefits for society, both in terms of reducing costs and unlocking better ways to treat diseases and patients. For example, thanks to next-generation sequencing, blood samples can be used instead of tissue biopsies in some cancer diagnostics, improving the speed, accuracy, and ease of detection and treatment.

A mega-cap pharmaceutical company uses a machine learning derived enzyme to manufacture one of its most-prescribed drugs, which treats diabetes. The production process provides a better yield to meet the growing global demand, which allowed it to gain higher production efficiencies and avoid additional capital investments. It has also allowed the pharmaceutical company to move to a more environmentally friendly production process.

When evaluating a research-driven company’s ability to create sustainable value for investors, partnerships can be very important. Companies that are able to understand the R&D challenges facing their clients and do the front-end work to create innovative solutions to those roadblocks should have a growing and highly defensible position in the value chain—regardless of industry.

Innovating for Profitability—and Sustainability

One of the biggest challenges facing manufacturers across industries is determining how to create a product with the same or higher quality at the same or lower cost—and with a smaller impact on the environment. This trend is being driven not just by regulators, but by consumers who are increasingly conscious of the environmental impact of their purchase decisions.

AI is playing a leading role in solving this engineering challenge. For example, by streamlining the drug development and manufacturing process or by increasing the yield from plants, AI is lessening the need for energy, water, chemicals, and other resources throughout the supply chain.

Across industries, companies that recognize the quickly evolving regulatory, competitive, and consumer demand environments and enlist innovative solutions to enhance the speed, quality, and sustainability of their R&D efforts will likely be among the longer-term winners.

References to specific securities and their issuers are for illustrative purposes only and are not intended as recommendations to purchase or sell such securities. William Blair may or may not own any securities of the issuers referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. It should not be assumed that any investment in securities referenced was or will be profitable.

Kurt M. Wiese
About the Author:
Kurt M. Wiese is a research analyst for William Blair Investment Management. He focuses on U.S. small-cap healthcare companies. Before joining the research team in 2001, he was a member of William Blair’s corporate finance healthcare team, where he was engaged in all aspects of transaction execution. Before joining William Blair in 2000, Wiese worked in the Chicago audit practice of PricewaterhouseCoopers for two years. He is actively involved in the Chicago community through his philanthropic work at the Chicago Jesuit Academy, a full-scholarship, college-prep middle school for underprivileged boys on Chicago’s West Side. Wiese received a B.S. in accounting and finance from Indiana University and an M.B.A. from the University of Chicago’s Booth School of Business. He was also a participant at the Center for Japanese Language and Culture at Nanzan University in Nagoya, Japan.

The Fed’s 'Financial Conditions' Conundrum

By Jason Brady, Guest Contributor

First-quarter returns marked a spectacular rebound from the December 26 lows, when investors were fleeing risk exposures. Many markets saw their best quarter in a decade. We’re back!

Not so fast. Markets and the U.S. Federal Reserve face a multifaceted conundrum: Where exactly are we in the economic cycle? Can we be late cycle but still have room to grow? Ex-energy, have we reached inflation targets, or is deflation still the concern? Is the labor market tight, as former Fed Chairwoman Janet Yellen recently said, or does significant slack still exist, as some current Fed officials assert? Excesses have built up, including corporate leverage and re-compressed yields, amid renewed investor risk appetite. After the selloff and subsequent rebound, should investors expect less volatility, or more?

Toward the end of her tenure, Yellen called out the excesses, but they haven’t become less spicy since current Fed Chairman Jerome Powell took over in early 2018. Risk markets suffered after the Fed hiked four times in 2018 and steadily shrank its still-bloated balance sheet. But since Powell’s end-2018 policy U-turn, the Fed’s focus now appears trained more on ebbing, albeit still decent, global growth and especially “financial conditions,” which nowadays means equity markets.

Stock prices are higher thanks to the Fed, not because earnings are better or growth is terrific. Ironically, U.S. blue-chip earnings rose last year, and price/earnings ratios declined. This year, it’s the inverse. Too often investors extrapolate the latest Fed signal out to the long run. That’s why we’re skeptical about the Fed’s about-face, which engendered hope its still-accommodative stance will long continue amid above-trend growth.

The Fed’s liquidity injections—not to mention those of the other major central banks—have fended off some problems. But they won’t produce higher growth if we can’t push credit creation further, a challenge when debt levels are running high globally. Typically, when the Fed is finished hiking, a relief rally ensues. Yet the close of an economic cycle isn’t good news.

Valuations don’t offer much support to equities or fixed income. When rates rose in 2018, it caused risk assets to falter because we are now dependent on ever-lower interest costs with debt burdens of corporations and governments quite high. The U.S. 10-year Treasury yield’s 80-basis-point fall helps. But most of the world is at the zero lower bound. Curves are flat or inverted not because there is imminent doom. Rather, markets expect medium-term rates to be lower to deal with a future downturn. Ultimately, this cycle won’t die of old age. It will die because we have borrowed and pulled forward growth, creating conditions for “Minsky Moment” instability.

Markets adjusting to better reflect current fundamentals and future prospects shouldn’t be cause for Fed capitulation amid above-trend growth. Nor should investors want rising valuations from easy money, absent improving fundamentals. Spotting the difference is crucial for successful investing.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Thornburg Investment Management or TEXPERS. 

About the Author:
Jason Brady
Jason Brady is president and CEO of Thornburg Investment Management. He is responsible for the company’s overall strategy and direction. He is also the head of the firm’s global fixed income investment team and a portfolio manager on multiple strategies. He joined the firm in 2006, was made portfolio manager and managing director in 2007, and president and CEO in 2016. His book, "Income Investing: An Intelligent Approach to Profiting from Bonds, Stocks and Money Markets," is a step-by-step guide to income investing. Brady holds a bachelor's degree with honors in English and environmental biology from Dartmouth College, and an master's degree with concentrations in analytical finance and accounting from Northwestern’s Kellogg Graduate School of Management. He is a CFA charterholder. Prior to joining Thornburg, Brady was a portfolio manager with Fortis Investments in Boston, and has held various positions at Fidelity Investments and Lehman Brothers.

Double Digit Equity Returns 2019 YTD

 How do you protect your equity position for the rest of the year?

By Thomas Cassara and Ryan McGlothlin, Guest Contributors

With both international and US equity markets up approximately 15% year-to-date reversing most of the 4th quarter 2018 correction, many plan sponsors are asking themselves “should we consider any changes to protect the equity gains that we have received?”

Most pension plan sponsors, however, haven’t seen a strong improvement in their pension funding status since the beginning of the calendar year. This comes as a result of declining discount rates (i.e. declining interest rates and credit spreads) that have increased their liability values. Thus many plan sponsors, especially those on glide paths, may be staying the course as they rely on the plan’s funded status to dictate changes in asset allocation.

So, what are some options for consideration if plan sponsors want to protect their equity position for the year?

One choice would be to reduce the amount of a plan’s equity holdings. Selling now will lock in the gains for that portion of assets being sold. However the choice of where to invest those proceeds will need to be considered. If a plan sponsor is trying to increase their hedge vs. future interest rates movements, then buying additional hedging assets could make sense. However if these assets are still needed to drive growth, investing in fixed income now after the recent sharp decline in long interest rates may not be wise as these assets will lose money if rates were to increase. That would leave cash, alternatives, or other equity segments as potential options, but those may not make sense either.

A second choice would be to use equity options to protect your position. This can be done in many different ways and can be designed in a cost effective way. One such strategy would be to sell off equity upside beyond what a plan may expect or need to purchase some level of down side protection. As an example, a plan sponsor could sell equity returns over 8% from current levels in exchange for protecting the first 10% of downside over the next year for a zero premium today.

Another strategy would be to use equity derivatives to change the effective asset allocation of a portfolio without moving physical assets. For example, one can use futures to change a 70% equity/30% fixed income portfolio into the economic equivalent of a 50%equity /50% fixed income portfolio without incurring the expenses of selling and buying physical assets. Thus the position can be easily reversed if market conditions would warrant a higher equity position.

With uncertainty in the global economy looming, why not lock-in 2019’s positive equity returns now regardless of what discount rates do? Using strategies as described above, pension plan sponsors can effectively protect their equity gains and still leave room for a certain level of additional positive returns. If you’d be happy with a 15% return this year, now is the time to celebrate and lock it in for 2019. It’s important to act quickly as the times can quickly change.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of River and Mercantile or TEXPERS. 

About the Authors:
Tom Cassara is a managing director in River and Mercantile’s New York office. In his role, he consults with institutional clients across the investment and actuarial spectrum. This includes defined benefit, defined contribution, not for profit and retiree medical. Cassara works with clients to bring his 30 years of experience across a wide range of institutional organizations to provide custom solutions. Prior to joining River and Mercantile, he was a senior partner with Mercer leading their U.S. East Wealth business in addition to providing strategic investment and actuarial advice to clients. He has consulted to organizations with less than $100M in assets to greater than $5B in assets. Included in his experience is working with corporate, not for profit, church, healthcare and endowments and foundations. He is a Fellow of the Society of Actuaries, an Enrolled Actuary, a CFA charterholder and has a Series 3 license.

Ryan McGlothlin is a managing director in 
River and Mercantile’s Boston Office. He serves as global head of Strategic Relationships as well as acting as the U.S. Chief Investment Officer. McGlothlin works with all types of institutional investors on customized investment and risk management strategies. He joined River and Mercantile Solutions in 2007 to found its U.S. business. Prior to that, he worked for Barclays in London, helping institutions to structure and execute derivatives transactions. He designed and executed some of the earliest interest rate, inflation and equity hedging programs for United Kingdom defined benefit pension plans. He began his finance career as an investment banker advising on capital raising and M&A transactions. Ryan has 20 years of financial services experience, with most of that time focused on institutional investment and risk management. He is a regular writer and speaker on investment and financial risk management issues. He serves on multiple firm investment committees, including the Global Investment Committee. Ryan also is active in the firm’s product development efforts. 

Modeling the Downside Case

By Linda Chaffin, Guest Contributor

Senior debt is considered the safest investment in the capital structure. Yet every loan has potential risks. Before investing with a private debt manager, it is important to understand how the manager evaluates risk and structures transactions, especially later in the credit cycle.

The loan due diligence process is known as “underwriting,” and its rigor can vary by manager. A strong underwriting process should include modeling downside scenarios to evaluate whether the borrower can generate sufficient cash flow to service debt, support ongoing operations and maintain an acceptable loan-to-value ratio.

How do lenders evaluate loans?

Cash flow lenders use qualitative and quantitative analyses to evaluate each loan opportunity. The qualitative analysis includes assessing the borrower’s competitive positioning, operations and market dynamics. The quantitative analysis includes assessing historical performance and the sustainability of prospective cash flows. As part of this, a best practice is preparing a detailed financial model with multiple scenarios including growth, baseline and downside cases.

Credit committees often focus on the downside case. If things go according to plan, there is generally little concern about loan recovery. If a situation deteriorates, recovery risk may increase.

Evaluating downside scenarios facilitates a constructive discussion about the borrower, quality of earnings, industry and an appropriate capital structure based on the risks inherent in the transaction.

Building a downside case

Creating a downside model begins with identifying a variety of negative events that could affect a company and/or its industry and result in the borrower generating less cash. These might include a recession, loss of a major customer, product obsolescence, new regulations, change in the competitive landscape or lack of expected synergies.

A thorough model includes a five-year review of a borrower’s historical financial performance and five years of projections. A company’s inability to provide this data can be a red flag.

The downside case and investment decisions

Downside analysis helps lenders determine the appropriate amount of debt that will allow a borrower to support debt service and other liquidity needs in a variety of cycle and stress scenarios. It also allows a manager to proactively structure a transaction for protection.

One key financial metric that lenders use to evaluate debt service is the fixed charge coverage ratio (“FCCR”), which is typically calculated as EBITDA less capex, divided by interest + principal payments + taxes + sponsor management fees. FCCR should remain above 1.0x in the downside case after shutting off subordinate debt interest payments and management fees following a default. Changes in loan to value (“LTV”) is another metric that lenders consider.

Armed with an understanding of downside scenarios, a private credit manager should propose a capital structure that results in sufficient FCCR and LTV during a period of stress. This might involve structuring a transaction to include a higher initial cash equity contribution or a lower funded leverage.

Ultimately, a private credit manager’s commitment to detailed underwriting and prudent transaction structuring should result in lower defaults and higher recoveries, which can help offer investors stable returns throughout economic cycles or periods of stress.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of NXT Capital or TEXPERS. 

Linda Chaffin
About the Author:
Linda Chaffin oversees NXT Capital’s investor relations activities and fundraising efforts. She is actively involved developing and maintaining investor relationships across the institutional LP community, including insurance companies, public and corporate pension plans, foundations, endowments and consultants. Chaffin brings over 20 years of investor relations, fundraising, private equity, and M&A investment banking experience to NXT.

REITs and Interest Rates: A Positive Shift in the Market

By Calvin Schnure, Guest Contributor

There has been a decisive shift in REIT markets over the past six months, and investors would do well to take careful note of it. The relationship between REIT returns and long-term interest rates has turned positive again.

REIT share prices generally rise as interest rates increase during periods of strong economic growth. The positive relationship is because a more robust economy boosts REIT earnings and the value of the buildings they own, while interest rates rise due to the demand for credit (and possibly inflation). The relationship tends to turn negative, however, when the Fed is tightening monetary policy, because the policies leading to the higher interest rates often slow the economy, which has a negative impact on earnings.

Click image to enlarge.

There have been extended periods over the past two decades when REIT stock returns and interest rates mainly moved in the same direction. Chart 1 shows the correlation was positive from 2001 through early 2004, and again from 2008 through the beginning of 2013. There were several shorter periods when the relationship was positive, for example, during most of 2016.

The periods with a negative relationship—that is, REIT share prices tended to fall on days that interest rates rose—follow a distinct pattern. From 2004 through 2006, the Federal Reserve was steadily raising its target for short-term interest rates, removing the monetary stimulus that had helped the economy and real estate markets recover from the 2001 recession; REITs responded negatively to rising rates for most of this period.

Similarly, following Ben Bernanke’s testimony on Capitol Hill in May 2013 that the Fed planned to end its purchases of long-term Treasury securities and mortgage-backed securities (often dubbed the “Taper Tantrum”), the relationship between REITs and rates once again turned negative. And while the relationship was positive for much of 2016, a period when Fed monetary policy was widely viewed as being on hold, the negative relationship returned around the time that the Fed began raising interest rates.

The period of negative responses is significant because it contributed to REIT underperformance relative to the S&P 500 and other broad market aggregates during the past few years. That’s why the Fed’s comments that their target for short-term interest rates will remain around current levels, and the return to a positive relationship between REITs and interest rates, is favorable for REIT investors.

Click image to enlarge.

Indeed, recent stock market performance of REITs confirms the importance of the new interest rate environment. REITs delivered a total return of 17.2 percent in the first three months of this year. With underlying momentum in the U.S. economy and solid REIT earnings, the outlook for the remainder of the year looks bright.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Nareit or TEXPERS. 

Calvin Schnure
About the Author:
Calvin Schnure is an economist and senior vice president for research and economic analysis at Nareit, where he is responsible for conducting a broad range of research and analysis on the real estate investment trust industry, the broader commercial real estate market and the economy and capital markets. He joined Nareit from Freddie Mac, where he was economic adviser to the CEO and, earlier, director of economic analysis, supporting management’s decision making with analysis of key trends in the housing and mortgage markets.

Best Practice in Money Manager Search and Review

By Albert Reiter, Guest Columnist

The days following the issue of an RFP, the loads of boxes sent by respondents might seem to be an inevitable part of your office interior for quite a while. In fact, it is just as avoidable as keeping your savings in a mattress instead of opting for an online bank account.

Due to simplification of the search process using digital technologies on investRFP, pension funds can conduct multiple RFPs and money manager reviews at the same time with ease. The platform was invented to support best practice implementation in the RFP and money manager Peer Group Review process, thus increasing the time- & cost-efficiency through advantages listed below.

Key benefits:
  • unbiased access to the money manager universe (1700+ companies connected; no investment advice/management on our part);
  • most up-to-date money managers’ responses only to the questions asked by the request issuer, avoiding database constraints, costs and obsolete information;
  • easily customizable industry questionnaire templates for optional use;
  • automatized ranking calculation based on request issuers' weightings & scores;
  • optional evaluation of responses on issuer team level (staff, investment committee and board members);
  • comparison of all answers to a particular RFP or Peer Group Review question in one go;
  • message system on Request level to communicate with money managers within the communication period defined by the Request Issuer;
  • customizable one-click standard reports (e.g. tables of aggregated key data, performance and risk parameters, fees, etc.);
  • optionally add colleagues or invite external advisors to join the team for a specific Request;
  • RFP/Peer Group Review data availability online anytime and anywhere;
  • all investRFP services are free of charge for Request Issuers. Managers are charged a standard 300$ fee per Response.
How does it work for pension funds and investors?

STEP 1: Create a Request. Once the pension fund has determined its unique search requirements, the fund and optionally the consultant can start a Peer Group Review, followed by a concrete RFP. If an ad hoc RFP fits the needs better, the same process applies. The platform can be used for any type of legal structure, asset class, data format and pension fund size.

STEP 2: Submit Request. Over 1700+ money manager companies in 68 countries will be notified by the platform, except for the ones which were specifically excluded by the request issuer on the level of the particular request.

STEP 3: Analyze Responses individually or as a team, using diverse scoring features and weightings set by the evaluation team.

STEP 4: Confirm the shortlist and provide feedback to money managers. The platform can be used until the shortlist submission which represents the last step on investRFP. We don’t intervene at any stage of the search process.

The flexibility of the platform has proved itself supporting prominent institutional investors in Europe and lately also in Texas, thus fostering best practice implementation, as well as simplifying the portfolio review and RFP process. Frequent portfolio reviews conducted in a structured way improve the overall efficiency of fund management, enabling the fiduciary duty aware pension funds to optimize their search method at no additional cost.

About the Author:
Albert Reiter, CFA, is the CEO

Looking Beneath the Hood

A Closer Look at Factor Investing

By Kent Huang, Guest Columnist

Factor investing, particularly within the scope of risk premia strategies, has been a popular topic. Vanguard has convinced the investing community that beta can be achieved by buying passive indices and the cost of owning beta should be very low. Investors use risk premia strategies as a source of generating alpha. But....are people looking carefully enough when evaluating these strategies? Much gets hidden in broad risk and return statistics. We thought we would take a deeper dive into how factors behave over market cycles.

Factor investing is built on the premise that excess returns to stocks can be had by buying stocks that exhibit the factor and shorting those stocks that do not. To test the theory, a factor strategy is back-tested over a sufficiently long historical period and the excess return of the factor over the period is shown along with some statistical information on the robustness of the factor. For example, using the Fama/French 3 Factor monthly data on Professor Kenneth French’s website, since July 1926 the HML factor (High book value to market capitalization stocks versus Low book value to market capitalization stocks, ie. the value factor) exhibited an annualized 3.8% excess return over the entire period. Since 1963, the HML factor exhibited an annualized 3.5% excess return over the entire period.

However, excess returns from factors are not stationary, a reality that isn’t clear enough by looking at one number over an entire historical period. Like most investment strategies, excess returns from factor investing go through cycles, periods where the excess returns are quite good and periods where the excess returns are not good at all.

Using the HML factor again, over the historical period available, the annualized rolling 5-year excess return of the factor ranges from up 18% to down 8%, with most observations occurring in the +12.5% to -2.5% range. While not shown here, you also see the variability of the HML factor’s excess return in both shorter (e.g. the annualized rolling 3-year excess return) and longer (e.g. annualized rolling 10-year excess return) periods.

Furthermore, there is hardly any relationship between the rolling 12-month excess return of the HML factor versus the direction of the general equity market (less the risk-free rate or more precisely, the equity risk premium) over the same period. This means that the ex-ante alpha of the value factor should not necessarily be correlated to the equity risk premium return in any 12-month period since there is very little ex-post relationship between the two.

While the benefit of using a single statistic of annualized excess return over the entire historical period is in its simplicity, a more relevant metric would be the distribution of the annualized rolling returns during the historical period as shown here:

From this distribution chart, you see that over the history of the HML factor, the excess returns of the factor in any 60-month period is usually between 0% to 9% annualized and the distribution of returns is positively skewed. However, there have been periods where the annualized excess returns of the factor have been negative and a few quite negative.

Quantitative investing strategies are built on testing a strategy over a historical period. The performance of the strategy is typically quantified by the return during the period, the volatility of the return stream, and a risk-adjusted return of the strategy. While this information is relevant, it may be biased by the starting and ending dates used in the analysis. As such, adding a distribution of returns helps an investor frame an appropriate expectation of the performance of the strategy, particularly for out of sample returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Mount Lucas Management or TEXPERS. 

About the Author:
Mount Lucas Management is a Newtown, Pennsylvania-based investment management firm specializing in innovative alternative investment strategies for institutional investors that enhance and diversify traditional portfolios. Kent Huang is a portfolio manager for the firm’s MLM Focused Large Cap Value strategy and the Chief Risk Officer for the firm. In these roles, he focuses on market and portfolio risk and quantitative equity research. Huang joined Mount Lucas in 2008 and became a partner in 2015. Prior to joining Mount Lucas, he worked at Goldman Sachs. Huang graduated cum laude in 2001 from Rutgers University with a bachelor's degree in Finance and is a CFA charterholder and certified FRM.

Drilling Down for Diversification: 

Diagnostics help investors see beyond the asset-class level through a factor lens, identify unintended risk


By Nicholas Savoulides and Jacob Borbidge, Guest Contributors

Asset owners and their managers are always striving for a portfolio that, on the whole, is greater than the sum of its parts. That’s a driving force behind the quest for diversification – a portfolio, viewed holistically, that has less risk than its individual components. Often, conversations about diversification begin and end at the asset class level. Today’s investors, however, have the opportunity to create a clearer, truer picture of diversification.

Asset-class level diversification remains important and cannot be ignored; however, diversifying across common attributes of securities within each asset class is now possible, due in part to factor-based analytics. Today we have a much more robust set of factors available that are investible, both on the equities and fixed-income side – think long-only, long-short, commodities, and alternative asset classes, for example. With a broader set of tools that can be implemented into portfolios, we can think about diversification at a deeper level and add the lens of factor diversification to the overall portfolio construction equation.

When factors are employed, an investor can assess a portfolio for value (to pick a factor) across the entire asset allocation, opening up new avenues that can reduce the correlation of strategies within the portfolio even further. That’s really the end goal of diversification – to drive down the average correlation within your portfolio by selecting investments that behave less like other investments in the portfolio. As long as you continue to include assets with lower correlation to existing investments, you’re going to increase diversification.

Investors’ goals are the starting point

One way of thinking about achieving diversification by using factors and related diagnostics is to compare asset allocation to complex surgery. The first thing a surgeon takes into consideration before planning the procedure is a simple question: What is the desired outcome? Investors typically have clear goals, and once those are identified, factors are the foundation upon which we start building the most appropriate solution to best achieve the metrics that the client is trying to maximize. Maybe the goal is to reduce the funding ratio volatility. In that case, as we’re calculating the risks and trying to see how we’ll best achieve the desired outcomes, we use the appropriate tools and analytics to perform the diagnostic. To the investor, factors sit behind the scene in this process, but they allow us to be more precise in our calculations, and to propose a solution that is much closer than if we stopped at the asset-class level.

Factors provide additional color in terms of expectations. Let’s say an asset owner has an equity-heavy portfolio and believes they are positioned to do well in a strong equity market. Factor analysis may show they are heavy from a defensive factor-exposure standpoint ­– so in fact, if equities win, they may lose. With the additional factor lens to assess their portfolio we can say, ‘Here's what you expect to happen; here’s what analytics show—are those two things aligned?’ That sparks the discussion of how to pivot and create alignment. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Invesco or TEXPERS. 

About the Authors:
Nicholas Savoulides
Jacob Borbidge

Nicholas Savoulides is the head of global solutions research and portfolio analytics at Invesco. In this role, he works with internal and external audiences to set the firm's solutions research agenda and develop solutions-enabling capabilities. Savoulides' team efforts span the pillars of portfolio analytics, strategic asset allocation modeling, and framework and tool development. Prior to joining Invesco in 2016, Savoulides spent nine years with Loomis Sayles, where he led the company's liability-driven investing solutions initiative while serving as a portfolio manager on several long-duration fixed income strategies. He has also worked as a consultant with The Boston Consulting Group. He earned his bachelor's degree, master's degree and doctorate in aeronautics and astronautics, with a minor in finance, from MIT. He is a Chartered Financial Analyst charterholder and is a member of the Boston Security Analysts Society.

Jacob Borbidge is a portfolio manager and the head of research for the Invesco Global Solutions Development and Implementation team, which provides customized multi-asset investment strategies for institutional and retail clients. In this role, Borbidge is responsible for directing the research and portfolio implementation efforts of the team’s investment process. This involves setting the research agenda, defining portfolio implementation methodology, and providing in-depth presentations of the investment process to internal and external teams. Previously, Borbidge spent 10 years as an analyst for the Invesco Global Quantitative Strategies team. Prior to joining Invesco in 2004, he was a mechanical engineer with ExxonMobil. Borbidge earned a bachelor's degree in mechanical engineering from Lehigh University and a master's degree in finance from the University of Houston. He is a Chartered Financial Analyst and Chartered Alternative Investment Analyst charterholder, and he regularly lectures on the topic of quantitative finance for the graduate program at the University of Houston.

Bad Investment Habits Can be Detrimental to Your Plan’s Financial Health

Photo by from Pexels.

By Christopher McDonough, Guest Contributor

Avoiding bad habits is an important part of life. An unhealthy diet, lack of exercise, and not getting enough sleep can negatively impact your well-being. Similarly, bad investment habits can negatively impact your plan’s investment returns. 

Allowing human emotion to interfere in the investment process

One of the most common pieces of investment advice is “buy low, sell high.” However, when we allow emotion to impact investment decisions, we are more likely to “sell low and buy high”. Markets can experience periods of decline, which can be painful for investors. For example, while the S&P 500 produced a positive return in approximately 75% of calendar years since 1980, the average intra-year decline for the index during this period was -13.9%. Investors that maintain a long-term outlook supported by a robust investment policy are more likely to avoid making emotional decisions and have been rewarded with strong cumulative (+6,512%) and annualized (+11.4%) returns since 1980 despite periods of steep negative returns.

Attempting to time the market

Given the frequency and magnitude of declines in equity markets, investors might be tempted to seek to avoid those declines by shifting portfolio allocations in advance of anticipated negative events. In reality, market timing strategies rarely work, and these strategies can have a significant adverse impact on an investor’s portfolio. Over the last 20 years, the S&P 500 has produced an annualized return of 5.6%. If an investor missed just the ten best days over the last 20 years (just 0.2% of all trading days), most of the positive performance would have been eliminated. Missing the 20 best days would have resulted in a negative return. Investors are better served by remaining invested with a diversified asset allocation designed to meet their objectives over the long term.

Failing to rebalance

As market returns fluctuate, portfolio allocations are likely to deviate from approved target allocations. These deviations can become significant over time and, if not proactively addressed, can be a drag on portfolio returns. A simple portfolio with a beginning allocation of 70% public equities and 30% fixed income would have produced an annualized return of 5.3% over the last 20 years if it were not rebalanced. However, if the portfolio had been rebalanced back to target when the allocations deviated by more than 5% from the target allocation, the return would have increased to 7.4% over the same period. A robust rebalancing strategy allows investors to take advantage of market volatility and removes emotion from the decision-making process. It also forces investors to “buy low and sell high.” 

Churning investment managers

Most plan sponsors would gladly hire an investment manager if they knew that manager would be a top quartile performer over the next ten years. However, it is common for all investment managers to experience periods of underperformance, even if their long-term track record is strong. For example, 74% of the large cap equity managers in the top quartile for 10-year returns have had at least 1 year in the bottom quartile. For U.S. small cap managers, it increases to 89%. A plan sponsor who terminates a manager after a relatively short period of poor performance is unlikely to reap the benefits of their long-term strong performance. In addition, transitioning from one manager to another can cost as much as 1% of assets due to trading costs. When evaluating investment managers, it is important to analyze their performance over multiple timeframes with a particular focus on long-term performance. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Investment Performance Services, LLC or TEXPERS. 

Christopher McDonough
About the Author:
Christopher McDonough is chief investment officer and a senior consultant at Investment Performance Services, LLC. He is responsible for developing and implementing investment policy for the firm. In addition, he works on all aspects of client funds including investment policy formulation, asset allocation strategies, performance monitoring, and manager searches. He serves as chairman of the IPS Investment Committee and a frequent speaker at educational conference. McDonough's manager research responsibilities include multi-asset allocation strategies and private equity.

A New Volatility Regime?

By Mark Shore, Guest Contributor

From speaking at conferences and teaching workshops, I’ve noticed increased volatility conversations as investors are asking if we entered a new volatility regime. It helps to understand how equity volatility from a historical perspective behaved as it cycled across various economic environments. Over the past year, a few of my volatility studies relative to the VIX (US) and the VSTOXX index (EU) examined historical volatility and its relation to the current environment.

VIX and VSTOXX volatility indices are defined as implied volatility 30 days forward and are frequently negatively correlated to their respective underlying equity indices (S&P 500 and EURO STOXX 50 Index) as they tend to rally when equity markets decline; hence they represent negative or “bad” volatility. The price is the volatility for 30 days and then annualized. For example, VIX at 15 is the annualized standard deviation. The bottom range of the VIX is 10 to 12 with resistance often found in the 17 to 23 area.

Between January 1990 and April 24, 2019, the VIX spot index closed below 10 on 68 days during six calendar years. 2017 accounted for 76% of those days as noted in Figure 1. The lows tend to occur at the end of the year and the beginning of the next year. However, 2017 experienced closes below 10 in eight months, which carried into January 2018.

Figure 1 Frequency of Days when the VIX spot price closed below 10

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Source: Bloomberg data as of 4/24/19

The preceding five years before 2017 and the two years following, once again demonstrate 2017 as an anomaly regarding low volatility. First, the maximum VIX price of each year is usually in the 20s or higher, as noted in Figure 2, while 2017 was just above 16. The minimum of each year has a smaller dispersion between years. However, in 2017 and 2018 were slightly above 9. January 2018 experienced the low just before the correction in early 2018 or as I call it the “compressed spring effect.” The 2017 spread between the yearly high and low stands out because it measured a compressed volatility spread of 6.9, a reduction of at least 50% or more relative to other years.

Figure 2 is the maximum, minimum, spread between max and min and the median price of VIX for each year

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Have the equity markets moved into a new volatility regime? The data suggests the markets haven’t transitioned into a new regime but have reverted into a more “normalized” environment. Higher elevations of downside volatility along with increased volatility spikes imply potential ongoing turbulence and reviewing a portfolio’s tail risk management.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all Coquest Advisors LLC or TEXPERS.

About the Author:
Mark Shore is director of educational research at Coquest Advisors LLC in Dallas. He has more than 30 years of experience in alternative investments, publishes research, consults on alternative investments and conducts educational workshops. Shore is also an adjunct professor at DePaul University's Kellstadt Graduate School of Business in Chicago where he teaches a managed futures / global macro course. He is a board member of the Arditti Center for Risk Management at DePaul University. Shore is a frequent speaker at alternative investment events. He is a contributing writer for several global organizations including the Eurex Exchange, Cboe, Swiss Derivatives Review, ReachX, and Seeking Alpha. Before Coquest Advisors, he founded Shore Capital Research, a research/ consulting firm for alternative investments. Shore received his MBA from the University of Chicago and is currently a doctoral candidate.

The Rise of BBBs: To Worry or Not to Worry?

By Dario Buechi, Guest Contributor

Over the last year or so, the growth of BBB-rated debt as a percentage of the overall investment-grade corporate bond market has sparked significant debate among investors. The key issue: the implications to the fixed income market should bonds at the lowest rung of the investment-grade ladder be downgraded.

Background: There are two distinct sections of the corporate bond market, based on the assessments produced by agencies that rate bonds:
  1. Investment-grade segment: composed of less risky bonds issued by corporations with a high probability of paying interest and returning principal to debt-holders
  2. High-yield segment: also known as “junk bonds,” composed of riskier securities issued by corporations with a higher probability of the issuer failing to make an interest or principal payment
Demarcating the two segments is the BBB rating, which indicates the highest level of risk in the investment-grade spectrum. Thus, a whole notch downgrade from BBB to BB moves an issuer’s status from investment grade to high yield. These “fallen angels” experience a material drop in price for the same bond in order to compensate investors for the additional risk while increasing the borrowing costs for the company. The new high-yield rating also shifts market access to a different set of investors. These changes are key pieces of the current discussion.

Much of the growth in the BBB market occurred following the Global Financial Crisis (GFC), when the U.S. Federal Reserve cut interest rates to nearly zero and introduced quantitative easing. These accommodative monetary policies brought about historically low costs of borrowing that incentivized U.S. companies to issue record amounts of debt, while also pursuing significant debt-funded M&A deals. The access to cheap funding led to a sharp rise in the amount of investment-grade U.S. corporate debt issued, from $1.7 trillion to $5.1 trillion, according to Bloomberg Barclays, between 2006 and 2018. BBBs as a percentage of the Bloomberg Barclays US Corporate Investment Grade Index grew from 35% to 51% during this same period.

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Source: Bloomberg Barclays

With the slowing U.S. economy posing challenges to companies, scrutiny about this market has risen significantly. The key concern: Can these BBB-rated corporations retain their investment-grade ratings? And, if not, what impact will a large number of fallen angels have on credit markets?

The Arguments 
On one side, there are investors increasingly worried about the weight of BBBs and the ability of the high yield market to absorb a wave of potential downgrades. They argue ratings agencies have been lenient on corporations that have not followed plans to reduce their borrowings as the economy recovered from the GFC. Now, amid a weakening U.S. economic backdrop, these corporations’ diminished credit servicing abilities could lead to a wave of downgrades when rating agencies tighten their rating standards. Due to the current size of the high yield market ($1.2 trillion, according to Bloomberg Barclays), these investors argue that such downgrades could not be absorbed without triggering decreases in bond prices throughout the ratings spectrum, including investment grade. Furthermore, there are multiple BBB issuers that would, if downgraded, each represent more than 2% of the Bloomberg Barclays US Corporate High Yield Index, exacerbating their concerns about the ability of the market to absorb this potential new supply.

On the flip side, other investors argue that the likelihood of such an event is overblown, and the characteristics of the BBB market do not foreshadow a wave of downgrades. To start, the largest industries in the BBB market as a percentage of market value are Financials (12%) and Consumer Non-Cyclical (10%). After the GFC, rating agencies changed their methodology on how they viewed Financials and downgraded many large entities into the BBB bucket. However, they say, these companies are arguably better capitalized with healthier balance sheets post-GFC, and they may likely see credit upgrades rather than downgrades. Issuers in the Consumer Non-Cyclical industry have also been historically more resilient in times of economic slowdown due to their stable cash flow and lower sensitivity to discretionary spending.

In addition, proponents cite the historical reluctance by ratings agencies to downgrade issuers to below investment grade, as well as the actions available to issuers in order to increase their credit servicing ability. Such actions include cutting dividends to equity shareholders, reducing operating expenses, and selling non-essential assets. It is also argued that corporations have substantial incentives to stay investment grade given the significantly higher marginal costs of borrowing and lower demand from a smaller base of investors if their debt fell to junk levels.


Irrespective of which side offers the most compelling argument, the record size of the corporate bond market and the growth within it of BBB-rated securities mandates that fund sponsors assess their exposure in this asset class and how either scenario would impact their portfolios. It is also imperative that fund sponsors understand their managers’ viewpoints in regards to this asset class. After a 10-year bull market, the next 10 years may require investors to continue their stringent due diligence in order to minimize unwanted volatility.

The views expressed are those of Callan and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

About the Author:
Dario Buechi is a senior analyst in Callan’s Global Manager Research group. His role includes the quantitative and qualitative analysis of investment managers and the compilation of detailed research reports for clients and the Manager Search Committee. Prior to joining Callan in September of 2017, Buechi was an investment consulting intern at Fidelity Investments. He earned a bachelor's degree in Business Administration with a concentration in Finance from Cal Poly San Luis Obispo. He is a Level II Candidate in the CFA program.

The Resilience of Class B Multifamily Housing

By Michael Chesser, Guest Contributor

With asset values considered high and being late in the cycle, is Class B multifamily going to have a correction or move to higher valuations? This is an interesting question an investor should have of all asset classes. The following facts highlight how demand exceeds supply contributing to the exceptional resilience of Class B multifamily housing:

  • The asset class has demonstrated persistent demand throughout the economic cycle. During strong economies and the deepest recessions, Class B multifamily occupancy rates have ranged from a high of 98% to a low of 90% in all markets across the country—a record unmatched by other real estate assets such as Class A multifamily, office or retail.
  • It is predicted that the U.S. will need 4.5 million new apartments between now and the year 2030. It also is expected that at our current rate we will only supply 2.5 million apartments, leaving undersupply of 2 million units.
  • Recent Goldman Sachs research shows that while a high-end supply glut is exerting downward pressure on the high-end market, vacancy rates in Class B nonetheless remain low and falling.
  • Diverse demographic and economic trends―rising interest rates, retirees attracted to the ease of apartment living and millennials unable to buy a home in the current market―have combined to create what the Urban Land Institute has called "a firehose of fundamental demand for rental apartments, which only shows signs of strengthening."
All these factors contribute to mitigate risk for investors in Class B multifamily. Effective managers can further mitigate risk through diverse strategies to generate efficient and smooth operations at the property level. Class B multifamily, as a main component of workforce housing, will be in high demand regardless of changes to the economic cycle. Working Americans want to live in clean, professionally managed housing that is close to work. The laughter of children at the pool or playground and the happiness of families that live in our apartment complexes is one reward of providing these hard-working Americans a place to call home.

Another reward is the return on investment we need to serve the beneficiaries of the pensions for which we work. The qualities mentioned above of “effective, efficient, mitigate risk, and high demand” all contribute to consistent and predictable investment returns. 

Return on investment for our beneficiaries, and a great place to live for our tenants; both great byproducts from the resilience of Class B multifamily.

  • Our Vision for 2030, Urban Land Institute and PricewaterhouseCoopers, June 2017.
  • The Case for Workforce Housing, CBRE, November 2018. 
  • Tale of Two Markets: High-End Apartment Supply and the Inflation Outlook, Goldman Sachs, September 2018.
Related sources can be found in the RESEARCH section of Aii's website;

The views expressed are those of Apartment Income Investors and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

About the Author:

Michael Chesser
Michael Chesser is president and founder of Apartment Income Investors.

Looking Forward,  Looking Back:  10 Charts After 10 Years

Report contributed by Alliance Bernstein

Just over a decade ago, global markets began to recover from the biggest shock in postwar history. In these 10 charts, we aim to show how much has changed since then and how market conditions over the past decade may influence big changes that are beginning to day.

Even as financial markets have rallied in early 2019, uncertainty is still in the air today. Macroeconomic growth, corporate debt, central bank policy and geopolitical risks are all adding to the anxiety. The roots of today’s market conditions can be traced back to the global financial crisis (GFC), the subsequent recovery that began in March 2009 and surprising developments around the world since then. For investors to overcome market challenges and position themselves in today’s complex environment, they should start by taking a closer look at some of the massive changes that have reshaped the financial world we live in today.

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After the GFC, extremely accommodative monetary policy lowered market volatility, culminating in an exceptionally calm year in 2017. In 2018, volatility returned to global equity markets and is widely expected to continue this year. Turbulent markets can be unsettling for investors, but also provide more opportunities for active managers to generate returns.

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Voters around the world are increasingly turning to populist parties, rejecting mainstream ideas and institutions that have underpinned stability for decades. A blizzard of political risks, from Brexit to trade wars, adds new challenges for economic growth and investors.

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Greater scrutiny of environmental, social and governance (ESG) factors has gained significant momentum over the past decade, and is becoming an essential ingredient for building responsible investing portfolios. Some countries are further along than others, but the trend is clear.

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Surging production of US shale oil is making the US less dependent on global oil supplies—and has pushed down oil prices in recent years. But US oil only makes up 15% of global supply, so conventional projects may still be needed in the coming years.

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In both the US and Europe, low interest rates have fueled corporate leverage, and the quality of debt has deteriorated. Caution is paramount as quantitative easing turns to quantitative tightening. Selective fixed-income investors can find opportunities in companies with lower-rated debt that have solid fundamentals. For equity investors, it’s important to pay close attention to debt levels and credit ratings when selecting stocks.

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For the last decade, historically low interest rates spurred corporate borrowing around the world. But in 2018, stocks of US companies with higher debt levels underperformed low- leverage stocks as interest rates began to rise. In Europe and Japan, leverage didn’t matter much—but that could change if rates start to rise from near-zero levels.

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While China’s economic slowdown grabs headlines, the changing composition of its economy will reshape its future growth path. Exports are becoming less important while the domestic retail industry gains dominance. These trends will create new opportunities, and new risks, as the onshore stock market opens to foreign investors.

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The US deficit typically narrows when unemployment falls. But in recent years, the deficit has kept widening even as unemployment declined. This reflects an unprecedented public spending spree that could have unintended consequences for the stability of the world’s largest economy down the road.

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Low interest rates around the world since the GFC have incentivized borrowing. Global debt reached approximately US$178 trillion by 2018. China, the US and many other nations have added to their debt burdens over the past decade. Massive debts and stretched balance sheets could be dangerous if financing conditions tighten.

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Investors have continued to move their money into passive investment funds that track an index, in both equities and fixed income. While passive funds are cheap, they aren’t risk free. As major imbalances around the world begin to unwind, we believe active investment portfolios are essential to help investors navigate the risks and capture return potential.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.

MSCI makes no express or implied warranties or representations, and shall have no
liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.