Investment strategy and style drift: Mind the gap?

Investment strategy and style drift: Mind the gap?

What’s the difference between systematic and mechanistic processes in complex systems? When it comes to investments, this is how we define it at KlarityRisk:

Systematic is a process dictated by principles of implementation (i.e. to provide guidelines that repeatedly conform with predetermined rules), applied in the same methodological way through time.

Mechanistic is a process that strictly abides by specific rules that aim to provide an austere framework of automation, without much inherent adaptability versus a system’s error tolerance.

Subjectively speaking, systematic emits a sense of critical thinking and mechanistic feels restrictively impersonal.

Investors aim to select a mix of available assets that reflect both their risk/return profile over time and their future lifecycle goals. Therefore, asset allocation models can be created using methodologies of varying mathematical complexity and implemented via an optimized combination of active (seeking skilled alpha) and/or passive (tracking market beta) investment styles.

The ultimate purpose of the process is to create a portfolio with the highest possible diversification that maximizes its risk-adjusted returns.

In the asset allocation process, geography, asset class, sector, and security must each be assigned upper and lower bounds for the portfolio weights, according to the criteria set with the client. This ensures that portfolio parameters lie within the ranges initially agreed and that the portfolio does not gradually divert from its targeted goals and cause a style drift.

The asset allocation mix is then updated at frequent time-steps (which vary in length depending on the type of the investment strategy), to bring the weights in line with the pre-agreed value ranges over time.

In this blog post, we address only style drifts caused by over-/under-weighted positions that fall within the agreed investment strategy. We do not address style drifts that happen due to managers drifting from their course by allocating capital to assets outside the scope of the mandate in an effort to chase returns.

Admittedly, this may be an unrealistic assumption, considering the ever-increasing pressure managers are under to create short-term returns that are at par or better than their indexed benchmarks.

In market regimes characterized by persistent upward or downward price moves, a style drift in a portfolio can occur simply because of the emerging price fluctuations of positions, especially for buy-and-hold strategies. A style drift may also be caused by active fund managers who have the leeway to deviate from their stated benchmarks, as permitted by their investment policy mandates.

Are all types of style drifts from the investment guidelines damaging to investors? Should they always be dealt with by immediate and strict reversion to the permitted benchmarks?

The answers may lie on the boundary between the systematic and mechanistic approaches to investment management. More specifically, the manner that a risk compliance officer of a pension fund perceives a diversion from the stated limits of an investment strategy is qualitatively different from that of an investment advisor or a hedge fund manager.

In the former case, strict compliance to the regulatory constraints set from the relevant financial authority is important to protect investors.

In the latter case, the focus of the process is the maximization of risk-adjusted returns via the adaptation of the portfolio parameters in a manner that may often exhaust the limits of flexibility allowed by the investment mandate.

A position’s under- or over-weighting should be assessed based on the impact that it has on the overall portfolio risk. While trying to chase returns, managers may overlook the alternation of a portfolio’s asset decomposition and end up with a blend of highly correlated styles and increased risk exposures. The hunger for short-term gains based on concentrated positions can lead to the wrong investment style in diverse market conditions; managers should focus on long-term risk-cautious decision planning.

Theoretically, style drift occurs less often in exchange-traded funds than in mutual funds, because the former must closely track an index to adhere to its investment objective. Having said that, actively managed exchange-traded funds may experience a style drift too, as their managers may have the permission to deviate from the stated benchmark.

It’s important to differentiate between style drifts and the need to adapt a portfolio composition to evolving market conditions.

Persistent, substantial, and over-looked style drifts can render an entire portfolio unstable. However, no style drift at all can also be quite risky; investment philosophy and goals change over time, as do risk profiles.

Well-performing assets with strong macro-economic, fundamental, or technical characteristics that end up with slightly higher weights than initially allocated should be re-balanced in a systematic (not a mechanistic) manner. Mechanistic rules for cutting losses or booking gains may make life simpler and less demanding, but over-protection and lack of a Darwinian adaptability may lead to long-term damage and intellectual laziness.

Some natural drifts may occur over time if the proper tools are used to identify and quantify the portfolio risks introduced by these drifts. As mentioned earlier, managers should systematically follow general principles and guidelines and not just obey numerical rules in a vacuum.

Various investor surveys indicate that market volatility from political, geopolitical, or macro-economic uncertainty is the main threat to sustainable wealth creation. Investors should ensure that a solid and adaptable risk measurement framework is in place. A combination of risk analytics should be used to monitor the gap between the current asset allocation and the allocation determined by the investment policy at each point in time to evaluate the ramifications of any spread-widening on the portfolio risk.

How quickly and to what extent such gaps should be rectified may be a balanced act of continuous risk assessment and stress-testing and the adaptability to emerging economic conditions and market perceptions.

 

Posted on January 31, 2018Yannis Sardis