A transparent ‘quantamental’ manager

Originally published in the October 2016 issue

THEAM’s award-winning funds are based primarily on its distinctive interpretation and application of academic research, and its proprietary research, into areas including anomalies around behavioural finance. THEAM belongs to one of Europe’s largest asset managers, BNP Paribas Investment Partners (BNPP IP), which manages over €530 billion, across around 20 groups with structures ranging from internal units to autonomous groups and partly or wholly owned subsidiaries, including THEAM, which manages around €38 billion. THEAM pursues predominantly systematic and quantitative, model-driven, investing, including indices and ETFs (branded as BNP Paribas Easy), multi-strategy quantitative approaches, factor-based investing, and ‘smart beta’.

THEAM’s alpha engines can be applied to long only, absolute return or hedge fund return objectives, in formats including UCITS funds, ETFs and structured products including some that can offer varying degrees of capital protection. THEAM’s asset split is roughly €15 billion in indices, €15 billion in model-driven and €8 billion in structured products. THEAM invests in all liquid asset classes: equities, fixed income, currencies, commodities and associated derivatives including volatility instruments.

THEAM was formed in 2011 as a merger between the Harewood Corporate and Investment Banking (CIB) business, which developed quantitative strategies in an investment banking environment, and the SIGMA (structured, indexed and multi-alpha generation) products unit. Explains THEAM CEO and CIO, Denis Panel, “Harewood had emphasised options, asymmetric strategies and faster trading strategies while SIGMA had focused on more traditional quantitative models such as value and low volatility. With no overlap between the two it made sense to combine all teams.”

THEAM’s investment philosophy and process
“Catching the behavioural biases” is part of THEAM’s investment philosophy along with a seasoned judgmental approach, explains Panel, who is a Professor of Asset Management on the MBA programme at HEC in Paris. THEAM’s investment philosophy is explained on the BNP Paribas Investors’ Corner website. Head of Quantitative Management, Etienne Vincent, is one of the 85 (and counting) of those who have written blogs for the site.

We mainly focus on equity investing to highlight THEAM’s perspective on markets. Decades of research, starting with Fama and French, has identified seven important factors for equity markets as being growth, value, size, momentum, low volatility, dividends and quality. THEAM has prioritised four of these as being more practically investible: low volatility, value, momentum and quality (the size, or small cap, factor for instance can run into liquidity constraints.)

Philosophy remains a compulsory part of the French educational curriculum for Baccalaureate students, so it is no surprise that, in one blog, Vincent draws analogies between these factors and Plato’s cardinal virtues of prudence, justice, courage and temperance/moderation. Vincent explains why value is analogous to justice; momentum approximated by temperance; quality is analogous to fortitude/courage; and the low volatility factor is seen as parallel to the prudence virtue.

THEAM sees “cognitive and emotional biases” as the source of these factor returns. For instance, momentum is driven partly by herd behaviour; the low volatility anomaly arises partly because humans are overconfident about predicting the future and ascribe unrealistic probabilities to lottery type events; while value and quality work in part because investors over-emphasise more resonant emotional considerations and overlook more abstract financial data.

The four factors are usefully combined in portfolios because they are lowly or negatively correlated to one another, over long lookback periods. Value and momentum, and quality and low volatility, have been negatively correlated while the other pairwise correlations are small and positive. Thus Vincent argues that some of these four factors help to correct weaknesses in others – for instance heeding momentum can help to avoid some value traps.

The debate over whether factors can be timed continues to rage on. THEAM does not hold an extreme stance on the topic but rather approaches it from a different angle. While Vincent does not think it is impossible to time factors, THEAM’s research suggests that certain factor alphas are highly correlated with market direction. If quality and value do best in bull markets while low volatility and momentum perform best in bear markets, it would be simpler and cheaper to make a directional call rather than incurring the transaction costs of rebalancing portfolios amongst hundreds or thousands of stocks. But THEAM’s factor-based products are not in fact making such calls. THEAM maintains balanced weightings to the factors and takes a long term view. For Vincent, perseverance pays off – so he is not about to capitulate on the value factor just because it has been unfashionable for many years.

A few years of underperformance does not contradict decades of evidence for THEAM. But alpha decay due to overcrowding can be an issue to address for any strategies based on historical analysis. Vincent argues that the long term factors employed by THEAM’s quantitative equity programmes – identifying prudent, profitable, trending and cheap stocks – tend to see fairly small alpha decay compared with some short term arbitrage approaches, but THEAM’s research process is nonetheless designed to ensure results are robust. Here Vincent prefers to apply an internal prudency factor (scaling down the information ratio by two) to in sample versus out of sample, rather than differentiating between back-test versus live. THEAM also requires models to have an ex ante rationale, to avoid the possibility that a strategy (such as buying companies whose names start with APP) could generate spurious results. Clearly, it is insights into human (and also monkey!) psychology that provide the rationale for behavioural finance biases.

Elements of discretion
Behavioural biases generally imply a systematic approach and some teams at THEAM, such as the Global Quantitative team (who run a product that won a THFJ performance award) are entirely quantitative, as are some asset classes, such as equity. But the Cross Asset Team mix quantitative approaches with selective use of discretion in some asset classes. In THEAM’s cross-asset strategies, there are seven strategies, of which three are fully systematic. They can include factor-based long/short equity investing; fundamental economic macro signals; and currency carry. Then four strategies combine systematic and discretionary inputs. They include global market timing where the manager decides whether to act upon technical signals; and a trend-following system where the manager again exercises discretion over whether and when to apply the signals. Discretion can also be an input into the portfolio rebalancing approach, where THEAM’s “ISovol” method uses recent volatility as well as some judgment, to determine asset class weightings and position sizing. Discretion can also apply to risk management. For instance, “We have a good track record of combining models with discretion, such as our use of options to hedge extreme risks in our cross asset strategy,” reflects Panel.

Volatility is the one constant
THEAM’s central risk management philosophy is that volatility is easier to forecast than expected returns (and indeed correlations where THEAM finds it hard to anticipate short term patterns and so uses more stable longer term correlations). THEAM uses GARCH techniques to forecast volatility and has found them to provide accurate predictions. All products have either a volatility target or a volatility ceiling. THEAM argues that maintaining stable volatility leads to outperformance because it implies downsizing exposure during higher volatility periods that are generally associated with lower or negative returns for most asset classes. On thistopic, THEAM relies on BNPP IP Financial Engineering methodology shared in the article by BNPP IP, entitled “Predicting the success of volatility targeting strategies: Application to equities and other asset classes”, by R. Perchet, R. Leote de Carvalho, T. Heckel and P. Moulin, published in the Journal of Alternative Investments in December 2015.

This so-called ISOvol approach may sound similar to risk parity, but the two are different. ISOvol aims to maintain constant volatility over time but, unlike risk parity, need not imply equal risk contributions from each asset class, which in turn entails the large (and often leveraged) allocations to government bonds that are seen in many risk parity portfolios. THEAM thinks that risk parity approaches would tend to perform poorly in a rising rate climate and THEAM’s multi-asset portfolios have lower weightings to bonds than a typical risk parity portfolio, a blog posting explains.

The risk process involves Panel, who originally trained as an actuary, validating all products and strategies, and monitoring the performance risk of all portfolios, including the risk budgets for each strategy. He can challenge teams in case of any breach and could enforce position closures if necessary. Additionally, Panel monitors concentrations of risk in multi-strategy products, and an overlay can be used to tone down any undesired concentrations. In total Panel has oversight of 400 products, of which 50 are model-driven funds, 100 are ETFs and 250 are structured products. We focus mainly on a selection of THEAM’s strategies that are of interest to hedge fund and absolute return allocators.

Factor investing for equities
THEAM’s equity strategies draw on strands from the financial engineering teams of both BNPP CIB and BNPP IP. Many quantitative and factor funds mention the same factors, but performance dispersion amongst these funds is wide for multiple reasons around timing, weighting, sizing and rebalancing, not to mention fund costs. And if we get back to first principles, the factors can be defined, and applied, in many ways. THEAM’s internal research determines how each factor is implemented. THEAM has 100 investment professionals including 60 fund managers and “We do not want to use external research as we have plenty of experience and research in this area,” Panel makes clear.
For instance, multiple metrics can be used to value companies, and THEAM emphasises cash-flow based measures. To gauge quality, accruals are one input used by THEAM as high accruals can be a warning signal for cash-flow delays or aggressive accounting or both. For momentum, the key variable is over what lookback period it is defined – because research shows that prices are more likely to reverse course than continue in the same direction over some periods.

The factor that THEAM finds most striking is the low volatility one, pioneered in 1972 by the late Robert Haugen, who later helped THEAM create some of the first factor funds in 1994. Vincent argues “the low volatility factor was being neglected as a hidden factor.” THEAM is distinguished by defining and applying this factor on an intra-sector basis. The most straightforward minimum variance approach, simply buying the lowest volatility stocks in the whole market, can look somewhat like a ‘bond proxy’ with high interest rate sensitivity that is avoided with THEAM’s ‘sector neutral’ approach. BNPP IP’s paper “Low-risk anomaly everywhere: Evidence from equity sectors” identifies the low risk anomaly as applying within sectors in both developed and emerging markets. THEAM selects the lowest risk stocks within each and every sector, rather than emphasising low risk sectors that tend tobe defensive ones (which in 2016 are valued at a premium to the market).

Vincent has sympathy with the suggestion that some low volatility stocks could be trading at “bubble” valuations, but THEAM’s models are not forced to own these “expensive defensives”. Low volatility is only one of the four factors and it applies within sectors. Though technology and financials are more volatile than the whole equity market that would typically be underweighted in the simplest low volatility strategy, THEAM’s Parvest Low Volatility strategy is often overweight of them. THEAM’s models can identify stocks within those sectors that are less volatile than the sector average. THEAM has also found that risk adjusted returns are enhanced by maintaining some exposure to all sectors, partly due to low correlations amongst low risk alpha per sector.

So important is the low volatility factor that THEAM has created the Low Volatility product range, based only on THEAM’s approach to this factor. The GURU™ range in contrast uses the other three factors: Quality, Valuation and Momentum. The DEFI (Diversified Equity Factor Investing) range uses all four factors. THEAM’s strategies are not “closet index huggers” and might own 300 stocks from the MSCI World’s 1,600, or 150 stocks out of the S&P 500.

The ‘GURU™’ range offers long only strategies split by region, while the long/short equity strategies are global (as is the long/short fixed income strategy). The long/short strategies are logically global as beta is not the objective, but “the GURU™ Long/Short strategy has a long bias that appeals to private bankers,” explains Vincent.

The DEFI approach can be accessed in long only or market neutral formats, which illustrates how THEAM aims to adapt alpha engines towards client appetites. If a low volatility equity mandate does not have enough beta for a client mandate, futures can be used to add it back. Equally, THEAM can create market neutral factor products by using indices on the short side to isolate the long book alpha. For instance, THEAM’s long/short product uses three short indices: the S&P 500, the Eurostoxx and the Topix. THEAM does not short single stocks, due to the costs of doing so, so the long book is the alpha engine.

Expanding the factor approach to multi-asset class, THEAM aims to apply smart beta as broadly as possible. Argues Panel, “barriers between asset classes, regions, styles, take away a lot of alpha from diversity of markets.” He “expects to see more and more factor investing in the hedge fund area as it creates value with lower costs.”

THEAM already has applied factor investing to multi-asset class products and fixed income. To this end Raul Leote de Carvalho of BNPP IP’s Financial Engineering department has developed innovative ways of combining alpha factors.

The equity factors will not necessarily be transplanted to other asset classes. Currency strategies include carry, as well as momentum as “it is not possible to apply a strict factor approach as currency markets are different,” observes Panel. Different factors, revolving more around contango, backwardation, roll yields and cost of carry, apply to commodity markets. THEAM is also cautiously exploring the potential to apply factor investing to corporate bond markets, but liquidity issues are a serious constraint to grapple with – “in an OTC market it is harder to have official rules,” acknowledges Vincent.

ESG investing
THEAM has developed ESG (Environmental, Social and Governance) expertise with award-winning products in European equity and the first low carbon ETF. There are also indices excluding controversial weapons stocks. The BNP Paribas ESG research team defines a blacklist that is taken into account for all strategies, but THEAM is also open to customising ESG mandates to specific client needs. “ESG is a key issue for the group and for us which is not so standard for a quant house,” says Panel. A range of ESG indices is being rolled out, using research into the space from BNP Paribas. Currently, THEAM’s ESG products are vanilla but there are plans to develop smart beta ETFs based on the approach. BNP already has some fixed income products designed for Islamic investors. Vincent sees potential to adapt the factor strategies to Islamic ‘Sharia’ investing constraints, specific countries and low carbon mandates.

Capital protected products and volatility strategies
In an environment of ultra-low, and often negative, interest rates the structuring of capital-protected products has changed. “They have to be very long maturity now so we need to reach out further on the yield curve,” explains Panel. Even so, 100% capital protection after fees is now almost impossible so products may instead offer 80% or 90% protection. Variations include products of 30 year maturity that start at 70% protection and increase it by 1% each year. A mix of zero coupon bonds and derivatives can be used to obtain capital protection.

Given the challenges of structuring capital protection, some investors prefer to allocate part of their portfolio to products designed to act as hedges. THEAM’s volatility strategies – using variance swaps and based on the shape of the term structure of volatility – are mainly intended to be portfolio insurance hedges. The strategies aim to optimise by varying the tenor of swaps traded, so if the short end of the curve is expensively priced, they may reach further out. They performed well during the 2008 crisis, recalls Panel, who adds “We do not have any clients who invested in the volatility strategies on a standalone basis.”

Quantitative multi asset class strategies
For now THEAM is using a range of quantitative signals for its multi-asset class products, including equity factors as one building block in some products. THEAM has already developed products applying a variety of quantitative models to multiple asset classes: Parvest Cross Asset Absolute Return as well as the MUFFIN (Multi Factor Investing) and MAD (Multi Asset Diversified) strategies. THEAM’s Quant Multi Asset Diversified fund, which trades both long and short, uses a basket of trend and mean reversion signals, along with relative value, long/short, volatility and term structure signals; it does not use any discretion. The fund won The Hedge Fund Journal’s UCITS Hedge award for “Best Performing Fund” in 2015 in the Quant Macro category (and it has continued performing well in 2016, up over 7.5% year to end September). The product’s objective is to increase the value of its assets over the medium term, by being exposed to a diversified long/short basket, with a target volatility of 10%. Annual performances have been +8.69%, +9.14% and +10.23%, in 2013, 2014 and 2015, respectively. Ongoing charges, including management fees, are 0.76% for the institutional class and there is no performance fee.

Returns have also improved since some changes were made to the strategy. In 2014 the strategy was streamlined to focus on fewer asset classes and strategies. It ceased trading currencies and added real estate, which is proxied using an index of listed real estate equities. The other asset classes are equities, fixed income and commodities (though agriculturals were removed from the commodities sleeve in 2015 partly due to ESG related concerns that trading in commodities could be perceived to be increasing food prices). Key performance contributors have recently included being short of equities in early 2016, and Panel finds the flexibility to go net short distinguishes the strategy from some other multi asset class funds that are long only. THEAM’s investor communications provide detailed performance attribution, breaking down asset classes into geographic regions. The factsheet splits equities into US, Europe, Japan, China and Emerging markets; bonds into US, Germany and Japan, and listed real estate into US and Europe.

Communication and transparency
For Vincent, smart beta is where hedge funds, active managers and indices meet at a crossroads. “Smart beta is more complex than traditional indices but adds outperformance. Smart beta combined with modern computing power can analyse thousands of stocks that would be unwieldy for human managers,” he summarises. Vincent views smart beta as a “revolution,” partly in the way it has changed methods of portfolio construction and risk management, but also in terms of public perception – because alpha sources are now so much more transparent. For THEAM, smart beta is moving into the mainstream. Vincent argues that the rationales behind smart beta can be intuitively grasped without any advanced mathematical knowledge. THEAM is spreading the gospel of smart beta through videos, designed for retail investors.

THEAM takes pride in transparency. “We are transparent in all steps of our process and our low volatility approach is transparent from A to Z,” explains Panel. “Our prospectus discloses how and why we select stocks, and it is entirely based on these rules,” he adds.

Vincent, who describes himself as an “evangelist for factor investing,” sees education, through communication, blogs, videos and road shows, as enlarging the market for factor investing to a much wider audience than hedge fund allocators. He stresses that clients should not buy only on the basis of past performance, and recalls how opaque quant strategies could not justify their losses in the past. BNP Paribas’ Investors’ Corner blog provides an accessible and concise tour of THEAM’s investment beliefs, and also flags up when particular quant approaches are expected to underperform or lose money.

Vincent is also keen to change the perception of equities. He thinks that aversion to equities dates back to the start of the century, when the stock-market was often seen as a casino. This may explain why some institutions, such as insurers, are forced to maintain such high weightings in bonds. But Vincent is also keen to emphasise how long/short equity strategies may not be very risky, can have daily liquidity and also benefit from the UCITS risk framework.