David Schofield, INTECH: “Given the underfunded status of many pension plans, an opportunity to realise alpha is critical”
David Schofield (pictured), president of the international division of INTECH Investment Management, says that while an increased aversion to risk has led to a shift in sentiment away from active management toward passive investing, investors are overlooking the opportunity lost by going passive, to achieve a return greater than the benchmark.
GFM: What is the history and background of your company, principals, strategies and funds?
DS: INTECH Investment Management is an institutional investment adviser that uses an investment process based on a mathematical theorem in order to capitalise on the random nature of stock-price movements. The theorem is the result of research conducted by Dr. E. Robert Fernholz, INTECH’s founder, and published in his 1982 paper, Stochastic Portfolio Theory and Stock Market Equilibrium.
The goal of the investment process is to provide an excess return above the benchmark index, while managing relative risk and trading costs. INTECH, an independently managed subsidiary of Janus Capital Group based in Denver, Colorado, offers active, US and global/international risk-managed mathematical investment strategies based on this theorem.
INTECH launched its first US large-cap equity strategy, US Enhanced Plus, in 1987 and expanded into the global space in 2005. INTECH’s investment process can easily be adapted and applied across various investment universes, geographies and strategic objectives. Today its suite of strategies includes core, growth, value, global and non-US, and absolute volatility product offerings.
The company’s global headquarters is located in West Palm Beach, Florida, with its research office in Princeton, New Jersey, and an international division in London. As of March 31, 2012, INTECH had approximately USD42.7bn under management and 85 employees worldwide.
Jennifer Young, who joined the firm in 1999, is INTECH’s chairman and chief executive, while Adrian Banner, who arrived in 2002, is chief investment officer. As president of INTECH’s international division since 2006, I am responsible for developing, implementing and managing the business effort for the firm outside the US.
GFM: What is the structure of your strategies and funds?
DS: INTECH’s strategies are offered as institutional separate accounts and as commingled pools. A select number of strategies are also available as mutual funds we sub-advise for Janus with a variety of share classes, including institutional offerings.
GFM: What is your distribution strategy and targeted client base?
DS: INTECH serves a geographically diverse base of institutional investors, with almost 20 per cent of assets under management (some USD8bn) coming from clients located outside the US. Corporations and public pension funds represent roughly 70 per cent of assets under management.
A team of dedicated INTECH client- and consultant-relations professionals is based in the US and London, in addition to distribution support worldwide from Janus. The firm’s global collaboration with our Janus partners provides a meaningful presence in markets around the world including Europe, the Middle East, Asia and Australia. Non-US institutional investors have shown significant interest in INTECH’s mathematical investment process, and we believe this represents a significant growth opportunity.
GFM: What impact has the recent global financial crisis and economic downturn had on your business?
DS: From an organisational perspective, INTECH’s financial health, flexible business model and overall stability allowed the firm not only to weather the global financial crisis without any reduction in staff but to add key senior investment professionals during that time. Over the past few years, INTECH has initiated research to expand its product focus from exclusively US large-cap equities to global and international equities, as well as a passive alternative to cap-weighted indexing, and most recently to the absolute volatility space when we launched our suite of low-volatility strategies in October 2011.
From an investment perspective, INTECH has been painted with the same brush as other quantitative managers by investors, consultants and the financial media, but the firm’s mathematical investment approach is quite different from that of traditional quantitative managers.
The challenge has been to help investors and their advisers understand that all quants are not the same; how INTECH differs from traditional quant managers; and that our performance was not as negatively impacted by the ‘quant meltdown’ as many other managers, in part because of the specific risk controls embedded in our process.
The global financial crisis left many investors with a renewed aversion to risk, resulting in a shift in sentiment away from active management toward passive investing. What they are overlooking, however, is the lost opportunity that results from going passive, to realise a return greater than the benchmark.
And given the underfunded status of many pension plans, an opportunity to realise alpha is critical – especially when you factor in the impact of compounding over time. For example, if you assume an annualised compounded return of 8 per cent over 30 years, a hypothetical USD100m investment will grow to USD1bn. With just 1 per cent more per year, that USD100m investment would grow to USD1.3bn, an increase if 30 per cent. And with 2 per cent more per year, the investment would be worth USD1.7bn. While the rates of return are hypothetical and don’t represent any specific investment, those extra dollars would go a long way toward helping a pension plan meet its long-term goals and obligations.
Additionally, a passive approach involved assuming all the downside risk of the market in exchange for the upside potential. While going passive might seem to be a prudent approach to managing risk, it could actually mean a fund taking on more risk than its managers realise. Many active managers, including INTECH, have been able to provide their institutional investors with above-market or market-like returns with less risk over time.
GFM: Please describe your investment process.
DS: INTECH uses powerful mathematical and statistical techniques to develop portfolios that over time have the potential to outperform their benchmarks. We do not pick individual stocks or forecast their performance, nor do we attempt to exploit market anomalies, believing they are already factored into stock prices.
Instead we use stock-price volatility and the correlation between stocks in an effort to generate alpha. Essentially, INTECH adjusts the capitalisation weights of an index to what it believes are potentially more efficient combinations.
A key to our success has been periodically to rebalance the portfolios back to their target weights. In essence, our process is a sophisticated ‘buy low, sell high’ methodology with the potential to capture the volatility in stocks in the form of an excess return over the benchmark, with less risk. Embedded in our process are specific risk controls that help minimise tracking error. INTECH’s history and long-term track record attest to the ever-present alpha source of our relative volatility capture process and the firm’s ability to translate it into excess returns.
With just a few minor enhancements made to the engineering, over time, we employ the same process today as when we launched the flagship US Enhanced Plus strategy in 1987. We don’t make changes to the process in reaction to unsustainable market conditions. Rather, it’s auto-adaptive, designed to balance the levels of volatility of stocks optimally with the level of excess return desired.
Our strategy has delivered positive relative returns over time. A nearly 25-year track record, with an information ratio of 0.77 (gross of fees), provides evidence of INTECH’s ability to add value in the form of higher returns with less risk. Risk management is a primary focus, and risk controls are embedded in the process
GFM: What is your approach to managing risk?
DS: Because extreme and adverse events – so-called black swans – occur more frequently than most investors realise, INTECH has embedded risk controls in its investment process, helping to navigate through periods of stock-market dislocations by attempting to limit both the magnitude and duration of our underperformance relative to the benchmark index. The goal is to ensure you don’t dig yourself a hole so deep it would take a long time to recover.
One of the best ways to measure the ability of INTECH’s investment process to manage risk over time is through tracking error control. Tracking error is realised in the form of above-average or below-average relative returns, a measure we look at very closely to gauge the effectiveness of our risk controls. The risk management techniques we use to keep tracking error under control range from limiting how much of any one stock in an index is weighted in our portfolios to capitalisation constraints to ensure we are not investing in stocks that are relatively illiquid.
We set long-term tracking error targets for each strategy at the time of its launch. For example, the tracking error target for our flagship US Enhanced Plus portfolio is approximately 2.0 per cent to 2.5 per cent annualised over the long-term, gross of fees. Since we launched this strategy nearly 25-years ago, the actual results have proven to be very tight around that range. The same can be said for many other strategies and is a strong testament to INTECH’s ability to manage risk over time.
GFM: How have your strategies performed?
DS: The US Enhanced Plus strategy (US large-cap) has produced approximately 1.45 per cent excess return above its benchmark, the S&P 500 Index (annualised, gross of fees as of March 30, 1.15 per cent net of fees), since July 1, 1987. While that might appear a modest level of relative return (and past performance does not guarantee future results), it can have a significant impact on the value of a portfolio over the long term, as evidenced in the hypothetical example provided earlier.
The US Enhanced Index strategy, launched in April 1998, is another example of INTECH’s ability to generate alpha over time. Every rolling three-year period calculated monthly, gross or net of fees within that 14‐year history (through March 31) has resulted in above-benchmark performance.
The underfunded status of many pension plans, together with today’s economic challenges, makes alpha generation a necessity. Realising benchmark-like returns simply isn’t enough to help plan sponsors avert funding shortfalls. This creates a compelling value proposition for a firm like INTECH that has delivered excess returns over time, with benchmark- or market-like risk.
We take a long-term approach to investing. All INTECH’s strategies with a track record of seven years or longer have produced positive annualised returns relative to their benchmark indices, gross and net of fees since their inception, with dividends reinvested. In addition to delivering alpha, INTECH’s return patterns tend to be less correlated to traditional fundamental or quantitative strategies, potentially providing an overall favourable risk/reward profile.
GFM: Are you looking at any new strategies?
DS: INTECH was founded in 1987 with one strategy, a large-cap US equity strategy benchmarked to the S&P 500 Index. Over time, we added other relative-return strategies across a spectrum of benchmarks and at varying levels of aggressiveness. As investors need change, INTECH attempts to respond by implementing customised solutions as well as new product ideas designed to meet their preferences.
For example, in early 2011 we launched a passive alternative to cap-weighted indexing, and in October we extended the application of our process to the absolute-volatility space. These low volatility and managed volatility strategies are based on the Russell 1000 and MSCI World Indexes and are engineered to generate market-like or above-market returns while minimising downside exposure.
In late March this year, we launched the Global High Dividend Yield Core strategy, which seeks to provide a high level of current income from a portfolio of global stocks with a solid history of paying dividends, plus capital appreciation. Institutional investors recognise that in today’s market environment, the low yields offered by more-traditional yield-based instruments may be insufficient to enable them to meet their return objectives.
INTECH’s risk-managed Global High Dividend Core strategy, benchmarked to the MSCI World High Dividend Yield Index, seeks to generate a yield that approximates the index, with an excess return target of approximately 2.5 to 3.0 per cent above the benchmark, annualised gross of fees. We believe this strategy should appeal to investors seeking yield as well as long-term capital appreciation. We also expanded our Absolute Volatility suite of strategies to include Global Dividend Low Volatility.
GFM: What do investors currently expect from managers?
DS: Following the severe market downturn of 2008-09, not to mention the extreme volatility we experienced toward the end of last year, investors are rightfully focused on risk management. At the same time, pension plan sponsors should be looking for managers that have demonstrated their ability to generate alpha over time and through varying market conditions and cycles. Given our track record of delivering alpha with market-like risk for nearly a quarter-century, we believe investors can find value in INTECH’s alpha engine, applied to either the relative- or absolute-risk space.
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