Mamdouh Medhat, senior researcher and vice president at Dimensional Fund Advisors, explains how to systematically assess systematic managers and their strategies.
Whether it is called quantitative or factor-based investing, there has been considerable interest in systematic funds and managers in recent years as more investors have become aware of rules-based investment strategies.
A systematic approach sits naturally between the traditional active style of investing and the passive approach of index tracking. Passive index-tracking strategies can offer broad diversification, increased transparency, and lower costs, while active managers target outperformance through concentrated portfolios but can be plagued by subjectivity and relatively high costs.
Systematic investing should give investors peace of mind that a manager is using rules to select and trade securities, offering broad diversification, transparency, and low cost, but with the added potential for higher returns than the market. And, because it is rules-based, a systematic approach is easy to customise. Furthermore, systematic strategies tend to be scalable and have high capacity.
A systematic strategy’s flexibility makes it an ideal tool to use within an asset allocation, acting as a diversifier or a complement to active or passive strategies or even alternative investments. It can be a core holding, or it can be part of a satellite approach. There are many roles that systematic funds can play in a portfolio.
But how can you ensure a systematic manager or fund is doing what they are supposed to?
A robust framework for selecting systematic managers
Investors must perform considerable amounts of due diligence before allocating when considering a systematic manager. The good news is that building a robust framework for selecting systematic managers is relatively easy and intuitive.
Before hiring a systematic manager, you should evaluate four things: research, design, process and track record.
Firstly, make sure the quantitative research behind a systematic strategy is rigorous. Systematic investing is rooted in academic research and often involves large datasets going back in time as far as possible. Ideally, that research adheres to well-established standards in the literature, has been peer-reviewed, and is implementable. Good managers should be able to distinguish signal from noise.
The design element should be transparent and straightforward to assess. The crucial part is translating the research into investable strategies while balancing trade-offs. The research will tell you which factors to over- or under-weight to outperform the market, but the implementation should be in a way that manages risks and controls costs.
A robust process is another important factor when choosing a systematic manager. A manager should be able to implement the investment process on a continuous, daily basis. This is important for delivering on a strategy’s goals as market prices and company fundamentals change. There are also corporate actions, news events or changes in market liquidity to consider. If a process moves much slower than the market, it is likely to leave returns on the table.
All investors gravitate towards a manager with a positive track record, but returns are notoriously noisy. Volatility can influence returns and does not always give a clear picture of why a strategy outperforms.
Is it due to skill or luck?
Underperforming funds may be closed or merged with better-performing ones, inflating track records. Therefore, it is important to look for high survival and outperformance rates across a range of strategies and over time.
What comes after hiring a systematic manager?
After hiring a systematic manager, it is important to ensure the manager is delivering on what they promised.
There are three factors investors should consider after hiring a manager: premium capture, risk management and total costs.
Premium capture is easy to establish and will show whether a manager is meeting investor expectations for the strategy. It determines whether a strategy has delivered a premium relative to its benchmark, net of fees, during periods when the strategy is expected to do so. A strategy pursuing the profitability premium, for instance, should outperform its benchmark during a month or a quarter when stocks with high profitability outperform those with low profitability.
Risk management is equally important to assess because pursuing premiums also means, for instance, avoiding style drift and excessive concentrations. A rules-based approach doesn’t mean throwing out human oversight. A good systematic manager knows how to strike a balance between having solid, quantitative risk management tools and necessary human oversight.
All investors worry about costs, too. Happily, systematic strategies can be relatively low cost compared with a traditional active approach. However, investors need to think about costs beyond just the management fee of a fund. How much did the manager try to minimise trading costs? What were the missed opportunities to increase returns? What are the monitoring costs for investors making sure their systematic manager is doing what they said they would? Every basis point counts.
The framework for evaluating systematic managers outlined here should not just be helpful for investors; we at Dimensional measure ourselves against it.
We adopt a systematic active approach to investing based on rigorous, quantitative research—often in collaboration with world-class academics—and efficient implementation that adds value over indexing. Our 40-year history and $634 billion under management are a testament to the appeal of this approach in both equities and fixed income.
Over the 20-year period ending with 2022, 73% of our US-domiciled strategies outperformed their benchmark after fees, compared with just 16% for the industry as a whole. Also, 100% of our strategies survived, while less than half of the other funds did.
We believe systematic investing can help investors reach their financial goals by delivering positive outcomes in the long run, either as a core holding or as part of a diversified asset allocation. The rules-based approach to investing can offer investors a more transparent and lower-cost alternative to active management and a more flexible option than passive strategies.
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