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How Do You Build Towards Repeatable Success? Ali Chabaane, Head of Portfolio Construction Pioneer Investments

The main challenge facing a pure alpha producer is to be able to repeat successful performance (risk adjusted or not). We will label this repeatability feature as “sustainable alpha’’. A manager must then have processes in place that leverage on the skill of the participating investment professionals. The processes should clearly contribute to alpha production either through (1) efficient use of the available risk, (2) effective management of correlation across different components of the portfolio, and (3) embedded asymmetry designed to limit the impact of drawdowns if success does not materialise. These processes, driven by risk management, have to be done in a way that promote risk taking rather than risk avoidance. Within Pioneer Investments, Portfolio Construction and Risk Budgeting play a fundamental role when combining investment ideas and strategies. To support the combination of different strategies in a single portfolio and to effectively monitor the risk contribution of each strategy, Pioneer Investments has developed a proprietary risk budgeting system supported by a dedicated Portfolio Construction team. The key to sustained successful performance is ensuring that “alpha generation’’ is repeatable and drives each step of the investment process. We believe that there are four major families of ingredients that increase the chance of reaching these objectives. Stable and Well-Articulated Performance Engine The first and primary challenge in defining the alpha sources is actually the separation of the active part of the portfolio from the non-active part. Although appearing

Risk-Adjusted Performance

Portfolio Construction and RISK Budgeting An Integrated Model

... Delegated Strategies Management

Efficient Drawdown Management Strategies Composition Optimisation Risk Budgets Planning and Review Strategies Definitions


Fixed Income instruments, for long considered ‘safe haven’ assets, have recently lost this privileged position. The asset class faces yet another concern as interest rate rises are a matter of “when” rather than “if”. On the other hand, boom-bust cycles have been the norm for the last few years and have led investors to value true uncorrelated performance across multiple assets. As the majority of asset classes exhibit highly unstable correlations, the real challenge for a portfolio manager is to be able to find pure alpha by investing actively in these asset classes. The final performance of these products has to be uncorrelated to major asset classes whilst limiting drawdowns. This pure alpha feature is even more important when we deal with an absolute return product.

Risk Measurement

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simple, this separation is crucial to define all the bets and risks in place from investments that need systematic hedges. Succeeding in this separation is half the battle. In general, the non-active component should be market neutral. It can be managed in a quantitative way. For example, a well-designed indexation process will help replicate the performance of the benchmark within a sovereign bond fund. For an absolute return fund, investing in a carefully selected portfolio of short term bonds can help realise the index performance. Once this indexed component has been designed and executed, the active component can be implemented in a clear fashion, and derivatives are used to achieve the type of risk the investor wants to be rewarded for. In a more volatile market, alpha generators should keep all options open to find additional sources of performance. It’s important to have some alpha producers aiming to generate performance from market normalisation after dislocation, whilst others should be trying to bet on the realisation of these market dislocations. This example illustrates the concept of diversification as being much more than a question of correlation management. However one must guard against the possibility of lower risk adjusted returns as a consequence of this diversity of alpha sources. Specialised and experienced investment professionals should address this concern.

FOCUS I How Do You Build Towards Repeatable Success?

Appropriate Sizing of Positions In a framework where every investment represents a view on specific market segments and is formulated independently, measuring the risk level appropriately is key to determining the size of positions. This risk measure should provide a way to convert the chosen metric (i.e. percentage weight, DV01) into a unique and comparable indication of position size. Comparing the measures of different investment ideas should then indicate whether the relative size of all the positions is appropriate enough to avoid (1) concentration and (2) offsetting. Concentration may materialise through one investment idea becoming a dominating factor in performance. The second way that concentration materialises is through an increased level of correlation between different investment strategies pushing performance in one direction or another. Offsetting materialises when investment ideas are negatively correlated. The ideas could then offset each other leading to a loss of effectiveness and little benefit from high conviction trades. Drawdown Tools The easiest way to manage drawdown is to reduce the probability of it happening. The first step to avoid drawdown is to make the diversification of the portfolio as effective as possible. Then sizing the position appropriately as illustrated in the previous section should dilute the effect of unsuccessful investment ideas. It should prepare the ground for an additional layer of protection through drawdown management. As an investment idea is formulated, drawdown levels are set. These levels should determine the maximum loss that can incur in a portfolio from the investment idea. For a highly liquid instrument, the drawdown strategy should mimic being protected by an option but without having to pay the premium. This leads to an absolute return mind-set on the investment idea.

Highly diversified investment ideas with appropriate levels of risk are still the best way to ensure that one poorly performing investment strategy will not adversely affect overall performance. Drawdown management helps protect the fund from a single poorly performing investment idea. However, it won’t protect against multiple unsuccessful investment ideas. This can happen either due to the low success ratio of the investment ideas, or due to an undesired correlation between the positions. In both cases, monitoring tools on groups of investment ideas using ex-ante and ex-post measures should be done in a systematic way. This helps identify, at an early stage, deviations from expected drawdowns that then allow prompt corrective actions. The risk budgeting system has been one of Pioneer Investments’ most important developments in recent years. Combining specialised investment skills with a strong risk management discipline allows active managers to better exploit market opportunities, while at the same time paying significant attention to drawdown management - making all the difference for our clients.

Unless otherwise stated all information and views expressed are those of Pioneer Investments as at 13th August 2013. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies.