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This Issue
insights newsletter
Volume 2, July 2011
The impact of long/short on your
portfolio
1
Conference addresses the challenges
of regulatory change for South African
pension funds
2
Firm’s CCO elected to IIROC’s
Quebec District Council
3
Team Update
4
Book review - Keynes: The return
of the Master
6
Contact
The impact of long/short on your portfolio
By Michael McMurray, Investment Consultant & Sunny Ng, Director, Alternatives Research
In the December issue of Insights, we provided
a qualitative overview of the three types of
long/short equity strategies: Active Extension,
Market Neutral and Directional. As a follow-up,
we thought that it would be helpful to provide
a quantitative comparison of how the strategies
have performed over the past six years.
The median risk and return numbers in this article
were created using Brockhouse Cooper’s proprietary investment manager database and return
streams from third party providers. The number
of products for each strategy, geographic region
and length of track record are listed below.
North America
All Regions
Length of track record
1 Yr
3 Yrs
6 Yrs
1 Yr
3 Yrs
6 Yrs
Active Extension strategies
78
72
12
---
---
---
Directional Long/Short strategies
574
499
346
---
---
---
Equity Market Neutral strategies
---
---
---
230
167
90
Continued on page 4
Inquiries or comments concerning this
newsletter can be addressed to:
Marie-Michelle Dumas
[email protected]
Brockhouse Cooper
1250 René-Lévesque Blvd W
Suite 4025
Montréal, QC
H3B 4W8 Canada
Tel: +1 514-932-1548
Fax: +1 514-932-8288
www.brockhousecooper.com
2
insights newsletter
July 2011
Conference addresses the challenges of regulatory change for South African
pension funds - By Carey Else, Marketing Director, Brockhouse Cooper South Africa
Eric Bolduc, Vice President, Implementation Services at Brockhouse
Cooper, presented a paper on Transition Management at the Southern
African Pension Fund Investment Forum (SAPFIF) Conference, held in June
in Sandton, South Africa.
The focus of the conference was “Managing Pension Funds in Times of
Regulatory Change”, which sought to address pertinent questions facing
South African Pension Funds concerning the amendments to Regulation 28
(Reg 28) of the Pension Funds Act.
The Pensions Fund Act was promulgated in 1956 and Regulation 28, which
prescribes limits in respect of asset classes, was published in 1962. As it
was last amended in 1998, its reform was eagerly anticipated to ensure
its continued relevance within the dynamics of the current investment
landscape.
Pension funds now need to evaluate their strategies in light of the amendments. What should they be doing now to ensure they remain compliant?
What are the key implications of the changes and how will this impact asset
allocation policy? How can pension funds manage their risk exposure and
cost effectively? Should pension funds be considering changes to their
investment policy and strategy?
Of particular significance within the global context, aligned with the
relaxation of exchange controls, is the increase in the offshore allowance
for institutional investors to 25 per cent, and an additional 5 per cent into
About SAPFIF
SAPFIF is one of the seven divisions of EPFIF, the European Forum,
whose pension fund members’ assets currently amount to about
€2000 billion.
The forum was started in October 2006, and holds three meetings
a year in Sandton and Cape Town, South Africa, and in Windhoek,
Namibia.
Attendance at the SAPFIF forum typically includes approximately 80
Principal Officers, who represent some of the largest Pension Funds
and Pension Fund Administrators in South Africa.
Africa. Equally significant was the change in asset allocation limits to
alternative investments, such as hedge funds and private equity, from
2.5 per cent to 10 per cent.
Institutions need to evaluate the optimal management of the changes to be
implemented and re-align their portfolios against this backdrop. Critical to
this process are the mitigation of risk and the minimization of costs, both of
which can significantly impact portfolio performance.
Transitioning Portfolios – How can this be done effectively?
Mr. Bolduc told conference attendees that effective transition management
is a vital part of a fund’s investment strategy and a key element in reducing
a fund’s risk profile.
He outlined the importance of comprehensive reporting, including a
pre- and post-transition analysis, with detailed implicit and explicit costs,
both estimated and actual. Effective risk management is vital to achieving a reduced portfolio tracking error, and algorithmic trading is one of the
advanced trading tools used to reduce imbalances in the portfolio within
country sector and market capitalization allocations. Hedging strategies,
such as the use of futures, OTC forwards, and ETFs may also be employed
to reduce tracking error.
Brockhouse Cooper uses the implementation shortfall method to measure
the cost of a transition. Implementation Shortfall is the difference in performance between the theoretical target portfolio and the actual transition
portfolio at the end of the transition period.
Given the complex dynamics of a multi-market investment scenario, the
selection of a transition manager with extensive international experience
and an established global network is critical in achieving the fund’s investment objectives.
Brockhouse Cooper offers a global transition management solution and
within that context, the South African team provides local specialist market
knowledge, relationships, compliance, and expertise.
Carey Else,
Marketing Director, Brockhouse Cooper South Africa
[email protected]
At the Mic
Dr. Nicolas Papageorgiou, Director of Quantitative Research, will be a
panelist at the Quant Invest Canada event, to be held in Toronto, October
17-19. Dr. Papageorgiou’s panel will take place on October 19 and will
discuss how to:
- Manage systemic risks;
- Factor in changing market volatility and regulatory risks;
- Determine a tolerable risk level; and
- View the same phenomena from different angles using multiple risk
models.
Dr. Papageorgiou will be joined by Barry Allan, Founding Partner, Marret
Asset Management and Ian Nisbet, COO, Style Research.
Also on October 19th, at the same
conference, Anton Loukine, Chief
Investment Officer of Pavilion Asset
Management Ltd., a sister-company to Brockhouse Cooper, will be presenting a case study: A framework for constructing customized, cost-efficient
portfolios. The case study will look at what elements can be controlled
(transaction costs, market impact, taxes, etc.) and how to add value through
tax management.
3
insights newsletter
July 2011
Firm’s CCO elected to IIROC’s Quebec District Council
Douglas Simsovic, Brockhouse Cooper’s General
Counsel and Chief Compliance Officer, has been
elected to the Quebec
District Council of the Investment Industry Regulatory
Organization of Canada
(IIROC).
“I’m honoured and excited to be part of this
Council which acts as a local committee of
IIROC. We fulfill both a regulatory role in relation
to regional approval and membership matters
and an advisory role with respect to regional
issues, providing a regional perspective on
national issues,” said Mr. Simsovic who will
serve a two-year term on the committee.
The Quebec District Council is one of 10 across
Canada with each Council comprised of four to
20 members. The Chairs of each of the District
Councils comprise the National Advisory Committee (NAC). The Chair of NAC meets with the
IIROC Board three times per year.
District Councils exercise their regulatory authority and perform their advisory function directly
or through delegation to staff or District Council
sub-committees.
Specific Responsibilities of the District Councils:
1. Approve “Applications for Approval” of individuals. (Rule 20.18(1)(a))
2. Impose terms and conditions on individuals
applying for approval (Rule 20.18(2)(a)) and
as a condition of continued approval for an
individual. (Rule 20.18(3))
3. Revoke or suspend the approval of an individual. (Rule 20.18(4))
4. Exempt individual approved persons from proficiency and continuing education requirements pursuant to Rule 2900. (Rule 20.24(2))
5. Grant exemptions from introducing-carrying
broker arrangement requirements with
respect to foreign affiliates. (Rule 35.6 and
Rule 20.25(1))
6. Hear and decide on appeals of proficiency
related decisions of the District Council’s
registration sub-committee under Rule
20.24 or 20.25. (Rule 20.26)
7. Recommend new membership applications
for submission to the IIROC Board for
approval. (Rule 20.20)
8. Approve ownership-related transactions for
IIROC Members. (IIROC Rules 5 and 6)
9. Approve the panel of district auditors annually,
as recommended by staff. (Rule 16.1)
10. Nominate (for appointment by the Corporate
Governance Committee) individuals resident
in the District to be members of the hearing
committee of that District. (Schedule C.1 to
Transition Rule No. 1, section 1.2)
11. Perform any other regulatory functions delegated to District Councils under IIROC’s
Rules or delegation orders.
12. Advise staff on policy matters of interest to
the membership and the industry.
There are 10 IIROC District Councils across Canada:
- Alberta District, comprised of the Province of Alberta and the Northwest Territories
- Manitoba District, comprised of the Province of Manitoba and the Territory of Nunavut
- New Brunswick District
- Newfoundland and Labrador District
- Nova Scotia District
- Ontario District
- Pacific District, comprised of the Province of British Columbia and the Yukon Territory
- Prince Edward Island District
- Quebec District
- Saskatchewan District
Montreal CFA dinner a success
Early last month, Brockhouse Cooper attended the 2011 Montreal Annual CFA Forecast Dinner, for
which Eric Fontaine, Investment Consultant, is part of the organizing committee. The event, held
under the theme “Investing in a troubled world: More than just financial risks!“ was a great success
and featured local and international panelists.
Moderator: Roland Lescure, First Vice President & Chief Investment at Caisse de dépôt et placement du Québec.
Panelists: Ed Devlin, Executive Vice President at PIMCO, Marc Lévesque, Vice President, Economics and Market
Strategy and Chief Economist at PSP Investments, Robert Lloyd George, Chairman & CEO at Lloyd George
Management and Dr. Magne Orgland , Chairman at Wegelin.
As is the tradition, the evening included a
contest whereby participants register their
economic predictions for the coming year. The
most accurate predictor is awarded a prize. Mr.
Fontaine presented the 2011 forecast contest
winner, André Chabot from Triasima, with the
commemorative trophy.
4
insights newsletter
July 2011
Brockhouse Cooper team update
Brockhouse Cooper is pleased to welcome two new research analysts to
its Advisory Services team.
Philip Coté joins Brockhouse Cooper
from CIBC Asset Management, where
he worked as a Consultant for Mutual
Fund Product Development & Management, providing recommendations on
the various funds. He also previously
worked for National Bank Direct Brockerage as a Senior Product Analyst. Mr.
Coté holds a Bachelor of Commerce
(Finance) from the John Molson School
of Business and a Graduate Certificate,
Treasury/Finance from McGill University. He was awarded the FRM designation in 2004 and the CFA designation in
2007.
Nicholas Rossy recently graduated
from McGill University with a Bachelor
of Science: Major in Biochemistry &
Minor in Management. Prior to joining
Brockhouse Cooper, Mr. Rossy worked
as Customer Service Representative for
the Bank of Montreal. He is a registered
Level II CFA candidate and completed
his Canadian Securities Course Certificate earlier this year.
Reporting to Ryan Anderson, Head
of Investment Manager Research,
Messrs. Coté and Rossy will conduct
due diligence on investment managers
via on-site visits or meetings at Brockhouse Cooper headquarters. They
will also work closely with our investment consultants to service clients.
The impact of long/short on your portfolio continued from page 1
For this analysis we have chosen to focus
on Directional and Extension strategies
that invest only in North American stocks.
The reasons for this are twofold: firstly,
the number of non-North American long/
short equity strategies is fairly low and thus
it is difficult to create meaningful median
and quartile breaks. Secondly, it is difficult
to compare the returns of strategies with
positive beta exposures when the underlying betas are different. However, given
that Equity Market Neutral strategies are
agnostic to market directionality, we do not
believe that the markets/regions in which the
manager trades are relevant for our analysis.
We have therefore grouped all the strategies
together into a single universe.
Exhibit 2 presents the calendar year returns
for the S&P 500 Index, the Brockhouse
Cooper US Large Cap Equity median, and
various long/short indices and medians representative of the strategies under review.
It provides a general overview of how the
strategies have performed relative to each
other in various market conditions over the
last six years. Exhibit 2 - Calendar Year Returns ($USD)
5
insights newsletter
July 2011
The impact of long/short on your portfolio continued from page 4
In Exhibit 3, we provide the median risk and return figures for the three
types of strategies under review. All relative risk measures are calculated
versus the S&P 500 Index.
Reviewing the median results from the three strategies, we see that, as
expected, Active Extension is the most index-oriented (relative return),
Equity Market Neutral is the least index-oriented (absolute return), while
Directional Long/Short lies between the two.
Absolute Return
As expected, the highest beta strategy – Active Extension – had the highest
absolute returns during strong equity markets and the lowest returns during
declining markets. It is generally expected that Equity Market Neutral will do
the best in negative markets while Directional will outperform in sideways
or neutral markets. However, we note that this is not always the case
as evidenced by the fact that Directional strategies actually outperformed
Market Neutral over the last three-year period of negative market returns.
In terms of risk, Equity Market Neutral produced the lowest standard deviation, Active Extension the highest, and Directional lies between the two.
We note that the strong returns of the higher beta strategies produced
the highest Sharpe ratios over the one-year period ending December 2010.
Meanwhile, Directional managers produced the best Sharpe ratios over the
three and six-year periods due to their strong returns compared with the
other strategies.
Reviewing the absolute returns of the strategies, we find that there is no
clear winner. Rather, the selection of a strategy should be made based on
the return profile which best meets the investor’s requirements.
Exhibit 3 – US$ Median Risk/Return Measures
(periods ending December 2010)
Strategy
Region
Benchmark
The returns of the high beta strategy – Active Extension – are more closely
linked to the indices and these products therefore tend to outperform
during bull markets. As expected, this strategy had the lowest tracking
error while the lower beta strategies had very high tracking errors.
The Directional Long/Short and Equity Market Neutral strategies were able
to produce the higher information ratios over the three- and six-year periods.
However we would not necessarily expect this to persist on a go-forward
basis, as the measurement period was one of higher-than-normal volatility
coupled with low index returns.
The median Active Extension strategy was able to produce consistent
positive excess returns and information ratios.
For an investor interested in relative returns, the Directional and Market
Neutral strategies should not be considered. Active Extension strategies
are much better suited for index-oriented investors.
We provide below a summary of the results by strategy.
Long/Short
Directional
Equity Market
Neutral
North America
North America
All Regions
S&P 500
S&P 500
S&P 500
1 Year (positive market return)
Return
15.2
11.6
1.6
Alpha
0.2
-3.5
-13.5
Std Dev
19.8
13.4
5.2
Sharpe Ratio
0.8
0.8
0.2
TE
3.4
14.2
18.2
Info Ratio
0.0
Negative
Negative
1.0
0.5
0.1
Beta
3 Years (negative market return)
Return
-2.1
3.4
0.9
Alpha
0.7
6.2
3.8
Std Dev
22.2
16.7
4.4
Sharpe Ratio
Negative
0.2
0.1
TE
5.2
18.8
22.4
Info Ratio
0.2
0.4
0.2
Beta
1.0
0.5
0.0
6 Years (market return close to zero)
Return
Relative Return
The excess returns of the lower beta strategies – Directional and Market
Neutral – versus long-only equity indices are highly dependent on the
market environment. As anticipated, these strategies tend to outperform
during low and negative return environments and trail during periods of
strong index returns.
Active Extension
(1X0/X0)
3.4
6.8
2.1
Alpha
0.7
4.1
-0.6
Std Dev
17.0
15.1
11.3
Sharpe Ratio
0.1
0.3
0.0
TE
4.6
14.6
21.5
Info Ratio
0.2
0.3
0.0
Beta
1.0
0.5
0.1
Active Extension Strategies
In general, the risk and return characteristics of Extension strategies have
not been significantly different from those of active, long-only strategies.
The expected impact on the absolute risk/return trade-off of replacing a
long-only equity strategy with an equity extension strategy is relatively
minimal given that the underlying beta exposure of the portfolio would not
change.
We believe that higher tracking error long-only strategies and Active
Extension strategies should be considered as competing products as they
produce similar risk/return characteristics at the portfolio level.
We expect Active Extension strategies to outperform Directional and
Market Neutral strategies during strong bull markets as in 2010, but underperform in weaker markets as over the last three and six years.
insights newsletter
July 2011
6
The impact of long/short on your portfolio continued from page 5
Directional Long/Short Strategies
Directional managers will, on average, have lower net exposure to the
markets than their long-only and Active Extension counterparts, and derive
a large portion of their returns from dynamically adjusting net exposures
and security selection.
Absolute and relative risk measures have generally been between those of
long-only/Active Extension and Market Neutral managers.
We would expect Directional strategies to outperform during negative, flat
and slightly positive market environments and underperform during bull
markets.
Although not shown in this article, Directional has the highest dispersion
between its top and bottom quartile. Manager selection appears to be very
important within these strategies.
Inquiries or comments concerning this
article can be addressed to
Michael McMurray
Investment Consultant
[email protected]
514-932-1548
Equity Market Neutral Strategies
Equity Market Neutral has had the lowest volatility of the three strategies
under review while tracking error has been the highest and beta the lowest.
Returns have been comparatively good over three and six years (poor
market returns), but underperformed in 2010 (strong market returns). We
expect Market Neutral strategies to outperform Active Extension strategies
during bear or flat markets.
We believe that this strategy will likely lower the long-term return expectations (assuming that the allocation is from equities), given that Market
Neutral managers, as a group, have generally produced lower absolute
returns (but higher risk-adjusted returns) than long-only managers.
We believe that replacing a long-only equity allocation with a Market Neutral
manager will result in risk reduction on an absolute basis due to their low
market exposure. Given their low beta, we believe that Market Neutral
will produce the highest tracking error and lowest information ratios of the
three strategies.
Book review by Alex Bellefleur, Financial Economist
Keynes: The
return of the Master,
by Robert Skidelsky
Penguin Books, 2010
227 pp., 26,95$
- “Is Barack Obama a Keynesian?”
- “No; he’s American! He was born in Hawaii!
That is a state of the United States!”
Last year, a YouTube video showing interviews
with a vox populi of participants in Jon Stewart
and Stephen Colbert’s “Rally to Restore Sanity”
in Washington went viral. The interviewer asked
whether the President of the United States was
a Keynesian. Confused rally participants, whom
it is safe to assume were mostly political liberals
sympathetic to the President, were apparently
confounded by the term “Keynesian”, which
many understood to mean “Kenyan”, i.e. a citizen
of Kenya. This rather amusing episode not only
speaks loudly about the current state of political
affairs in the United States, but also about the
legacy of the economist John Maynard Keynes.
After many years in the intellectual wilderness,
attempts to answer. Readers looking for a bioKeynes is back - and back in a big way. His ideas graphical sketch of Keynes’s life should turn to
are now in vogue in political circles that, in the Skidelsky’s three-tome biography of the econopast, would not have paid much attention to his
mist rather than The Return of the Master, which
economic policy recommendations. Even coninstead summarizes and explains Keynes’s ideas
servative politicians such as Canada’s Stephen and details their rise, fall and subsequent 21st
Harper or France’s Nicolas Sarkozy introduced
century renaissance.
large economic stimulus programs to dampen
the effects of the
Skidelsky is most
“Skidelsky is most interesting in his description
recent Great Recesinteresting in his
of the current intellectual debate between the New
sion. This probably
description of the
Classical and the New Keynesian economists, who
ran counter to their
current intellectual
ideological instincts,
debate between the
differ both in their respective explanations for the
as both politicians
New Classical and
recent crisis and policy prescriptions on how to get
were initially elected
the New Keynesian
out of this mess.”
by promising less
economists,
who
state intervention in the economy, not more. But
differ both in their respective explanations for the
such was the strength of the Keynesian tide that recent crisis and policy prescriptions on how to
no policy maker could stand in the way nor resist
get out of this mess – a task that is taking longer
the temptation to introduce stimulus to the ailing than just about everyone would have expected.
global economy and expand government’s role in
The side of the debate from which Skidelsky
the economy, either through increased spending is writing is quite clear; his pro-Keynes views
or regulations.
permeate the book, especially in his depiction of
the other side’s arguments. For example, SkidelHow did Keynes come back so strongly? And
sky describes the New Classicals (i.e. the supplywhy did he disappear in the first place? These side, tax-cutting, deregulating economists) in a
are the questions that Robert Skidelsky’s book slightly simplistic way, as if they were ultra-rigid
insights newsletter
July 2011
in their views that markets must always clear
and that economic agents’ expectations are
always rational. He deliberately highlights their
contradictions and exposes their flaws, making
them look bad in the process.
Had this book been written a
few years from now – when Greece,
Portugal and Ireland will probably
have restructured their debts and
when the U.S. will likely face a day
of reckoning with respect to its own
national debt – the author’s tone
might have been slightly different when
discussing government spending.
Despite this bias, Skidelsky hits the nail on
the head when describing the New Classical
mindset as believing that in a risky world where
expectations are rational, it must follow that
financial assets fully reflect all available information. Additionally, if markets never fail, then the
crisis must be explained by policy mistakes,
such as the excessive money creation that led
to the epic U.S. 2000-2007 housing boom and
bust. The Milton Friedman-inspired monetarist
mindset then interprets the housing bust as
an unexpected shock that caused the money
supply to collapse. In this context, “The Quantitative Easing” applied in two waves by “The
Ben Bernank” should be seen as a distinctively
New Classical monetarist response to the crisis,
attempting to offset the collapse in the money
supply by injections of cash into the economy.
The Keynesian school of thought, on the other
hand, explains the crisis differently and prescribes a different remedy. Rather than seeing
the crisis as having been caused by monetary
forces, New Keynesians attribute it to a collapse
of aggregate demand caused by the instability of
7
investment. Skidelsky also succeeds when summarizing Keynes’s ideas in the current context.
New Keynesians acknowledge their limited
foresight in that economic stability is inherently
destabilizing, which creates many “unknown
unknowns” (in the words of Donald Rumsfeld).
According to the Keynesians (and to Skidelsky),
the exit from the crisis might have been quicker
had there been more fiscal, rather than monetary,
stimulus. In the Keynesian view, a crisis caused
by a collapse in aggregate demand must be
remedied by an offsetting increase in government spending – a policy that is derived directly
from Keynes’s account of the Great Depression.
its own national debt – the author’s tone might
have been slightly different when discussing
government spending. Skidelsky’s description
of Keynesian policies’ track record (during the
period when they were applied, i.e. between
1945 and the early 1970s) also sometimes
confuses correlation and causation. Did Keynesian policies really cause the economic boom of
that period, or did other factors also contribute to
the expansion? It is doubtful that Keynes alone
engineered the boom. For example, Skidelsky’s
claim that fixed exchange rates did much to
ensure strong and stable growth between
1945 and 1970 is not convincing since, in other
periods, fixed exchange rates were more of a
Keynes is useful not only for policy makers,
but also for investors
Skidelsky demonstrates how in a world where
consumers and firms are focused on paying
down excessive debt, it is clear that injections
of cash into the economy (à la QE1 and QE2) will
only have a limited effect. This failure to revive
aggregate demand would lead to falling prices.
Sounds familiar? Keynesian-minded investors
who understood this would have made a lot
of money by going long U.S. Treasury bonds in
the spring and summer of 2010, when the U.S.
experienced a deleveraging-induced deflationary
scare, which was ultimately cured with QE2.
problem than a solution, notably in the Eurozone
between 2000 and today!
Where Skidelsky fails to be convincing, however,
is in his apparent disregard for governments’
fiscal constraints. In his enthusiastic approval
of Keynesian government spending policies, he
fails to consider the adverse effects of excessive
government spending and the rapid build-up of
government debt that can occur in the wake
of recessions and stimulus programs. Had this
book been written a few years from now – when
Greece, Portugal and Ireland will probably have
restructured their debts and when the U.S. will
likely face a day of reckoning with respect to
This reviewer doesn’t feel a particularly strong
intellectual attachment toward either the New
Classical or the New Keynesian side of the
debate. Both points of views are relatively
appealing, especially in their respective explanations for the recent crisis (monetary causes
versus sudden collapse in aggregate demand).
Both policy remedies (“QE-as-long-as-needed”
and additional government spending) have their
respective costs and benefits. Skidelsky is clearly
a Keynesian, but this should not deter classicallyminded individuals from reading his book. The
Return of the Master is a great place to start to
understand the far-reaching consequences of the
ideas of an architect of many of the economic
policies and institutions of our day.
Inquiries or comments concerning this
book review can be addressed to
Alex Bellefleur, Financial Economist
[email protected]
514-227-7712
DISCLOSURE: INSIGHTS is prepared for circulation to institutional and sophisticated investors only and without regard to any individual’s circumstances.
This report is not to be construed as a solicitation, an offer, or an investment recommendation to buy, sell or hold any securities. Any returns discussed
represent past performance and are not necessarily representative of future returns, which will vary. The opinions, information, estimates and projections,
and any other material presented in this document are provided as of this date and are subject to change without notice. Some of the opinions, information, estimates and projections, and other material presented in this document may have been obtained from numerous sources and while we have made
reasonable efforts to ensure that that the content is reliable, accurate and complete, we have not independently verified the content nor do we make any
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accept no liability whatsoever for any loss arising from any use of or reliance on this report or its contents.
© 2011 Brockhouse & Cooper Inc. All rights reserved. This report may not be reproduced, distributed or copied, in whole or in part, in any form, without the
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