The inefficient pair

A recurring divergent performance on an equity pair could redefine alpha.

Robert Arnott's, Research Affiliates, has received a patent for an indexing methodology that selects and weighs securities using fundamental measures of company size, such as dividends and sales. Fundamental indexing has gained popularity with $27 billion tracking the indices. This is 3 per cent of the total investments tracking the S&P 500. Apart from the fact that the patent gives intellectual rights to Research Affiliates and generates license fee for the company, the revolution here is challenging the benchmark.

Fundamental indexing
We talked briefly about fundamental indexing in our last two features. Putting it simply, Arnott and his team at Research Affiliates suggest that active investing is a futile exercise and passive investing (indexing) is better, if done using fundamental indexing.

The researchers have published many research papers and a book on the subject. In their book Robert Arnott, Jason C Hsu and John M West detail out how passive investing outperformed money managers over the long term. Since 1983, for example, both average equity mutual fund and average equity mutual fund investor underperformed the S&P 500 Index fund by more than 200 basis points.

Seeking alpha

Arnott makes a case against active management by saying "active managers cannot collectively outpace the indices, relative performance is a zero-sum game, any winners must have losers on the other side of their trades, and the quest for alpha is a zero-sum game". This, the authors say, happens because selling the most profitable investments run contrary to human nature and buying the bleakest underperformers is against our natural instincts. Neglecting this simple exercise is a source of negative alpha, especially when risk and mean reversion of market is taken into account. Fundamental indexing assumptions rests on historical back testing which proves that negative alpha comes from first; over reliance on equity, second; ignoring re-balancing opportunities (courage to exit winners), and third; chasing winners (capitalisation weighting portfolios). The second and third aspects are similar, but it's the aspect regarding over reliance on equity that could be relooked at.

Diversified equity
This first aspect suggests that failure to look at other assets to diversify will create negative alpha over the long term. This means that an investor can not have a pure equity based investment strategy to generate higher returns than the benchmark. Equity has one of widest range of offer. There is equity based on commodity, green assets, renewables etc. If we consider the broad economic cycles panning out multi years of low interest rates or multi years of higher interest rates, interest rate sensitive sectors will diverge from interest insensitive sectors. We at Orpheus can illustrate more examples to challenge the idea that pure equity portfolio cannot itself offer internal diversification in a pure equity portfolio to outperform the benchmark. Times are always unprecedented and to accept that equity components as an asset class fall together and rise together could be challenged if one looks at the performance between sectors.

Sector return divergence
If equity components rise together and fall together, there is no business of inter equity sector performance to diverge as much as 100 per cent on an annualised basis. We carried a half-year review on Indian markets (India outlook H2, 2009) where we illustrated cases with more than 100 per cent annualised divergent performance between sectors. BSE Realty had outperformed BSE Sensex by 173 per cent on an annualised basis from March lows to July 24. As anticipated, the performance cycle reversed and BSE Realty underperformed BSE Sensex by 27 per cent annualised since the July 24 case. This leads us to question the whole idea of risk premium.

Comparing pairs
Do we really understand the idea of risk premium? Or the market did not know how to measure alpha in the first place? Now we have instruments which let us trade with a leverage of -1 on spot. Did anyone say it's hard to find negative correlation? Modern finance has a solution. Suddenly Arnott's historical back testing on over reliance on equity reason seems changeable. After the sectoral performance divergence if one can highlight cases of equity pairs built from Dow 30 components or BSE 30 (India) components that not only show 100 per cent divergence across recurring periods but also deliver more than what conventional wisdom might find coincidence, the over reliance on equity clause stands open to debate.

We took this case in Grasim and Larsen and Toubro (L&T), two multi-billion dollar blue chips from the Indian equity universe. Performance pair cycles can isolate extreme divergences between highly correlated and similar sector peers too. Starting October 24, 2008 - March 24, 2009, a long Grasim – short L&T strategy returned 7 per cent, while from March 25 to July 1, 2009, the short Grasim–long L&T strategy returned 100 per cent.

This might look like a strange coincidence that if you buy one sector peer and sell the other one, the one you sell goes down, while the one you buy goes up. A similar divergence can be showed between Chevron - Exxon, Coca Cola -Kraft, GE-Caterpillar, Pfizer and J&J and even between equity components and index. How can one explain this divergence? How would the market explain and measure this ability to isolate such performances on a regular basis?

The author is CEO, Orpheus.asia, a global alternative research firm