Advanced Analytic Tool To Beat Benchmarks And Passive Investing

[The nature of markets evolve and change. What is driving today’s volatile markets are increased uncertainty, complexity, huge institutional money flows, sentiment and social media. In this current environment it has become important to pay more attention to and have respect for price trends. That is because these trends can make a substantive difference in an asset manager’s yearly performance.

In any list of stocks satisfying whatever fundamental and quality criteria, there will be outperformers and underperformers caught up in these market trends. The ability to overweight the exposure to the winners, while limiting the losers can boost the performance of any investment strategy. But evaluating and measuring trends requires sophisticated models that capture investors’ money flow. Relying solely on traditional technical analysis approaches may not be enough as they can prove erratic across market cycles.

That is why Bloomberg and other research platforms are aggressively adding new data sets and analytical resources. There seems to be a growing demand in the market for more intelligent, sophisticated tools and advanced analytics, especially predictive analytics. This is leading to newer analysis approaches that can rate an equity portfolio based on price trend exposure with strong correlation and predictive ability. This is similar to how the Sharp ratio was originally developed to project the expected relative performance of a portfolio to a risk-free asset. 

To better understand and dig deeper on some of these newer advanced analytical tools available and how to apply them to your investment process, we reached out to a leader in this field, Rocco Pellegrinelli, CEO of Trendrating — a Swiss based company providing advanced price trend analytic solutions for active investment managers. With the ongoing perception and SPIVA performance report statistics in the active versus passive debate driving flows to passive funds, Trendrating is taking on the challenge to prove that active managers can beat the benchmarks and passive fund performance with the right tools and market intelligence added to their investment methodologies.]

Bill Hortz: Why is it that active managers struggle to outperform their benchmarks and passive products? What’s your take on this?

Rocco Pellegrinelli: Many fund managers explain this away by saying the fee structure to run an active fund is higher than passive ones. I find this to be over simplistic and it deflects us from the core issues behind the underperformance problem. Actually, active managers have a great opportunity to deliver alpha profiting from the fact that equity markets display a huge dispersion of performance all the time.

In 2020, if you look at the S&P 500 constituents, the differential between the top 25% performers and the bottom 25% performers is massive. The average return of the top 100 stocks was 105% while the bottom 100 was -18%. This is enough to provide an opportunity for intelligent, evolved stock picking to beat the 16% return of the index.  It is clear that if an active manager can capture a part of the top performers and avoid most of the bottom performers, they can make up for the fees several times over. So, the real problem is not fees, but investment decision processes that are still based on decades old theories that rely heavily, if not exclusively, on fundamental analysis and subjective valuations.

Hortz: How should advisors and asset managers be looking at this overall performance gap between active and passive? What do you suggest they should be focusing on?

Pellegrinelli: Look, active managers have the latitude to pick the stocks they want. They do not have to replicate or hug a benchmark. Any benchmark at any time is a list of stocks aggregating securities in a bull trend and securities in a bear trend with a well-defined distribution or allocation. All it takes is for active managers to make sure that the “trends allocation” of their portfolios is better than the one of the chosen benchmark to beat.

The key is to develop strategies that overweight the exposure to rising stocks, while limiting positions on falling issues. We call it “trends allocation analysis and management” vs. the index. We developed a sophisticated multi-factor model to provide a way to rate the trends of individual stocks and enable an aggregated “rating” for portfolios.  For example, a portfolio rating of A-, higher than the benchmark rating of B+, increases the probability to outperform.

Hortz: Does this approach necessitate a major change for active managers’ investment process?

Pellegrinelli: At Trendrating, our vision is that every strategy should incorporate an element of trend valuation. It’s about acknowledging, respecting and profiting from actual, observable price trends at the heart of this price dispersion, rather than strictly believing in subjective forecasts or price objectives based on whatever approach. To put it simply, all it takes is to incorporate some trend valuation metrics into the defined investment strategy. This leverages the profit potential of their existing by adding a layer of objective, unbiased trend assessment.

Price trends are more extreme and last longer than in the past as they are impacted by several factors of which company fundamentals are only a small part. Money flow caused by major firms, analyst sentiment, social media sentiment, momentum players, and an economic landscape full of uncertainty and fast changing scenarios all contribute to creating and accelerating price trends in either direction that value-driven methodologies cannot capture.

Hortz: Can you explain further how your firm designed your advanced price trend analytic tool to help active managers?

Pellegrinelli: Our team has 25 years of experience building equity models, and after many years of research and development, we designed a way to rate price trends. We provide a rating for trends with a time horizon of 6-to-18 months. These trends tend to make a measurable difference in the yearly performance important to active managers. The model captures the beginning of bull and bear trends on individual stocks with a reasonable accuracy. A and B ratings confirm bull trends while C and D rating identify bear trends.

Our mission is to provide a well validated, robust metric to qualify the true direction and quality of price trends. We do not forecast how long and how far a trend can go. We do not believe in forecasting. What we provide is a clear rating that reflects the strength and quality of existing price trends. Our data provides discipline and objectivity as a solid sanity check across the holdings of any portfolio.

To make this easy and actionable, we introduced a critical, innovative metric to evaluate the overall trend exposure of portfolios. In addition to rating the individual holdings, we can then calculate the aggregated, weighted rating of the entire portfolio. It’s called the Trend Capture Rating (TCR).

Hortz: Can you give an example of how fund managers can use your TCR tool to beat their benchmark?

Pellegrinelli: TCR measures how your portfolio is positioned in terms of rising stocks vs. falling securities. For example, if the portfolio TCR is B- while the benchmark TCR is B+, you need to examine the underlying holdings to find out why.  If my portfolio is holding 30% or greater of C and D rated stocks, while the benchmark contains only 15%, then the probability for the active portfolio to beat the benchmark is little to none. By raising the TCR of the portfolio to B+ or higher the chances to outperform substantially increase.

Improving the portfolio rating is easy. The manager can just reduce the exposure to C and D rated stocks by reallocating more to other stocks in the same universe that fit with a positive rating (A or B). Adding TCR analysis can remarkably improve the performance of fundamental-driven investment strategies, combining good fundamentals with proven price action predictive analytics.

Hortz: The concept of reducing holdings in poorly rated stocks and reallocating to stocks in clear uptrends makes sense. What are the potential obstacles you face in the adoption of TCR?

Pellegrinelli: I have to say that we are experiencing a growing demand for our solutions as the asset management industry is turning more to the adoption of alternative data and advanced analytics. The challenges portfolio managers face are not only related to delivering more value to investors, but also to stay in line with risk controls, to increase efficiency, and drive down costs. However, sometimes we still meet resistance to innovation and change.

The evolution of incorporating objectively based technology versus subjective human instinct is still a barrier we run up against. Skepticism can be a problem and inertia is even more challenging. Some managers look at their investment process as rock solid, without acknowledging that the entire dynamic of investment management has dramatically changed over the past decade. Some reject any potential improvement as unnecessary, despite the fact that their performance figures may show otherwise.

Hortz: Any other thoughts or recommendations you can offer advisors and asset managers on this new investment technology?

Pellegrinelli: To work with investment professionals, we readily offer free evaluations of our data and technology platform to let them put our tools to the test. We encourage those interested to run an actual performance comparison of sample portfolios with and without using our methodology. Facts will show if what we say is true.

We invite you to explore our asset management toolkit on Bloomberg or visit us on our website to see how we work with professional investors.

The evolutionary trend toward higher standards of value and efficiency by combining elements of both human knowledge and technical innovation will force a change away from the status quo. And our proposition is simple and clear — “get the trend allocation right and beat passive products.”

Source: Nasdaq, Inc.

‘Best financial services innovation articles and thought leadership discussions that the Institute for Innovation Development (IID) developed throughout 2021.’

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