By Joshua Satten, director of Sapient’s fintech practice and head of business development and market strategy with specialties in fintech, over-the-counter operations and business architecture, and David Depew, vice president of Sapient Consulting.
While an Investment Book of Record (Ibor) has traditionally focused on operations and accounting support to strengthen data utilisation, optimise trade support analytics and tighten risk management, a properly optimised investment management system can include many more beneficial elements. Investment is the key term that defines an Ibor: It should contain information to analyse and improve the fundamental steps of the investment process.
Without alpha generation, any downstream protection is simply damage control. Therefore, an Ibor should provide data that combines a defined fundamental template (that is, valuation model), price history and performance with recent news, sell-side analyst reports and internal analyst recommendations.
Additionally, an Ibor can deliver the data for back testing tools for different alpha characteristics used by the portfolio manager. This would allow the manager to better understand performance in different market or economic environments.
To support asset preservation, the Ibor must feed security selection tools involving quantitative screens based on the manager’s investment philosophy. When properly executed, a robust Ibor becomes a combination of tools and processes that results in a more efficient and transparent alpha process.
Using this data, an analyst can calculate information coefficients (the correlation between a factor’s changes and a security’s performance in some subsequent period) for a manager’s alpha factors. This quantifies the effectiveness of a given alpha factor, and can be done over multiple time periods and within different market environments. This information helps determine what is working and what is not. Senior management can use this information to determine whether a manager is following his or her stated investment philosophy.
Portfolio Construction and Risk Management
Portfolio risk management ensures there is exposure to alpha factors in any given portfolio and outlines the exposures to risk factors, which the portfolio manager may or may not want to minimise. An Ibor can help achieve these goals. It stores all the factor exposures and returns to enable analysts to then analyse a time series of exposures and returns to explain performance. Investment personnel can then modify and adapt exposures going forward. The Ibor should store all needed information to perform historical back tests and bias tests to illustrate the effectiveness of risk models.
Trading costs have never been more important. The average domestic mutual fund has 100% turnover with costs of 75 basis points. These costs and turnover imply a trading performance drag of 150 bps, therefore any efficiencies can translate into significant improvements.
Transaction cost analysis (TCA) offers an information set to make trading process improvements. Ibor data can fill this gap with trading studies that define action items and trading strategies to improve the implementation process.
Further, more fund managers are using derivatives to express investment views, modify payoff patterns or manage risk. However, not all buy-side firms have the analytical tools to properly analyse different strategies. An Ibor could store what-if analyses to facilitate meaningful dialogue between portfolio managers and traders.
For trading to have a defined effect on fund performance, trading groups need a varied toolkit, real-time information and ex-post analytics. Ibor data can be the input for tools to help trading groups define their value within the investment process.
A tightly held investment philosophy provides discipline and a foundation during a period of volatility. Most commercial performance attribution systems do not have adequate (or comprehensive) derivatives capability.
One solution is to create a system where the derivatives exposures are mapped to the underlying physical securities and then stored in an Ibor. This would allow the constituents of a stock futures index to be included in sector, capitalisation or style performance analysis.
A performance attribution system that feeds an Ibor would provide timely information to all participants in a format conducive to effective use, resulting in performance and process improvements.
It can also provide insight into how the activities and systems of one step interact with the other steps in the investment process. For example, if optimisers are used in portfolio construction, one should be careful to manage the risk associated with risk factors as opposed to the alpha factors from the alpha generation.
Otherwise, the optimiser could inadvertently reduce alpha. The stock selection process could drive up trading costs if analysts and portfolio managers consistently buy and sell stocks with strong negative momentum. The value of identified alpha drivers must be proved and can act as a test as to whether an investment team is following their stated game plan.
Preserving alpha through analysis and improvement
Using an effective and holistically complete Ibor, investment managers can address a number of issues at each step in the investment management process, thereby adding value and preserving alpha.
It has the potential to redefine the very nature of how investment operations are performed. The cost of reacting slowly can be significant, especially for undifferentiated firms. This is an opportune time for firms to refine or develop their Ibor strategy. The foundational framework for the alpha process can benefit from design thinking and disruptive innovations— and ultimately enable firms to get ahead of their contemporaries.