Read this article and learn about:
- Why operational efficiency spurs investment performance
- The detrimental impact of shortfalls in your operational setup
- Why an IBOR is fundamental to an operational framework
- Enabling profitable growth for asset managers
- Forecasting operational performance to build your ROI case
About the author:
Chito Jovellanos, President and CEO, forward look inc., Boston, USA.
Prior to heading up forward look, inc., he held executive management posts with Instinet, ScotiaMcLeod, Thomson Financial, and ISI Emerging Markets. Chito Jovellanos participates in industry groups on derivative processing and commodity trading, publishes in refereed journals, and speaks regularly on information quality in the global securities industry.
About forward look, inc.
forward look, inc. is a Boston and San Francisco based advisory firm that enables investment managers to systematically improve portfolio performance by minimizing implementation shortfalls stemming from suboptimal investment operations. It works exclusively with asset managers and plan sponsors with AUM ranging from USD 5bn to 500bn.
A new case study on leveraged loan portfolios further demonstrates how the quality of investment operations contributes directly to portfolio performance. Well-established analytic tools applied to data already on hand highlighted the value of an investment book of record (IBOR). Analytics also enabled forecasting of operational performance as a means to sustain growth in asset management, and evaluate potential return on IT investments.
In our 2013 Journal article1, we described how minimizing portfolio implementation shortfalls within investment operations prevented the slippage of between 51-242 basis points (bps) of alpha inherent in the manager’s strategy.2
Analytics were applied to:
a) identify the sources of portfolio performance degradation due to issues arising within investment operations (e.g. cash management), and
b) clarify pathways for remediation (e.g. better variation margin reporting and simpler prime broker workflows).
Although asset selection is the primary driver of alpha , expressing and retaining that alpha over the life of a portfolio is determined largely by the quality of investment operations.Chito Jovellanos, President and CEO, forward look inc., Boston, USA.
Since that initial article, we have had the opportunity to monitor additional real-world portfolios. The new information gave us the latitude to move from a purely descriptive approach to a more inductive posture, such as forecasting on-going sources of implementation shortfalls as inputs into risk management models and firm-wide strategic planning.
As an example of our inductive approach, we will present a recent case study that highlights:
- the sequential and recurring nature of implementation shortfalls,
- why continuous operational vigilance is the best guarantor of attaining alpha; and
- how analytics enable actionable insights into investment operations processes.
Case study: Leveraged loans ... higher yield, higher risk
Since 2010, asset managers have begun to invest increasingly in leveraged loans. This strategy is a response to rising rates and renewed inflation in a ‘new normal’ of muted returns across a broad spectrum of asset classes. Leveraged loans offer higher yields but are complex structures4 with equally complex servicing needs (e.g. the mean time to settle in 2013 was 23 days).
Between 2012 and 2015, we worked with three institutional managers who ran high-yield strategies that were driven mainly off leveraged loan portfolios. Our analysis of the operational workflows in these leveraged loan portfolios highlighted three essential outcomes.
1. Sources of portfolio implementation shortfalls emerge in sequence and often in cascades (see upper line in Figure 1).
For leveraged loans, the implementation shortfalls that depressed portfolio performance (as expressed via our DOT metric5) included basic data management (e.g. issuer and credit quality attributes); reconciliation accuracy; cash management lags; and breaks in manual processes.
2. To preserve the inherent alpha over the duration of a strategy, constant vigilance is required to offset the impact of implementation shortfalls (see lower line in Figure 1).
Many shortfalls are non-recurring given that the investment landscape is constantly shifting (e.g. new issuers with novel reset terms rushing to market in advance of an anticipated rate hike, giving rise to reconciliation problems early on). However, many are also in the realm of déjà vu (e.g. data management of issuer and security attributes). As shown in the lower line of Figure 1, portfolio performance reverts to its true potential once the source(s) of the implementation shortfalls are addressed.
3. Portfolio implementation shortfalls can be forecast and addressed in near time.
We further leveraged our analytics to enable short-term forecasts (i.e. a one-month horizon) of potential implementation shortfalls as expressed in the DOT metric (see Figure 2). We accomplished this goal by running Monte Carlo simulations of an asset manager’s workflows and evaluating the potential range of DOT values projected by our model 30 days out. The relative shifts month-to-month in DOT values correlated well with the observed changes (both degradation and improvement) in portfolio returns. For asset managers in particular, pre-empting shortfalls is critical. Growth can be sustained only if their strategic choices in market positioning (e.g. new asset classes and strategies) and investments in distribution capabilities (i.e. sales ‘alpha’) are consistently validated through positive product performance.6