Alpha

By Eric Peters, CIO of One River Asset Management

Alpha

“It requires that you think holistically about your portfolio,” said the CIO of a sovereign wealth fund, somewhere in Asia Pacific. “It’s the way you’d think in my seat. You’d look at the overall risk, netted off across all the portfolio positions,” he said. “It’s similar to running a multi-strat fund with a comprehensive risk management structure and a center book, the difference being that we are by design long the market rather than market neutral.” We were talking about a Total Portfolio approach to investment management. Of the largest pools of investment capital in the world, several of the leading performers are run in such a way.

“Typical large investment funds have asset class teams, and each will try to optimize its own portfolio, its own allocation,” continued the same CIO. “Whereas we try to optimize across the whole portfolio, every asset class, all opportunities, at least conceptually,” he said. “If you go down the route of having asset class teams, you somehow need to find how to compare the returns of capital across asset classes and manage a competition for capital so that you allocate to the best investment. There’s always a conflict between bottom up and top down.”

“We organized ourselves in a different way,” he said. “We have a whole team of generalists and hopefully they can do anything,” he said. “But the reality is that you naturally get market segmentation. And expertise on certain asset classes and sectors is very important.” So, he’s been trying to increase the degree of specialization across the investment team without losing the whole of portfolio approach. “And it gets harder at the size we’re running at,” he admitted.

“One of our key advantages is that we have a very long-term horizon,” he explained. “It allows us to have quite a high risk appetite.” They take substantial active risk around their reference portfolio, accepting the volatility required to generate alpha. “We think about where we have structural advantages, where and why we may have a better chance of making money than others in such a competitive marketplace.” They don’t require short term cash flows. “We can really look through situations, events, dislocations, see across the chasms.”

“Perhaps our biggest advantage is governance,” he explained. “You can only really think long-term if you have real buy in from your investors,” he said. “We have only one investor, a clear mission, and strong buy in.” As a sovereign wealth fund, they have access to unique investment opportunities, managers, and certain reputational advantages too. “We’ve been able to stick with our strategy because people have bought into it. And of course, if there were ever a few years of negative returns, that could be tested. But the philosophy has worked well.”

Anecdote:

“Conceptually it’s very easy,” said the CIO. “Practically it’s very hard,” he continued. A lovely winter day in August, the world upside down. We were discussing dynamic asset allocation, which for them consists of adjusting one’s portfolio to lean against powerful market trends. “It is the part of our investment program that our peers are most interested in discussing.” He leads a sovereign wealth fund with the world’s top performance for the past decade. To outperform requires investors do those things others generally do not. Defying the crowd at such scale is high art.

“We base our dynamic asset allocation decisions mostly on relative valuations. It is a mean reversion process that capitalizes on volatility harvesting. And at times we will underperform, even have substantial drawdowns, but in the long run it has produced tremendous alpha.” In 2021-22 the approach helped contribute to the portfolio outperforming its 80/20 equity/bond benchmark by 700bps.

“If you’re entering a high-volatility trending environment, the strategy is not very good. But if you’re entering a high-volatility non-trending environment, it is quite a good approach,” he said. “The periods that are both most challenging and ultimately rewarding are when you’ve had markets selling off a lot and your long position gets bigger and bigger, your liquidity is drawing down. You need to have the right limits at those times, and our limits are bigger than others because of our long horizon,” he said. 

“When that happens, like it did during Covid, when the collapse was faster and deeper than we thought it should be, it made us wonder, do we understand the underlying distribution?” Such periods torture those who risk defying the crowd, because of course, no one can outperform without paying a steep price, emotionally, mentally, physically. “It made us consider, if something is at an extreme, do we feel more confident that it will revert? Or less confident, because perhaps we don’t understand the underlying system?”