Rare positive returns with a passive index format

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There have been few things to smile about this year. But here’s one. An index based on US stocks has outperformed the total returns of the S&P 500 by 51.7 percentage points over the first 11 months of the year. Over the past three years, its annualised outperformance was nearly 17 percentage points; over the past five years, it was more than 13 percentage points.

Société Générale’s SGI Wise US Long-Short Index, which was introduced in early April, has been able to outpace the broad market in all kinds of conditions, revealed by back testing to 1992. Since then, its annualised return was 13.2 per cent through the end of November versus 6.5 per cent for the S&P 500.

SocGen does not appear to be taking significant risk to generate these kinds of returns. The index maintains a standard deviation target of 8 per cent. Over the past three years, the S&P 500 standard deviation has been averaging more than 15 per cent.

SocGen is achieving this outperformance not just in the US but in many of its quantitative indices across the globe, whether they are tracking Nordic, European, emerging market or global stocks and bonds.

Quantitative strategies like this have been roundly criticised since the subprime meltdown started rattling markets in 2007. They were accused of failing to anticipate the impact of huge sums of money following similar strategies at the same time, which exacerbated the initial sell-off.

But that claim unfairly paints all quant-driven strategies with the same brush. Yannick Daniel, head of SG Indexes in Paris, says: “Our transparent algorithmic indices are designed to deliver alpha regardless of what the market is doing, with a better risk-return prospect than traditional indices.”

SocGen offers these indices primarily through structured products and certificates. Some products are designed with capital guarantees; others seek greater returns by taking on more risk over predetermined investment horizons that range anywhere from three to eight years.

Of the 17 alpha indices, eight are based on SocGen’s Wise investment model that analyses various valuation and momentum metrics, such as earnings trends, price-to-earnings, price-to-cash flow, and price sensitivity to corporate news. SocGen then identifies a concentrated number of a benchmarks’ most and least attractive stocks in establishing long and short positions.

Three indices are based on multiple asset classes, involving stocks, bonds, commodities, interest rate trades, real estate, and hedge funds. The remaining six indices each rely on their own distinct strategies, such as the Fed Model, covered calls, and global bonds.

The latter, known as the SGI Bond Optimized Sharpe Strategy (Boss), has €400m (£391m, $564m) in institutional money tracking the index. Selecting from a universe of sovereigns denominated in pounds, dollars, yen, euros, and Swiss francs, with maturities ranging from six months to 30 years, the index capitalises on the slope of the yield curve using interest rates swaps.

In the first nine months of this year, Boss significantly outperformed its benchmark, returning 7 per cent versus 2.5 per cent for the index. However, extraordinary volatility and fear from October to early December sent the sovereign benchmark’s year-to-date returns climbing to 8.37 per cent while the index’s performance sank to 1.9 per cent.

Among the biggest outperformances generated by SocGen’s quantitative indices is that of the long-short Emerging index. While the MSCI Emerging Market index was off by nearly 54 per cent for 2008 as of early December in euro terms, SocGen’s strategy was down 13 per cent.

Mr Daniel explains the index achieves alpha by investing in only 50 of the most compelling emerging market shares while shorting a select group of global mega-cap stocks, known as the Dow Jones Global Titan Index, which reduces the index’s sensitivity to global equity markets.

Since its launch in May, the index has attracted €150m from European private banks and Asian retail networks.

Vianney Dubois, director of Seeds Finance, a Paris-based independent financial consultant with €1.2bn under advisory management and no current exposure to the indices, thinks SocGen “has effectively pushed the integration of quantitative strategies further than we’ve ever seen in a passive index format”.

However, Mr Dubois is concerned how well some of the long-only and short-volatility indices will hold up under the most stressful times, which back testing may not have captured. The long-only indices for the
US, Europe, and emerging markets, for example, have been underperforming their benchmarks, albeit during one of the worst trading periods ever seen.

It is too early to know if recent market weakness has hurt SocGen’s business model. It is not evident in asset growth. In less than two years since introducing its alpha indices, related structured products have grown to more than €1.3bn, 40 per cent held by retail investors and 60 per cent by pension funds, asset managers, and insurers. SocGen’s top-line is based on an up-front fee structure determined by the complexity and maturity of the product.

To enhance distribution, SocGen is speaking to fund managers in the US, continental Europe and Asia who are considering licensing some of the indices to create their own branded versions. But Mr Daniel intends the lion’s share of business to remain inhouse.

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