Returns from thematic robo-advice portfolios can be boosted by using quantitative screens without increasing risk for investors, according to a whitepaper from digital investment solution provider Quantifeed.
In its whitepaper titled Designing thematic indices with a quantitative factor, released today, Quantifeed analysed an improved methodology for global thematic index construction to help digital wealth management providers drive higher returns for clients without additional risk to portfolios.
Senior quantitative strategist and author of the white paper, Gaudi Schneider, said mass affluent consumers in the Asia-Pacific region who are receiving wealth management online can truly benefit from a quantitative overlay to their portfolios.
Mr Schneider said there are two distinct approaches to building indices: thematic indices, based on investment themes; and factor indices, based on empirical research of past investment returns.
While the former approach is based on a forward-looking growth story for a niche industry, the latter uses quantitative variables, such as volatility, yield, size and momentum, Mr Schneider said.
“The thematic and factor approaches to building indices have their own individual advantages for digital wealth management services,” he said.
“However, at Quantifeed we believe that through a calculated combination of both, financial institutions can deliver a much better risk-adjusted performance.”
“Financial institutions, on the other hand, can also capture the opportunity of digital wealth management services not only by servicing this segment of clients remotely, but also by delivering to them an enhanced portfolio performance,” he said.
According to Mr Schneider one way of introducing a factor to a given thematic portfolio is to apply weights to securities based on a specific variable, for example, volatility, instead of the standard weights based on market capitalisation.
“Low volatility stocks have been shown to outperform higher volatility stocks over extended periods of time,” he says. “Taking advantage of this phenomenon can be achieved by giving stocks with low volatility a greater weight in the portfolio. We call this inverse volatility weighted.”
To illustrate the effect that a factor can have on a thematic index, Quantifeed looked at a group of stocks of US listed companies that are active in the design of robots and automation services.
By applying the inverse volatility weighting (IVW) quantitative factor to this group of stocks, Quantifeed’s model outperformed the original index by 11 percentage points over a three-year period between February 2014 and February 2017, Quantifeed said.
“While the original version of the index declined by 4 per cent during this period, the version with the quantitative overlay rose by 7 per cent during the same period,” the statement said.
To enhance performance further, Quantifeed’s analysts applied an additional quantitative factor but into the stock selection process.
The additional screen included the fundamental measurement of Return-on-Invested-Capital (ROIC), considered by the analysts as an appropriate criterion for the robotics industry, which usually requires large investments in research, factories or machinery.
The results of the ROIC inverse volatility weighted index showed this time a 11 per cent return during the three-year period, leading to an outperformance of 15 percentage points over the original index.
In neither of these cases did the factorised portfolios gain in volatility versus the original index, Quantifeed said.
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