Let’s go even further back to school mathematics. Simply put in maths one uses one or more known variables to determine the value of an unknown. The simplest 1 + 2 = 3 equation works this way. “1” (is a known variable) the “plus” tells us what to do (this is addition) the “2” is the second known variable. Add the two known variables together and you determine the value of the unknown which is “3”. Capital can be managed in the same way, by using mathematics or quantitative techniques to determine what assets should be included or excluded in a portfolio.
Let’s go back to our actuary.
An actuary by analysing the responses on a life assurance application is trying to exclude those persons who are more likely to submit a claim to early in the life of the policy. In other words the actuary is trying to select the healthier lives to place under insurance policies by avoiding the unhealthier lives that could damage the claim history of the risk pool as a whole, which would then require a severe increase in policy premiums causing policyholders to cancel their policies.
So, let’s apply this to managing portfolios of listed shares….
Imagine a listed company has a share price of R1000 per share, they have 50 shares in issue, and they produce loaves of bread which sell for R50 a loaf and the company’s annual earnings are R50,000. So simply put the company needs to sell 1000 loaves to justify their share price. If they only sell 500 loaves, then the company does not justify its share price but if it sells 5000 loaves then they more than justify their share price. But this is only the current information for this financial year. Our actuarial models say you must look into the medical history of the life assured…. So, in our listed share example, we need to look into the history of the company and look into how often in the past the company has justified its share price. So if we research the company’s history and we see that in the last 10 years the company has justified its share price 90% of the time in the last 10 years then we have a good probability that this company will continue to do this into the future. We then find more and more companies with a similar probability of justifying its share price and we have a portfolio of strong performing shares. This portfolio of strong performing shares can be created into an index and be measured on a daily basis as share prices change and hence the probability of the performance of the company is either improved or deteriorated as the share price changes. This is known as Required Business Performance, a concept developed by New Age Alpha in New York.
This index of shares is constantly being monitored by algorithms and the shares on the index are added to the index or removed from index based on the probability of the management of the company being able to justify the share price. This index is the portfolio of a unit trust that investors can invest their capital into.
Simply put this method is not looking for the winners of tomorrow but is rather avoiding the constant losers. Similar to asking a mountain biker to ride a trial where there is a 95% chance that he will fall and break a collarbone as opposed to asking the same mountain biker to ride a trail where he will have a 95% chance of enjoying the ride and not getting hurt, which trail do you think he will pick?
The index is managed by an algorithm because in this way there is no fund manager who after researching a company for many year decides to buy that company’s shares only to hold them in his portfolio for too long or for not long enough. This is called avoiding the “Human Factor”. The higher the Human Factor the higher the probability that outcome will not be in your favour. The lower the Human Factor the lower the probability that the outcome will be in your favour. Once again, we are not picking the winners of tomorrow, just avoiding the losers. The human factor is also applied to share selection for the index. If the probability of the management of the company cannot justify the share price consistently then the company requires a human to change something within the company so that the management of the company will be able to justify the share price. Hence the human factor is high.
New Age Alpha in New York have complied a human factor score for many of the listed shares on stock exchanges around the world. This is much of the techniques being used in the GLAM funds that we have launched.
But that’s not all
In researching the JSE and the ability to use the Human Factor approach to managing equities in SA, we discovered that because the SA market is so small, we had to mix this approach with other factors developed by Salient Quants lead by Prof Paul van Rensberg in Cape Town. The factors used by Salient Quants use Large Cap, Small Cap, value, Low volatility and momentum factors mixed with the Human Factors to determine the perfect mix of shares in an index which will deliver a higher than average return over time consistently without increasing risk simply by avoiding the losers and not picking the possible winners of tomorrow which is an unknown variable. The funds are all managed by an algorithm which selects the shares and rebalances the allocation in the fund.
So, in the end we have passive funds, managed actively.