My experience at the startup BSD Investing

December 14, 2021 by Rohit SALUNKE

My experience at the startup BSD Investing

In this article, Rohit SALUNKE (ESSEC Business School, Grande Ecole Program – Master in Management, 2018-2021) shares his experience working in a startup and the evolution of his role and responsibilities…

About BSD Investing

BSD Investing is an independent research firm operating in the asset management industry. It primarily provides research and analysis on active vs passive fund performances for equity and debt funds present across the global financial markets.

The funds are domiciled in Europe (i.e., these are European funds investing in domestic and international markets) and span across 62 universes (i.e., global markets and investment styles).

Logo BDS Investing

The goal of the research is to provide BSD Investing clients with insights into the active vs passive performances and help them optimize the portfolio to get better risk adjusted returns.

The evolution of my missions

I started working at this startup in July 2019 in a small office in Saint-Lazare area in Paris, France. At the beginning, it was just me and two others, the founder, and her colleague. We started from scratch, trying to figure out the best data source to use, figuring out the process flow, the product and much more. After selecting Morningstar as our primary data provider, I began writing codes in Python to fetch the data, create our own portfolios and develop performance key performance indicators (KPIs) for those portfolios. Since we did not have any employee skilled in IT, I was the one who took charge of creating the entire IT architecture from data handling to reporting.

After working for about eight months, we hired our head of IT, and he took over the handling of the IT system and made it much more efficient. That’s when I got the chance to devote my entire focus in developing quantitative models and simulations for the performances of our portfolios.

I started off with researching various technical indicators that gave insights into the market performances and how active funds fared in comparison to passive funds. A major portion of my time was devoted to simulating portfolio performances using various indicator signals. The signals were basically an indication to increase or decrease the active allocation to the portfolio.

Apart from this, I helped a lot with creating marketing materials, conducting market research, interviewing portfolio managers to understand the asset management industry and their needs.

In addition, I work very closely with the IT head to implement our models and key indicators onto the website.

Active and Passive funds

The asset management industry is broadly divided into two management styles: the active style and the passive style. Both styles follow a benchmark that could be an index (e.g., CAC 40), or a combination of indices, or a new portfolio that represent the entire universe of financial instruments in the category that the manager wants to invest in (e.g., Emerging countries large cap ESG funds).

Passive style

The goal of the passive fund manager is to create a portfolio that tracks closely the chosen benchmark. But, since a benchmark consists of a large number of stocks, investing in all of them is not very feasible or cost effective. Therefore, the passive manager creates a portfolio using a smaller number of instruments that aims to replicate the returns from the benchmark.

A good metric to measure the performance of a passive fund is tracking error. It is the divergence between the fund returns and those of the benchmark. A low tracking error means that the fund is tracking the benchmark closely and thus is performing well. Since, a passive fund (also known as ETF or index fund) manager does not aim to outperform the benchmark, but just to simply replicate its returns. Therefore, passive funds charge low fees.

Active style

An active manager on the other hand aims to beat the funds benchmark through stock picking, sector rotation and/or other methods. He or she thus takes a larger risk than a passive fund manager and needs a lot more research, expertise, and management. Therefore, an active fund generally charges more fees than a passive fund. For example, among the France large cap funds, an average passive fund charges around 0.25% of fees, whereas an active manager’s fee may range from 1-2%, in some cases more than 4%.

Active managers are alpha seeking. Alpha is the excess return that an active manager generates compared to its benchmark. There are multiple ways to calculate alpha. One such way is using the CAPM model. We predict the expected return of the portfolio using the CAPM model. Subtracting this return from the active managers portfolio gives the alpha. A passive funds alpha is supposed to be zero.

Fund of funds managers create a portfolio of active and/or passive funds to meet their return and risk objectives.

Best style?

In the asset management industry, there is an ongoing debate about which management style is better and are the extra fees charged by the active managers really worth it?

In the US, for example, the active funds have performed very poorly as compared to the ETFs. Whereas, in Europe the performance was mixed and in Japan, the active funds performed better. However, these are the results over the entire period of 10 years. There have been many periods when the active funds outperformed.

Taking the recent example, after the Covid-19 pandemic, the markets went haywire. Since then, in most of the universes active funds have outperformed the passive funds. Therefore, higher returns can be achieved by understanding the markets and allocating the portfolio to the right management style at the right time.

My key learnings

Working in a startup is always challenging and the job comes with heavy responsibilities.

And although working in a startup sounds very interesting, most of the work during the very beginning is quite tedious when it comes to data handling. I spent a few months just understanding the data, checking for errors from the source, figuring out ways to deal with data errors and so on.

Once, I started working on the quantitative models and the simulations, I felt that my work has just begun. During this time, I learnt a big lesson regarding building quantitative models. I build very sophisticated models including machine learning models such as neural networks, gradient boosted trees and so on. However, despite the good results, I had to use simpler logistic models because selling overly sophisticated models would become very difficult.

People in the asset management industry need to know what the real meaning of the data is. And giving recommendations using a black box model does not make it very easy to understand the functioning of the model.

Working on the various indicators, trying to understand their correlations with active and passive fund performances gave me good insights about them. For instance, one good variable that works the best for me is dispersion. This is the standard deviation of returns among funds or stocks. During periods of high dispersion, I observed that active funds generally outperformed the passive funds. I saw a similar result during periods of high volatility. An explanation to this is that a high dispersion could signify a period of high inefficiency in the market, which the active managers could take advantage of. When markets are highly efficient, it makes sense to invest in ETFs, and reduce your costs. Whereas, during periods of high inefficiency, a good active manager could be worth the higher fees that he/she charges. As described above, since March 2019, the active managers have generally outperformed the passive funds across many universes. And this period is also marked with high dispersion and volatility.

In addition, we found that bear periods were more conducive to active outperformance, while bull periods were not. This can be understood since the volatility and dispersion is generally high during bear periods. However, periods after March 2019 were an anomaly to this, since although the markets are in a bull run, there is high dispersion and volatility, and the active funds are outperforming the ETFs.

Knowledge and skills required

For this job I had to have strong data skills, coding skills as well as sound knowledge about finance.
In addition, since I had little to no guidance in my role, I had to come up with my own tasks, define the product and its objects and then learn the essential skills to build it.

Therefore, there was a lot of market research, visits to stackoverflow, reading research papers, cold mailing portfolio managers and so on. Thus, project management and communication skills are essential.

Hard Skills

Python
SQL
HTML
MorningstarDirect
Capital Markets
Portfolio Management, Optimization …
Risk Management
Market Research

Soft Skills

Communication
Project Management
Leadership
Entrepreneurial Thinking
Ability to handle pressure
Dedication to your project and display of ownership

Useful resources

BSD Investing

Morningstar

About the author

The article was written in December 2021 by Rohit SALUNKE (ESSEC Business School, Grande Ecole Program – Master in Management, 2018-2021).

Passive Investing

November 21, 2021 by Youssef LOURAOUI

In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) elaborates on the concept of passive investing.

This article will offer a concise summary of the academic literature on passive investment. After that, we’ll discuss the fundamental principles of passive investment. The article will finish by establishing a link between passive strategies and the Efficient Market Hypothesis.

Review of academic literature on passive investing

We can retrace the foundations of passive investing to the theory of portfolio construction developed by Harry Markowitz. For his theoretical implications, Markowitz’s work is widely regarded as a pioneer in financial economics and corporate finance. For his contributions to these disciplines, which he developed in his thesis “Portfolio Selection” published in The Journal of Finance in 1952, Markowitz received the Nobel Prize in economics in 1990. His ground-breaking work set the foundation for what is now known as ‘Modern Portfolio Theory’ (MPT).

William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966) separately developed the Capital Asset Pricing Model (CAPM). The CAPM was a huge evolutionary step forward in capital market equilibrium theory because it enabled investors to appropriately value assets in terms of their risk. The asset management industry intended to capture the market portfolio return in the late 1970s, defined as a hypothetical collection of investments that contains every kind of asset available in the investment universe, with each asset weighted in proportion to its overall market participation. A market portfolio’s expected return is the same as the market’s overall expected return. But as financial research evolved and some substantial contributions were made, new factor characteristics emerged to capture some additional performance.

Core principles of passive investing

Positive outlook: The core element of passive investing is that investors can expect the stock market to rise over the long run. A portfolio that mimics the market will appreciate in lockstep with it.

Low cost: A passive strategy has low transaction costs (commissions and market impact) due to its steady approach and absence of frequent trading. While management fees required by funds are unavoidable, most exchange traded funds (ETFs) – the vehicle of choice for passive investors – charge much below 1%.

Diversification: Passive strategies automatically provide investors with a cost-effective method of diversification. This is because index funds diversify their risk by investing in a diverse range of securities from their target benchmarks.

Reduced risk: Diversification almost usually results in lower risk. Investors can also diversify their holdings more within sectors and asset classes by investing in more specialized index funds.

Passive investing and Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) asserts that markets are efficient, meaning that all information is incorporated into market prices (Fama, 1970). The passive investing strategy is built on the concept of “buy-and-hold,” or keeping an investment position for a lengthy period without worrying about market timing. This latter technique is frequently implemented through the purchase of exchange-traded funds (ETF) that aim to closely match a given benchmark to produce a performance that is comparable to the underlying index or benchmark. The index might be broad-based, such as the S&P500 index in the US equity market for instance, or more specialized, such as an index that monitors a specific sector or geographical zone.

A study from Bloomberg on index funds suggests that passive investments lead 11.6 trillion $ in the US domestic equity-fund market. Passive investing accounts for approximately 54% of the market, owing largely to the growth of funds tracking the S&P 500, the total US stock market, and other broad US indexes. Large-cap stocks in the United States are widely recognized as the world’s most efficient equity market, contributing to passive investing’s dominance. The $6.2 trillion in passive assets represents less than a sixth of the US stock market, which currently has a market capitalization of approximately $40.4 trillion (Bloomberg, 2021).

Figure 1 depicts the historical monthly returns of the S&P500 highlighting the contraction periods in orange. It is considered as a key benchmark that is heavily tracked by passive instruments like Exchange Traded Funds and Mutual Funds. In a two-decade timeframe analysis, the S&P managed to offer an annualised 5.56% return on average coupled with a 15.16% volatility.

Figure 1. S&P500 historical returns (Jan 2000 – November 2021).

Source: Computation by the author (data source: Thomson Reuters).

Estimation of the S&P500 return

You can download an Excel file with data for the S&P500 index returns (used as a representation of the market).

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in grasping the concept of passive investing, which is in practice key to investors, and which has attracted a lot of attention in academia.

Useful resources

Academic research

Lintner, J. 1965a. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1): 13-37.

Lintner, J. 1965b. Security Prices, Risk and Maximal Gains from Diversification. The Journal of Finance, 20(4): 587-615.

Mangram, M.E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research, 7(1): 59-70.

Markowitz, H., 1952. Portfolio Selection. The Journal of Finance, 7(1): 77-91.

Mossin, J. 1966. Equilibrium in a Capital Asset Market.Econometrica, 34(4): 768-783.

Sharpe, W.F. 1963. A Simplified Model for Portfolio Analysis.Management Science, 9(2): 277-293.

Sharpe, W.F. 1964. Capital Asset Prices: A theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3): 425-442.

Business analysis

JP Morgan Asset Management, 2021.Glossary of investment terms: Passive Investing

Bloomberg, 2021. Passive likely overtakes active by 2026, earlier if bear market

About the author

The article was written in November 2021 by Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).

ETFs in a changing asset management industry

February 3, 2021 by Youssef LOURAOUI

ETFs in a changing asset management industry

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2016-2020) talks about his research conducted in the field of investing.

As a way of introduction, ETFs have been captivating investors’ attention in the last 20 years since their creation. This financial innovation has shaped how investors place their capital.

Definition

An ETF can be defined as a financial product that is based on a basket of different assets, to replicate the actual performance of each selected investment. An ETF has more or less the same proportion of the underlying components of the basket, depending on the style of management of the asset manager. ETFs represent nearly 90% of the asset under management of the global Exchange Traded Products (ETP).

History

The first ETF was the Standard and Poor’s Depository Receipts (SPDR) introduced in 1993. It appears to be an optimized product that enables investors to trade it like a stock, with a price that fluctuates during the day (not like mutual funds whose value is known at the end of the day only). The main advantage of ETFs for investors is to diversify their investment with lower fees than buying each underlying asset separately. The most important ETFs in the market are the ones with the lowest expense ratio as it is a crucial point to attract money from investors in the fund.

Types of ETF

ETFs can be segmented in different types according to the asset class, geography, sector, investment style among other criteria. According to Blackrock’s classification (2021), the overall ETF market can be divided into the following classes:

Stock ETFs track a certain stock market index, such as the S&P 500 or NASDAQ.
Bond ETFs offer exposure to a wide selection of fixed income instruments.
Sector and industry ETFs invest in a particular industry such as technology, healthcare, or financials.
Commodity ETFs track the price of a commodity such as oil, gold, or wheat.
Style ETFs are devoted to an investment style or market capitalization focus such as large-cap value or small-cap growth.
Alternative ETFs offer exposure to the alternative asset classes and invest in strategies such as real estate, hedge funds and private equity.
Foreign market ETFs follow non-U.S. markets such as the United Kingdom’s FTSE 100 index or Japan’s Nikkei index.
Actively managed ETFs aim to provide a certain outcome to maximize income or outperform an index, while most ETFs are designed to track an index.

Figure 1. Volume of the ETF market worldwide 2003-2019.

Source: Statista (2021).

Figure 1 represents the volume of the ETF market worldwide over the period 2003-2019. With over 6,970 ETFs globally as of 2019 (Statista, 2021), the ETF industry is growing at an increasing pace, recording a thirty-fold increase in terms of market capitalization in the 17-year timeframe of the analysis. It reflects the growing appetite of investors towards this kind of financial instruments as they offer the opportunity for investors to invest virtually in every asset class, geographical region, sector, theme, and investment style (BlackRock, 2021).

iShares (BlackRock), Xtrackers (DWS) and Lyxor (Société Générale) can also be highlighted as key players of the ETF industry in Europe. As shown in Figure 2, Lyxor (a French player) is ranked 3rd most important player with nearly 9% of the overall European ETF market (Refinitiv insights, 2019). iShares represents nearly eight times the weight of Lyxor, which is slightly above the average of the overall European ETF volume in dollars.

Figure 2. Market share at the promoter level by Assets Under Management (March 31, 2019)

Source: Refinitiv insights (2019).

It goes without saying that the key player worldwide remains BlackRock with nearly 1/3 of the global ETF market capitalization. According to Arte documentary, BlackRock is without a doubt a serious actor of the ETF industry as shown in Figure 2 with an unrivaled market share in the European and global ETF market. With more than 7 trillion of asset under management, BlackRock is the leading powerhouse of the asset management industry.

Benefits of ETF

The main benefits of investing in ETFs is the ability to invest in a diversified and straightforward manner in financial markets by owning a chunk of an index with a single investment. It allows investors to position their wealth in a reference portfolio based on equities, bonds or commodities. It also helps them to create a portfolio that suits their needs or preferences in terms of expected return and risk and also liquidity as ETFs can be bought and sold at any moment of the day. Finally, ETFs also allow investors to implement long/short strategies among others.

Risks

Market risk is an essential component to fully understand the risk of owning an ETF. According to the foundations of the modern portfolio theory (Markowitz, 1952), an asset can be deconstructed into two risk factors: an idiosyncratic risk inherent to the asset and a systematic risk inherent to the market. As an ETF are composed of a basket of different assets, the idiosyncratic risk can be neutralized by the effect of diversification, but the systematic risk, also called the market risk is not neutralized and is still present in the ETF.

In terms of risk, we can mention the volatility risk arising from the underlying assets or index that the ETF tries to replicate. In this sense, when an ETF tries to emulate the performance of the underlying asset, it will also replicate its inherent risk (the systematic and non-systematic risk of the underlying asset). This will have a direct impact on the overall risk-return characteristic of investors’ portfolio.

The second risk, common to all funds and that can have a significant impact on the overall performance, concerns the currency risk when the ETF owned doesn’t use the same currency as the underlying asset. In this sense, when owning an ETF that tracks another asset that is quoted in another currency is inherently, investors bears some currency risk as the fluctuations of the pair of currencies can have a significant impact on the overall performance of the position of the investor.

Liquidity risk arises from the difficulty to buy and sell a security in the market. The more illiquid the market, the wider the spreads to compensate the market maker for the task of connecting buyers and sellers. Liquidity is an important concern when picking an ETF as it can impact the performance of the portfolio overall.

Another risk particular to this instrument, is what is called the tracking error between the ETF value and its benchmark (the index that the ETF tries to replicate). This has a significant impact as, depending on the overall dispersion, the mismatch in terms of valuation between the ETF and the benchmark can impact the returns of investors’ portfolio overall.

Passive management and the concept of efficient market

Most ETFs corresponds to “passive” management as the objective is just to replicate the performance of the underlying assets or the index. Passive management is related to the Efficient Market Hypothesis (EMH), assuming that the market is efficient. Passive fund managers aim to replicate a given benchmark believing that in efficient markets active fund management cannot beat the benchmark on the long term.

Passive fund managers invest their funds by:

Pure replication of the benchmark by investing in each component of the basket (vanilla ETF)
Synthetic reproduction of the benchmark by replicating the basket with derivatives products (like futures contracts).

An important concept is market efficiency (also known as the informational efficiency), which is defined as the ability of the market to incorporate all the available information. Efficient market is a state of the market where information is rationally processed and quickly incorporated in the market price.

It is in the heart of the preoccupations of fund managers and analysts to unfold any efficiency in the market because the degree of efficiency impacts their returns directly (CFA Institute, 2011). Fama (1970) proposed a framework analyzing the degree of efficiency in a market. He distinguishes three forms of market efficiency (weak, semi-strong and strong) which correspond to the degree in which information is incorporated in the prices. Earning consistently abnormal returns based on trading with information is the opposite view of what an efficient market is.

The weak form of market efficiency refers to information composed of past market data (past transaction prices and volumes). In a weakly efficient market, past market information is already included in the current market price, and investors will not be able to distinguish any pattern or prediction of future prices based on past data.
The semi-strong of market efficiency refers to publicly available information. This includes market data (as in the week form) and financial disclosed data (financial accounts published by firms, press articles, reports by financial analysts, etc.). If a market is considered in the semi-strong sense, then it must be in a weak sense as well. In this context, there is no additional gain in determining under or overvalued security as all the public data is already incorporated in the asset price.
The strong of market efficiency refers to all information (both public and private). Markets are strongly efficient when they reflect all the available information at any time in the asset prices.

Useful resources

Academic resources

Fama, E. (1970) “Efficient Capital Markets: A Review of Theory and Empirical Work” Journal of Finance 25(2), 383–417.

Business

Arte documentary (2014) “Ces financiers qui dirigent le monde: BlackRock”.

BlackRock (January 2021) ETF overview.

Refinitiv insights (2019) Concentration of the major players in the European ETF market.

About the author

The article was written in February 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2016-2020).