Turning theory into reality - EDHEC-Riskdocs.edhec-risk.com/EAID-2007/presentations/PM5_SINOPIA.pdf · Turning theory into reality ... Source: Bridgewater Associates’ article:

Absolute return and alpha overlay

21 November 2007

Turning theory into reality

Jean-Charles Bertrand,Global Head of Fixed Income and Absolute Return strategies

Presentation only intended for professional investors

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Commercial information - Non-binding document - Reproduction prohibited

g Portable alpha is the process that adds sources of return in excess of the underlying asset class (beta) while maintaining the systematic exposures

g Portable alpha has been more talked about than implemented but it is becoming a reality: Growing acceptance of the use of derivativesDevelopment of LDI approach

Portable Alpha and alpha overlay

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g Portable alpha can be generated mainly in two ways: Invest in a portable alpha strategy where the manager purchases securities and use derivatives in order to adjust the systematic exposures Invest in an alpha-generating portfolio consisting entirely of derivatives which uses very little cash and provides an alpha that can be applied over the strategic allocation (alpha overlay)

g Main advantages of alpha overlay strategies: Can be attached to any asset class. No need for liquid derivatives to take the beta exposureCan be easily calibrated in order to meet clients’ risk levels

Portable Alpha and alpha overlay

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g Numerous sources of alpha for a better diversification

g Sources of alpha should be uncorrrelated to each other

g Last but not least, they should also be uncorrelated to betas

When is alpha transportation optimal?

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g Alpha transportation has to be based on a very good knowledge of the sources of alphaSkills and faith in the manager’s abilityTransparency of alpha sourcesInformation advantage for the manager in using in-house sources

g Alpha sources can also be provided by third parties They really do exist…… but there is a need to know them well in order to efficiently manage related risk

Alpha diversificationWhich alpha to transport?

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Mixing uncorrelated alpha sources: A very simple rule

g When mixing uncorrelated alpha sources, the risk contribution of each alpha source should be proportional to its Sharpe ratio:

the global performance will then be maximised for a given total alpha risk budget

g Consider i ∈ [1, 2,…, n], a group of independent sources of alpha i has a Sharpe ratio of SRiThe total alpha risk budget is σTotal .The optimal individual risk budget is

TotalSR

SRi

ii

i σσ∑

=2

Alpha diversification

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Mixing uncorrelated alpha sources increases the Sharpe ratio

0.0

0.2

0.4

0.6

0.8

1.0

1.2

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0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%Sh

arpe

Rat

io o

f the

str

ateg

y Risk contribution of alpha source 1

Risk contribution of alpha source 2

Correlation = 0%

Correlation = 100%

g Hypothesis: SR of alpha source 1 = 1.5SR of alpha source 2 = 0.75

Highest SR = 1.68 with 67% of alpha source 1 and 33% of alpha source 2

Source: SINOPIA – For illustrative purpose only


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g When the alpha sources are not independent, one must take into account the correlation between the performance engines

⇒ Individual SharpeRatios

⇒ Correlationbetween drivers

allocation of risk budget

α source 1α source 2

α source 3

α source 4

α source 5

Sharpe ratio can be significantly improved by mixing numerous alpha sources


Source: SINOPIA

Mixing alpha sources

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Alpha diversificationMixing alpha sources: Structuring an optimal alpha portfolio

Source: Bridgewater Associates’ article: « Engineering Targeted Returns and Risks » written by Ray Dalio, President and Chief Investment Officer.

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Sources: EDHEC, Fung & Hsieh, Agarwal & Naik

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Fixed IncomeArbitrage

Convertible Arbitrage

MergerArbitrage

Distressed securities

Long/ShortEquity

Global Macro

CTA Global

Impliedvolatility

Change in impliedvolatility

Small Cap vsLarge CapS&P 500 Credit

spreadChange in credit

spreadLehman Global

Bond IndexOptionalstrategy

+

Traditional assets Credit Liquidity Volatility Options

Alternative strategies have systematic exposures to risk factors

How to differentiate between alpha and beta?

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g Alpha is the additional performance above the strategic portfolio’s strategic return:

g How to define « pure alpha »?

Specific Systematic

pure alpha and Σ betasj * alternative factors j

"alpha"

Cash return or rate that best neutralizes risk

Value added by investment manager

Excess market/asset class return over risk-free rate

Portfolio return = risk free rate + Σ betasj * traditional factorsj + alpha

g Only pure alpha is uncorrelated to betas…

How to differentiate between alpha and beta?

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SINOPIA's pure alpha generation

g Alpha is created through relative value or tactical exposure to markets

g SINOPIA can extract alpha from all major international markets

g SINOPIA’s innovative alpha solutions are designed to be:lowly correlated with other asset classes to improve the portfolio’s risk-return profilebased on the conviction that active management of selected performance drivers and consistent investment process will lead to stable outperformancestrongly focused on risk management

How do we do it?

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g Long/short positions in OECD equity marketsg Zero betag Currency risk hedged

g Overall long or short position on global equity (MSCI world)Equities

g Long/short positions in developed OECD currencies (11)Currency Overlay

g Capture the volatility risk premium by taking short option positions (equity markets)

g Market risk systematically hedgedVolatility

SINOPIA’s alpha sources

* Breakeven inflation: difference between the nominal yield of a bond and the real yield of an ILB with the same maturity and issued in the same country / region - ** credit spread: difference between the yield of a corporate bond and the yield of a government bond with the same maturity, denominated in the same currency - *** Emerging credit spread: difference between the yield on an emerging-market nominal bond issued in a hard currency (EUR or USD) and the yield on a developed-country nominal bond with the same maturity and denominated in the same currency

Relative Value Tactical exposure

g OECD government bond marketsg Long and short positions / shift and rotation factorsg Zero duration and beta

g Overall long or short position on the shift and rotation factors in the global bond market (JP Morgan Global)

Nominal government bonds (NBs)

g OECD government bond marketsg Long and short positionsg Near-zero sensitivity to breakeven inflation *

g Overall long or short position in breakeven inflation in all OECD countries

Inflation-linked bonds (ILBs)

g Investment grade (euro zone)g Long and short positions on sectorsg Near-zero sensitivity to the overall credit spread **

g Overall long or short position on the overall credit spreadCorporate bonds

g EMBI universeg Long and short positionsg Near-zero sensitivity to the emerging market spread***

g Overall long or short position on the emerging sovereign spreadEmerging bonds

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SINOPIA Global Macro (open-ended fund)

Tactical ExposureVolatility

Tactical Exposure

Relative ValueCurrencyOverlay

Tactical Exposure

Relative ValueEquities

Tactical Exposure

Relative ValueEmergingBonds

Tactical Exposure

Relative ValueCorporateBonds

Tactical Exposure

Relative ValueInflation linkedbonds

Tactical Exposure

Relative ValueGovernmentBonds

Multi Fixed Income Strategies (open-ended fund)

Tactical ExposureVolatility

Tactical Exposure

Relative ValueCurrencyOverlay

Tactical Exposure

Relative ValueEquities

Tactical Exposure

Relative ValueEmergingBonds

Tactical Exposure

Relative ValueCorporateBonds

Tactical Exposure

Relative ValueInflation linkedbonds

Tactical Exposure

Relative ValueGovernmentBonds

Customized solutions

?Tactical ExposureVolatility

?Tactical Exposure

?Relative ValueCurrencyOverlay

?Tactical Exposure

?Relative ValueEquities

?Tactical Exposure

?Relative ValueEmergingBonds

?Tactical Exposure

?Relative ValueCorporateBonds

?Tactical Exposure

?Relative ValueInflation linkedbonds

?Tactical Exposure

?Relative ValueGovernmentBonds

Through open funds or via a customised solutionExamples of multiple alpha solutions

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g Client's needs and constraints:A global fixed-income overlay mandate20 millions Euros ex-ante 95% 1 mth VaR as a risk budget

g Sinopia’s proposal:A Pure Alpha Strategy – ability to go long and short. Any Beta exposure is based on outright Active Risk (or tactical positions)Multiple alpha sources on the different fixed income markets giving an uncorrelated profile of returns

Case studyRFP for a major European pension fund (2006 - 2007)

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Multi Fixed Income StrategiesSinopia’s proposal

Relative Value Tactical exposure

OECD government bond marketsLong and short positions / shift and rotation factorsZero duration and betaFutures, swaps, government securities

Overall long/short position on the shift androtation factors in the global bond market (JP Morgan Global)Futures, swaps

Nominal governmentbonds (NGBs)

OECD government bond marketsLong and short positionsZero sensitivity to breakeven inflation1

Inflation swaps

Overall long/short position in breakeven inflation in OECD countriesInflation swaps

Inflation-linked bonds (ILBs)

Investment grade (euro zone)Long and short positions on sectorsZero sensitivity to the overall credit spread2

Credit DefaultSwaps

Overall long/short position on the overall creditspreadCredit Default Swaps

Corporate bonds

EMBI universeLong and short positionsZero sensitivity to the emerging market spread3

Credit Default Swaps, government securities

Overall long/short position on the emerging sovereign spreadCredit Default Swaps, government securities

Emerging sovereignbonds (ESBs)

1 Breakeven inflation: difference between the nominal yield of a bond and the real yield of an ILB with the same maturity and issued in the same country / region2 Credit spread: difference between the yield of a corporate bond and the yield of a government bond with the same maturity, denominated in the same currency3 Emerging sovereign credit spread: difference between the yield on an emerging-market nominal bond issued in a hard currency (EUR or USD) and the yield on a developed-country nominal bond with the same maturity and denominated in the same currency

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Allocating the risk budgetSinopia’s proposal

Source: Sinopia - * These values are not fixed limits and may be exceeded

⇒ Individual Sharperatios

⇒ Correlation between tacticadriversl

Average strategic allocation of the risk budget

Tactical allocation of the risk budget

Corporate spread - Tactical ILBs

- Tactical

NGBs- Tactical

ILBs - Relative Value

NGBs- Relative Value

ESBs - Relative Value

Corporate spread - Relative Value

ESBs - Tactical

9% 13%7%

6%

38%

9%9%

9%Expected performance (tactical and relative)

of the differentfixed income asset classes

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Use of the risk budgetSinopia’s proposal

g The risk budget should not be constant but should vary depending on the strength of opportunities

g The strategy is calibrated by taking into account an average value of 20 millions Euros for the monthly 95%

g A maximum value for the VaR is defined (for example 25 millions) in order to avoid excessive risk-taking

g Methodology for VaR calculation: RiskmetricsMultivariate GARCH approach

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Fund Segregated account/mandate

g All-in solution

g Operational process (derivatives handling) as well as all the legal aspects fully taken care of by the asset manager

g Client name can remain confidential to market counterparts

g Stronger external control (the fund accounts are audited by external auditors)

g Custodian and fund administration done by third parties and included within the fees

g Daily NAV and positions available

g One line accounting might be possible … but depending on the client applicable accounting rules, a dedicated fund may need to be consolidated in the client accounts

g Lower cash requirements because credit worthiness of sponsor can be used in negociating swaps… but mechanical commitment to provide margin calls or swap collateral if needed

g Full transparency on positions… provided the client (and/or its custodian) has the required capacity

Advantages

g Higher cash requirements (collateral, margin calls) g A solution requiring client’s involvement in the operational process (OTC counterparts approval process, legal aspects, NAV calculation), and line by line integration of the portfolio positions in the client’s accounting.

g Heavier operational set-up

Drawbacks

The structure: Fund vs segregated account/mandate

Sinopia’s proposal

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Tasks description and responsibilities

xxReconciliation with Clearer statementsxCheck costs/interestxAuthorise payment cost/interestxSend payment instruction to the Bank (for cost/interest) and a copy to HSS France

xTransfer payment (of cost/interest) to Clearer

xTransfer capital to the bank accountxSend capital call to Client when cash balance is not sufficientxGeneral: check if the cash balance is sufficient to process a payment

xAccountingxxSend daily NAV to Client

xCheck Daily NAV (incl. Monthly)xxDaily NAV (incl. Monthly)

xTransfer payment (of margin call) to ClearerxSend payment instruction to the Bank (for Margin call) and a copy to HSS FrancexAuthorize margin callxCheck margin call (+ consistency checks of clearer statement)

xSend margin call and statementxSettle transaction

xCheck confirmationxSend transaction to HSSxCheck transactionxExecute Transaction

xInitiate transaction

ClientClient ClearerClient CustodianHSBC Securities ServicesSinopiaSteps in the process

ResponsibleFutures

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Tasks description and responsibilities

xTransfer payment to the counterpartyxSend monthly interest statements to client

xCheck interest statement

xCredit event notification: when the mandate has bought the protectionxCredit event notification: when the mandate has sold the protection

xCredit event: notify client about credit eventxCredit event: payment check and authorisationxCredit event: transfer payment instruction to the bank

xxCredit event: payment to / from the counterpartyxGeneral: check if the cash balance is sufficient to process a payment

xAuthorise payment

xInitiate swap unwind

xSend payment instruction to the Bank (collateral)

xCalculate payments (unwind payment, initial premium for iTraxx)xCalculate interest paymentsxCheck payment with the counterparty

xSend payment instruction to the bank (interest, unwind, premium)xTransfer payment to counterparty

xTransfer capital to the bank accountxSend capital call to Client when cash balance is not sufficient

xCredit follow-upxAccountingxSend daily NAV to Client

xCheck Daily NAV (incl. Monthly)xDaily NAV (incl. Monthly)

xExecute swap unwind

xNetting of all swaps collateral payments with counterpartiesxSend daily collateral statements & margin request to client

xSend daily MtM to the clientxCalculate MtM swaps

xConfirm via Swaps Wire (IRS) or DTCC (CDS)xSend transaction ticket to HSSxCheck transactionxExecute TransactionxInitiate transaction

ClientCounterpartiesClient CustodianHSBC SecuritiesServices

Sinopia Fund ManagerSteps in the process

ResponsibleSWAP & CDS

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Calculating the return of an equivalent funded strategyPerformance measurement

g Definition of a Notional Amount (NA) based on a volatility assumption (3%) :NA = VaR 95% 1 yr /(1.65*3%)

g Equivalent Funded AUM (EFAUM) and Equivalent Funded Strategy market Value (EFSVM) defined as :

EFAUM = NA + Cumulated P&L since inceptionEFVSM = EFAUM – Sum of [Daily Assets Provided * daily risk free rate] since inception + Sum of [Daily NA * Daily Risk Free rate] since inception

( )

month beginning

month beginning

month beginningend-month

EFSMV

Pr&100

EFSMVEFSMV-EFSMV

100Re

∑ −×+×=

×=

ovidedAssetsdailyNAdailyrateFreeRiskdailyLP

monthaforturn

monththeover

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g Growing interest in Portable Alpha strategiesA concept which has turned into existing investment solutionsAn efficient way to implement it: alpha overlay strategies

g There are multiple solutions and essential considerations requiring a good knowledge of the sources of alpha to find the best customised solution

g What makes Sinopia a legitimate player in alpha overlay managementAbility to deliver pure alphaTransparencyAbility to fit the clients' constraints: financial aspects, risk management, operations (counterparts, custodians, etc.)Flexible implementation adapting to the evolution of the clients’ needs

Turning theory into realityAbsolute return and alpha overlay

SINOPIAAsset Management

Quantitative specialist of the HSBC Group

26 janvier 200

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HSBC Group Investment Businesses

HSBC Investments

Halbis

SINOPIA

Core business

256.4 billion euros in assets under management1

Source: HSBC Investments (France) – 1 as of 29 June 2007

Recognised within the HSBC Group as the specialist quantitative asset manager

HSBC’s core investment and distribution platform

Specialist businesses

A fundamental active investment specialist

A leader in quantitative asset management

SINOPIA Asset Management

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g Founded in 1989, member of the HSBC Group since 2000

g Forerunner in introducing active quantitative management to Europe

g Headquartered in Paris with international subsidiaries in London and Hong Kong

g Over EUR 33.4 billion assets under management as of 29 June 2007

Company overview

Billion euros

68

1416

21

32.5 33.4

0

5

10

1520

25

30

35

40

2001 2002 2003 2004 2005 2006 June 20071

Source: SINOPIA Asset Management – 1 as of 29 June 2007


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Source: SINOPIA Asset Management – 1 allocation as of 29 June 2007

Guaranteed and structured products

18.9%

Absolute Return 25.8%

Equity41.7%

Fixed Income13.6%

Intermediaries50%

Institutionals50%

A single core business: quantitative asset management

g Providing innovative investment solutions with the aim of delivering consistent outperformance while minimising trading costs in a risk-controlled environment

g Over EUR 33.4 billion assets under management as of 29 June 2007

Assets Under Management by investment type1

Assets Under Management by client type1

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SINOPIA is a key player in Absolute Return Strategiesg Launch of the first single strategy Absolute Return fund in March 2001 (Global Bond

Market Neutral strategy)

g Launch of two Multi-Strategy funds in 2006 (Global Macro, Multi Fixed Income Strategies)

g Dedicated Absolute Return team created in 2004

g Top 5 Europe Hedge Funds (Institutional Investor Jan-Feb 2006)

SINOPIA has been awarded "Best Alternative Investment Manager of the Year" at the UK Pensions Awards 2007*

The awards aim to recognise the providers that offer the highest level of service to occupational pension schemes and their members. Nominees were judged against set criteria - innovation, communication, performance and service standards - and also asked to submit a general overview. Innovation was the most significant criteria (30% of the total). The submissions were being considered by a panel of judges made up of professionals from across the occupational pensions industry.

SINOPIA has been awarded "Best Alternative Investment Manager of the Year" at the UK Pensions Awards 2007*

The awards aim to recognise the providers that offer the highest level of service to occupational pension schemes and their members. Nominees were judged against set criteria - innovation, communication, performance and service standards - and also asked to submit a general overview. Innovation was the most significant criteria (30% of the total). The submissions were being considered by a panel of judges made up of professionals from across the occupational pensions industry.

Past performance is no guarantee of future results

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This presentation is produced and distributed by HSBC Investments (France) and is only intended for professional investors as defined by the European Directive, MIFID. It is incomplete without the oral briefing provided by the representatives of HSBC Investments (France) and/or the management company.

The commentary and analysis presented in this document reflect the opinion of Sinopia Asset Management on the markets, according to the information available to date. They do not constitute any kind of commitment from Sinopia Asset Management. Consequently, neuther Sinopia Asset Management nor HSBC Investments (France) will be held responsible for any investment or disinvestment decision taken on the basis of the commentary and/or analysis in this document. All data from Sinopia Asset Management unless otherwise specified. Any third party information has been obtained from sources we believe to be reliable, but which we have not independently verified.

The funds presented in this document may not be registered and/or authorised for sale in your country. Capital is not guaranteed. Fluctuations in the rate of exchange of currencies may have a significant impact on fund performance. Unless stated otherwise, equity indices are not with dividends reinvested.Please note that according to article 314-13, performance for periods of less than 12 months cannot be shown to non-professional investors, as defined by the MIFID directive.

HSBC Investments represents Sinopia throughout the world; it is responsible for the business relationship and provides client services both in France and abroad, as part of a strategic partnership.

This presentation is not intended for general distribution, it is provided on specific request.

Transactions in derivatives are likely to make considerable profits, but they also entail substantial risks. An investment in the SINOPIA Alternative Funds (SAF) should be considered in the light of the financial condition of the investor. Since an investment in such a Fund represents an above average risk, the Fund in question is only suitable for those persons who can afford to take such risks; it is advisable for sophisticated investors to invest therein only a part of the sums such investor intends for a long-term investment.

The term Sinopia Asset Management ("Sinopia") refers to a business engaged in fund management activities, which are ultimately owned by HSBC Holdings plc. Sinopia's registered office is in Paris: Immeuble Ile de France - 4 place de la Pyramide - La Défense 9 - 92800 Puteaux - France, and has subsidiaries in London and Hong Kong: Sinopia Asset Management UK Limited - Sinopia Asset Management Asia Pacific Limited - Portfolio management company - 379 837 800 RCS NANTERRE - AMF authorisation no. GP97142.

All subscriptions in any fund presented in this document are accepted only on the basis of the current prospectus, available on request from HSBC Investments (France), the centralisation agent, the financial department or the usual representative. Before subscription, investors should refer to the prospectus for more detailed information on the risks associated with this fund.

"HSBC Investments (France) - 421 345 489 RCS Nanterre. Portfolio management company authorised by the French regulatory authority AMF (no. GP99026) Postal address: 75419 Paris cedex 08Offices: Immeuble Ile de France - 4 place de la Pyramide - La Défense 9 - 92800 Puteaux - France"www.hsbcinvestments.fr

Non contractual document, updated on : 15/11/2007

Documents

Turning theory into reality - EDHEC-Riskdocs.edhec-risk.com/EAID-2007/presentations/PM5_SINOPIA.pdf · Turning theory into reality ... Source: Bridgewater Associates’ article: