19 December 2008, Financial Times Fund Management

There’s been few things to smile about this year. But here’s one. Imagine an index fund based on US stocks that has outperformed the total returns of the S&P 500 by 51.7 percentage points for the year through early December. Over the past three and five years, its annualized outperformance 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 annualized return was 13.2 percent through the end of November versus 6.5 percent for the S&P 500.

One would think that SocGen must be taking significant risk to generate these kinds of returns.But it doesn’t appear so. The index maintains a standard deviation target of 8 percent. Over the past three years, the S&P 500 standard deviation has been averaging more than 15 percent.

But the story doesn’t end in the states.

SocGen is achieving this outperformance in many of its quantitative indices across the globe, whether they’re tracking Nordic, European, emerging market or global stocks and bonds. And what’s most impressive is not just their relative returns, but how well many of these indices have been performing during one of the worst years on record.

Since the first tremor caused by the subprime meltdown started rattling markets during the summer of 2007, so-called “quant” strategies were roundly criticized because they didn’t anticipate the impact of huge sums of money following similar strategies at the same time, which exacerbated the initial sell.

But that claim unfairly paints all quant-driven strategies with the same brush.

“In contrast,” says Yannick Daniel, head of SG Indexes in Paris, “our transparent algorithmicindices are designed to deliver alpha for retail and institutional investors regardless of what the market is doing, with a better risk-return prospects than traditional indices.”

SocGen offers these indices primarily through structured products and certificates in various currencies. This enables investors, through the use of options, to customize their investments based on the level of risk and reward that best suits their mandates. Underlying exposure, both long and short, can include baskets of stocks and bonds, various indices, hedge funds, and commodities.

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, 8 are based on SocGen’s WISE investment model that analyzes 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 €400 million 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 capitalizes on the slope of the yield curve using interest rates swaps. The strategy constantly shifts exposure, and then resets long and short positions each to 100 percent at the beginning of each month. It controls risks by limiting annual standard deviation in two versions of the strategy to 3 and 5 percent, respectively.

Back testing of the BOSS euro index [with a 3 percent volatility target] over five years through November revealed annual appreciation of 6.3 percent per annum versus 4.7 percent for the euro MTS Global index. Through the first nine months of this year, BOSS significantly outperformed its benchmark 7.0 versus 2.5 percent. However, extraordinary volatility and fear in October through early December sent the sovereign benchmark’s year-to-date returns climbing to 8.37 percent while the index’s performance sank to 1.9 percent.

Currently, among the largest alpha generated by SocGen’s quantitative indices is by its long-short Emerging index. While the MSCI Emerging Market index was off by nearly 54 percent for the year through early December in euro terms, SocGen’s strategy was down 13 percent. Back-tested to May 2001, the index generated annualized returns of 16.6 percent versus only a fractional profit registered by MSCI.

Again, low volatility is one of the surprising qualities of the index. Where the 3-year trailing annualized standard deviation of the MSCI index is north of 28 percent, SocGen’s index targets volatility at 11 percent. [A more aggressive version of the strategy pushes target volatility to 15 percent.] The index uses leverage to keep volatility steady. And to further manage risk, the index rebalances both its long and short exposure [which will change throughout the year] at 100 percent every January.

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 €150 million from European private banks and Asian retail networks.

Vianney Dubois, director of Seeds Finance, a Parisian-based independent financial consultant with €1.2 billion under advisory 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.” He’s particularly impressed with the long-short indices, which have excelled beyond most managed by banks and hedge funds, and recognizes their tactical potential.

However, 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 actually been underperforming their benchmarks, albeit during one of the worst trading periods ever seen.

It’s too early to know if recent market weakness has hurt SocGen’s business model. It’s not evident in asset growth. In less than two years since introducing its alpha indices, related structured products have grown to more than €1.3 billion, 40 percent held by retail investors and 60 percent 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 US, continental Europe, and Asia who are considering licensing some of the indices to create their own branded versions. But Daniel intends the lion share of business to remain in house.