Systematic investment management consists of 2 equally important integrated processes. First, a clearly formulated investment strategy summarising the objectives and constraints of the portfolio, and second a market model summarising all insights about the market dynamics.
The investment strategy is the process of
- Identifying the investment objectives and investment constraints.
- Translating objectives and constraints into a strategy.
- Expressing the strategy as a set of (mechanical) rules.
Formulating this rule-based investment strategy is a one-off process, which gets reviewed periodically. The only part that is different from a traditional investment strategy is its emphasis on expressing the strategy as a set of ‘mechanical’ rules. A bit like the checklists for airline pilots. You need this emphasis on clear rules to achieve a straight-through integration of analysis and decision-making…and it also helps to avoid behavioural pitfalls.
Building and maintaining the market model on the other hand is the ongoing process of
- Collecting all available information about the market
- Analysing the data to understand the anatomy of the market
- Summarising your insights into a set of repeatable rules
This set of rules forms your model. It describes the patterns you expect the market to follow. The model doesn’t accurately predict the next move, but it contains all your insights about more likely and less likely market scenarios.
Take two examples for the market model; a longer-term macro model and a shorter behavioural model. The two sub-models assess different market characteristics. Hence, their judgement and consequently their suggested optimal exposure can be different. The behavioural model assesses the mood of the market participants, whereas the macro model indicates how favourable an asset is at the current point in the market cycle. The best blend of signals depends on your objectives and constraints. If tail risk management is a main objective, then more weight is given to the behavioural model, if long-term alpha generation is the main objective you tilt more towards the macro models.
Merging the market model with the investment plan yields a customised “navigation system” indicating the optimal exposures while you drive your portfolio through time.
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