Seeking Incremental Alpha by Exploiting Index Inefficiencies
The Westwood Managed Investment Solutions team has helped countless institutional investors using a consultative process to develop unique rules-based, outcome-oriented investment solutions for their specific needs and goals. The following case study illustrates how they created a solution for an institutional client with a specific set of challenges.
The Westwood Managed Investment Solutions team (MIS) partnered with a client who was interested in improving the performance of its U.S. small-cap equity exposure within a clearly defined risk budget. The client used both internal and external managers and leveraged a sophisticated approach to investing and risk management. They were looking for a solution that would add value without introducing excessive risk.
The client required a customized solution that adhered to constraints on holdings due to religious beliefs and business relationships, while maintaining risk characteristics aligned with their existing strategies. They sought a differentiated source of alpha uncorrelated with their current managers. MIS was selected for its adaptive, outcome-focused approach, capable of evolving with client direction. The team’s independence and ability to leverage best-in-class tools made them well-suited to manage the complex mandate.
After a series of discussions, MIS and the client agreed on investment objectives for the strategy. The client sought incremental excess returns while adhering to the specified exclusionary criteria while maintaining a relatively tight tracking error to the policy benchmark.
The MIS team collaborated extensively with the client to define clear risk and return parameters, ensuring alignment on the desired strategy. The resulting Index Plus strategy focused on executing a large, diverse set of opportunistic trades, with each trade being relatively small in terms of the impact on the index’s misweighted positioning. The strategy sought to capitalize on micro-inefficiencies around index events such as rebalances, IPOs, share changes and corporate actions.
By engaging in numerous event-driven trades, the strategy provided a broad diversity of alpha sources, reducing reliance on any single opportunity and enhancing incremental returns. Additionally, the strategy improved portfolio quality by underweighting non-earning companies, further strengthening long-term performance.
The solution delivered several key benefits aligned with the client’s strategic objectives. By exploiting inefficiencies around index events and other market-driven opportunities, the strategy generated incremental alpha with low correlation to the client’s existing fundamentally managed strategies.
The portfolio’s quality was further enhanced through the systematic underweighting of non-earning companies, aligning with the client’s long-term investment horizon and balancing capital growth with controlled risk.
The adaptable, rules-based approach allowed for adjustments in response to evolving client needs or market conditions, enabling the MIS team to fine-tune risk allocation as necessary.
Finally, the strategy adhered to a controlled risk budget, maintaining low tracking error to the policy benchmark. This ensured the delivery of alpha without excessive volatility or style drift, meeting the client’s stringent risk and governance requirements.
The MIS team brought a wealth of experience to the implementation process, having developed and implemented many bespoke strategies for clients around the world. The client initiated an in-kind transfer of assets to a separate account where the MIS team immediately began processing event-driven trades.
A major consideration in the implementation phase was managing hidden transaction costs due to the market impact of their trades. The strategy incorporated sophisticated trading models to optimize these costs relative to the expected return of each trade. For example, in the case of an index addition, the MIS team could anticipate the timing and volume of trades and capitalize on this information to enhance execution.
Finally, in managing the client’s specific risk budget, the MIS team balanced the allocation of risk between event-driven trades and the non-earners tilt. The process allowed the portfolio to remain fully aligned with the client’s policy benchmark while carefully deploying risk where it was expected to generate excess returns.
The MIS team managed the strategy and delivered consistent and measurable outperformance relative to the client’s policy benchmark over a multi-year period, within the client’s specified risk budget. The strategy achieved steady, non-correlated outperformance compared to both passive and active benchmarks, with minimal periods of underperformance.
By focusing on lower-risk event-driven opportunities and underweighting non-earning firms, the portfolio exhibited superior risk-adjusted performance compared to the small-cap benchmark. This enhanced the overall quality of the client’s U.S. small-cap exposure while aligning with their long-term investment horizon.
The strategy complemented the client’s external active managers by providing a differentiated source of alpha that did not replicate their existing exposures. It fit smoothly into their overall investment architecture, demonstrating the flexibility and adaptability of the Index Plus approach.
The strategy provided the client with a scalable, sophisticated and flexible solution that not only met their risk and return objectives but also enhanced the overall quality and efficiency of their small-cap exposure. It achieved these results through a combination of disciplined execution, risk management and the strategic exploitation of market inefficiencies.
Investment solutions that work for you
Your needs and objectives are specific. You deserve an investment solution that is best suited to accomplish your goals. The experienced professionals of Westwood’s MIS team take the time to work with you, understand the challenges you face, and design a customized approach that specifically aligns with your unique goals, beliefs and objectives. Our MIS team is in a unique position to choose the tools and data sources required to achieve your desired outcomes.