ACADIAN DIVERSIFIED ALPHA STRATEGY
AUGUST 2015
D
iversified Alpha is a global absolute return
strategy that seeks to generate modest positive
returns in most market environments, with low
correlation to a variety of asset classes. Implementation
is via a beta-neutral long/short portfolio that leverages
Acadian’s experience capturing the mispricing of
fundamentals as well as the mispricing of risk within the
cross-section of equities.
Specifically, the strategy will incorporate stock
selection based on Acadian’s proprietary Value, Quality,
and Momentum signals. It will have a bias to sell short
high-beta stocks and buy low-beta stocks, reflecting
research suggesting that over many decades, high-risk
stocks have typically underperformed their lower-risk
counterparts on a risk-adjusted basis.
The Diversified Alpha strategy leverages Acadian’s core
strengths and experience. Acadian has invested based on
the systematic stock selection methods employed by the
strategy for over 25 years, and we have captured mispricing
of risk within equities via our long-only Managed Volatility
strategies for more than eight. Acadian has subadvised U.S.
mutual funds and managed hedge funds for over a decade.
Key features of the strategy:
•• Simulated net performance from Jan 2004 - Feb 2015
demonstrated returns of 10.2% per year and a Sharpe
Ratio of 1.2. (Figure 1a)
•• The strategy is designed to have low overall correlation
with equity index returns. We believe the strategy has the
potential to outperform in downturns and underperform in
the strongest rallies. We target positive returns in both up
and down markets. (Figures 1b-c)
•• The strategy will offer daily liquidity and significant
capacity. It will invest in liquid stocks ($3B+ market
cap) in developed markets. The strategy will maintain
short exposure not exceeding 100% of capital and total
exposure not exceeding 250%.
FIGURE 1A
Simulated performance, January 2004 - February 2015 1
Diversified Alpha Simulation (gross)
Diversified Alpha Simulation (net)
90 Day U.S. T-Bill
Annualized Return
11.3%
10.2%
1.4%
Annualized Standard Deviation
7.5%
7.5%
0.5%
1.3
1.2
--
Sharpe Ratio
1
F igures: 1A, 1B and 1C: The above returns represent a simulated/theoretical Diversified Alpha equity portfolio. They do not represent actual trading or
an actual account, but were achieved by means of retroactive application of a model designed with the benefit of hindsight. Results may not reflect the
impact that material economic and market factors might have had on the adviser’s decision-making if managing actual client assets. All returns reflect
the reinvestment of dividends and other earnings as well as estimated transaction costs. The net simulated performance returns reflect a 1.00% flat
advisory fee. These results assume a $5B initial investment. Additional information about how the simulated portfolio was constructed is available upon
request. Reference to the benchmark is for comparative purposes only. Simulated performance is not indicative of actual future results. Investors have the
opportunity for losses as well as profits.Index Source: MSCI Copyright MSCI 2015. All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
1
For institutional investor use only. Not to be reproduced or disseminated.
FIGURE 1B
Monthly returns of Diversified Alpha simulation and MSCI World Index, January 2004 - February 20152
DIVERSIFIED ALPHA SIMULATION (%)
20.0
Correlation = 0.15
10.0
0.0
-10.0
-20.0
-20.0
-10.0
0.0
10.0
20.0
MSCI WORLD (%)
FIGURE 1C
Simulated performance during rising and falling markets, January 2004 - February 20152
 Diversified Alpha Simulation
 MSCI World
NET RETURN (%)
6.0
4.0
2.0
3.3
1.1
0.4
0.0
-2.0
-4.0
-3.5
-6.0
Average Return in
82 Up Months
2
Average Return in
52 Down Months
See simulation disclosure for Figures: 1A, 1B and 1C on page 1.
2
For institutional investor use only. Not to be reproduced or disseminated.
TWO DRIVERS OF RETURNS: MIS-VALUATION OF FUNDAMENTALS
AND RISK MISPRICING
MIS-VALUATION OF FUNDAMENTALS
Acadian believes that investors consistently and
predictably err in valuing companies relative to their
fundamentals. To capture the resulting mispricings, we
create return forecasts based on proprietary fundamental
and technical signals associated with three broad
classes of stock characteristics—value, quality, and
momentum. The Diversified Alpha strategy will select
long and short stocks based on a high-conviction blend
of these attributes. We believe this multifactor approach
is superior to investing along any one of the value,
quality, or momentum dimensions individually.
Through consistent exposure to strong fundamentals
on the long side and weak fundamentals on the short
side, we seek a steady return stream largely
independent of market conditions. The underlying
investment philosophy is based on empirical evidence
that fundamentally sound companies consistently
outperform weak ones over time. In the strategy
simulation, fundamental stock selection contributes
roughly half of the simulated portfolio returns over
Treasuries, and returns attributable to stock selection
are largely uncorrelated with the market. (Figure 2)
FIGURE 2
Returns to fundamental stock selection in Diversified Alpha simulation and MSCI World Index, January 2004 - February 20153
STOCK SELECTION (%)
RETURN (%)
¢ Stock Selection
¢ MSCI World
20.0
Stock Selection Contribution vs. MSCI World
Correlation = 0.05
125%
100%
10.0
75%
0.0
50%
25%
-10.0
0%
-25%
2004
2006
2008
2010
2012
2014
-20.0
-20.0
-10.0
0.0
10.0
20.0
MSCI WORLD (%)
MISPRICING OF MARKET RISK
One of the central tenets of modern portfolio theory is that
investors should expect higher returns from higher-risk
stocks. Yet empirical evidence suggests that this
relationship does not hold. Academic studies show that
market beta, for example, is not a good predictor of future
returns, i.e., the CAPM doesn’t describe the cross-section
of returns. We believe that this anomaly is driven, in part,
by irrational—and typically unrewarded—investor
preference for high-risk “lottery tickets.” We believe too
that market structure effects also play a role. Specifically,
benchmark-relative tracking error limits discourage
institutional investors from allocating to low-beta stocks.4
3
The above returns represent a simulated/theoretical Diversified Alpha equity portfolio. They do not represent actual trading or an actual account, but were
achieved by means of retroactive application of a model designed with the benefit of hindsight. Results may not reflect the impact that material economic
and market factors might have had on the adviser’s decision-making if managing actual client assets. All returns reflect the reinvestment of dividends and
other earnings as well as estimated transaction costs. This attribution analysis does not reflect the deduction of advisory fees, or their potential impact.
These results assume a $5B initial investment. Additional information about how the simulated portfolio was constructed is available upon request.
Reference to the benchmark is for comparative purposes only. Simulated performance is not indicative of actual future results. Investors have the opportunity
for losses as well as profits. Index Source: MSCI Copyright MSCI 2015. All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
4
See endnote I
3
For institutional investor use only. Not to be reproduced or disseminated.
Figure 3 provides a hypothetical illustration of the risk
mispricing. In a mildly rising market (left chart), the CAPM
implies that investors should expect stock prices to
increase in proportion to their betas (the dotted line). But
the actual relationship between beta and subsequent
returns is flatter than the CAPM implies. As depicted by
the blue dots in the chart, high-beta stocks tend to rise less
than theory would predict, perhaps because they were
overpriced lottery tickets to begin with, while low-beta
stocks rise more. Inversely, when the market drops in a
market selloff (right chart), the actual relationship between
beta and returns tends to be steeper than predicted by
theory. In other words, high-beta stocks fall more than
their betas would imply, perhaps because nervous
investors become overly eager to dump assets that they
perceive most risky, while low-beta stocks fall less. Figure
4 shows that this pattern has held, on average, over the
1999 - May 2015 period. Returns of low-beta stocks
exceeded what we would have expected given their betas,
while returns on higher-beta stocks trailed.
FIGURE 3
Hypothetical illustration of the CAPM-predicted and actual relationship between stock returns and their betas in a single month when equity
markets rise by 1% (left chart) or fall by 1% (right chart)5
RETURN
RETURN
3.0%
0.0%
2.5%
-0.5%
2.0%
-1.0%
1.5%
-1.5%
1.0%
-2.0%
0.5%
-2.5%
0.0%
-3.0%
0.0
0.5
1.0
1.5
2.0
0.0
0.5
1.0
1.5
2.0
BETA
BETA
FIGURE 4
Average realized return and beta-implied return by beta quintile, Jan 1999 - May 2015 6
 Actual 1M Return
 Beta-Implied 1M Return
AVG. 1M RETURN
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
Lowest
2
3
4
Highest
BETA GROUP
5
Source: Acadian Asset Management LLC. For educational illustrative purposes only.
6
S ource: Acadian Asset Management LLC. AAM World Universe. Methodology: Beta-implied returns, top 90% of Acadian’s developed market investible
universe. Within quintiles, returns are weighted by square root of market cap. See Endnote II.
4
For institutional investor use only. Not to be reproduced or disseminated.
To systematically exploit the risk mispricing effect,
Acadian has managed low-volatility strategies since
2006. In a long/short context, we believe that we
can more efficiently exploit the relative mispricing by
creating a zero-beta portfolio positioned with a bias
towards selling short high-beta stocks and buying low-beta
stocks. To achieve beta neutrality, the portfolio must hold
a larger long position in low-beta stocks than the short
position in high-beta stocks, i.e., the portfolio is net long
in terms of dollar notional. Nevertheless, the strategy is
market-neutral by nature of beta neutrality and will seek
to generate modest positive returns in most market
environments, whether rising or falling, from beta-adjusted
relative outperformance of the low-risk stocks held long
versus the high-risk stocks sold short. If beta turns out to
have been priced correctly by the market, then the strategy
would derive zero return from this high-beta/low-beta
positioning (since it is beta neutral). Otherwise, we believe
there is potential to harvest excess returns arising from
our long positions performing somewhat better than their
market betas suggest and our short positions performing
somewhat worse.
Figure 5 shows that the strategy simulation generated
steady, material returns from capturing the risk mispricing
and that these returns are largely uncorrelated with the
market. (See Appendix A for a more in-depth decomposition
of the risk mispricing in a long/short context.)
FIGURE 5
Returns to risk mispricing in Diversified Alpha simulation and MSCI World Index, January 2004 - February 20157
RISK MISPRICING (%)
RETURN
20.0
Risk Mispricing Contribution vs. MSCI World
Correlation = 0.05
125%
100%
10.0
75%
0.0
50%
25%
-10.0
0%
-25%
-20.0
2004
2006
2008
2010
2012
2014
-20.0
-10.0
0.0
10.0
20.0
MSCI WORLD (%)
IMPLEMENTATION: COMBINING THE TWO DRIVERS OF RETURNS
We construct the strategy’s portfolio as follows: for
each $100 of investor capital, we will implement a $150
long/$100 short, beta-neutral portfolio. That the portfolio
is net long $50 notional, but also is required to be betaneutral, induces the desired bias towards selling highbeta versus buying low-beta stocks.
We set the relative long-short dollar exposure at
$150/$100 to balance opportunities associated with
mis-valuation of fundamentals and mispricing of market
risk. A more aggressive lean with respect to risk mispricing
(higher net-dollar long in a beta-neutral context) would
restrict flexibility to select stocks with attractive
fundamental characteristics. A more aggressive
7
lean towards harvesting fundamental alpha in a traditional
market-neutral context (smaller net-dollar long) would
shrink the gap between betas on the long and short sides,
inhibiting capture of risk mispricing. The simulated results
suggest that the two drivers of returns contribute similarly
to the cumulative gain, as demonstrated in Figure 6.
Acadian has managed both stock selection-driven long/
short portfolios and low-volatility portfolios in many market
environments across full business cycles. The Diversified
Alpha strategy, which is designed to harvest the relevant
compensated risks inherent in both approaches, will
holistically leverage that experience.
T he above returns represent a simulated/theoretical Diversified Alpha equity portfolio. They do not represent actual trading or an actual account, but were
achieved by means of retroactive application of a model designed with the benefit of hindsight. Results may not reflect the impact that material economic
and market factors might have had on the adviser’s decision-making if managing actual client assets. All returns reflect the reinvestment of dividends and
other earnings as well as estimated transaction costs. This attribution analysis does not reflect the deduction of advisory fees, or their potential impact.
These results assume a $5B initial investment. Additional information about how the simulated portfolio was constructed is available upon request.
Reference to the benchmark is for comparative purposes only. Simulated performance is not indicative of actual future results. Investors have the opportunity
for losses as well as profits. Index Source: MSCI Copyright MSCI 2015. All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
5
For institutional investor use only. Not to be reproduced or disseminated.
FIGURE 6
Simulated performance of the proposed strategy and attribution to fundamental
mis-valuation and risk mispricing8




RETURN
Stock Selection
Risk Mispricing
Diversified Alpha Simulation
MSCI World
125%
100%
75%
50%
25%
0%
-25%
2004
2006
2008
2010
2012
2014
ANALYSIS OF SIMULATED PERFORMANCE
As shown in Figure 1a, simulated returns (net of fees) averaged roughly 10.2% with 7.5% volatility from 2004 - 2015.
Beyond the headline numbers, several aspects of the simulation results highlight the strategy’s appeal within
a broader portfolio:
•• Performance stability: Figure 1c shows that the simulated strategy generated modest positive average returns in both up
and down markets. Figure 7 provides further detail, suggesting that the strategy could produce neutral to positive returns in a
variety of market conditions. In a downturn, the strategy may help cushion losses in a broad portfolio potentially holding long
equity positions alongside this strategy.
FIGURE 7
Simulated performance of strategy by quintile of MSCI World Index returns, January 2004 - February 20158,9
AVG. 1M NET RETURN
 Diversified Alpha Simulation
 MSCI World
9.0%
6.0%
3.0%
0.0%
-3.0%
-6.0%
-9.0%
Worst
2
3
4
Best
AVG. MSCI WORLD 1M RETURN REGIMES
F igures: 6, 7, 8 and 9: The above returns represent a simulated/theoretical Diversified Alpha equity portfolio. They do not represent actual trading or an
actual account, but were achieved by means of retroactive application of a model designed with the benefit of hindsight. Results may not reflect the
impact that material economic and market factors might have had on the adviser’s decision-making if managing actual client assets. All returns reflect the
reinvestment of dividends and other earnings as well as estimated transaction costs. The net simulated performance returns reflect a 1.00% flat advisory
fee. These results assume a $5B initial investment. Additional information about how the simulated portfolio was constructed is available upon request.
Reference to the benchmark is for comparative purposes only. Simulated performance is not indicative of actual future results. Investors have the opportunity
for losses as well as profits. Index Source: MSCI Copyright MSCI 2015. All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
9
Market regimes were determined by creating quintiles of monthly MSCI World returns from January 2004 – February 2015; each regime includes 26
independent observations of monthly returns.
6
For institutional investor use only. Not to be reproduced or disseminated.
8
•• Low correlation: The simulated strategy has low correlation with MSCI World returns, roughly 0.15, as shown in Figure 1b. To
further highlight the strategy’s diversification potential, Figure 8 shows the simulated strategy’s low correlations to U.S. and
emerging market equity returns as well as indices representing several other asset classes and hedge fund benchmarks.
FIGURE 8
Correlation of simulated monthly strategy returns with benchmark indices representing other asset classes, Jan 2005 - Feb 2015 10,11
MSCI World
MSCI EM
VIX
Dollar Spot
Index
WTI
Crude Oil
Barclays
Aggregate
HFRI EH: Equity
Market Neutral
HFRX EH: Equity
Market Neutral
0.20
0.15
-0.06
-0.22
-0.02
-0.13
0.04
0.09
0.13
Diversified Alpha
Simulation
S&P 500
•• Equity-like returns with low beta: In the simulation, both risk mispricing and stock selection components contribute approximately
equally to overall returns. While the strategy is more than the mechanical sum of these two parts, it could be said that each one
contributes roughly 5-7% p/a, depending on the market environment. Despite the 50% net long notional position, the simulation
realized beta is low, only 0.07. The simulation suggests that the strategy has the potential to capture a portion of long-term returns
not unlike that of the equity market, without substantial market beta exposure.
•• Modest drawdowns: We would expect the strategy to be vulnerable to losses in panics if investors sell high- and low-beta stocks
indiscriminately. Even so, while the simulated strategy did experience a material drawdown during the global financial crisis, as
shown in Figure 9, the loss is considerably smaller than that experienced by MSCI World. This is consistent with the strategy’s low
market correlation and relatively low volatility. Conversely, we believe the strategy has the potential to perform well in modest
down markets characterized by risk-averse behavior.
FIGURE 9
 Diversified Alpha Simulation
 MSCI World
Simulated performance drawdowns10
DRAWDOWN
0%
-15%
-30%
-45%
-60%
2004
2006
2008
10
S ee simulation disclosure for Figures: 6, 7, 8 and 9 on page 6.
11
Source: Acadian Asset Management LLC, Bloomberg. See Endnote III.
2010
2012
2014
7
For institutional investor use only. Not to be reproduced or disseminated.
CONCLUSION
Acadian’s Diversified Alpha strategy seeks to exploit both the fundamental mispricings at the core of our systematic
Long/Short stock selection strategies as well as the mispricing of risk within equities that underpins our Managed
Volatility offerings. Designed to be beta-neutral, the strategy will seek to generate modest positive returns in most market
environments. The strategy provides the daily liquidity that investors increasingly demand. We believe that this
diversified approach to capturing equity market mispricings via a liquid, market-neutral, long/short implementation
represents a compelling source of uncorrelated returns.
ENDNOTES
I: The extensive academic literature on volatility mispricing includes: Fama, Eugene F. and Kenneth R. French, “The Cross Section of Expected Returns,” The
Journal of Finance, 47 no.2 (1992), 427-465. For discussion of behavioral and structural roots of the mispricing, see: Baker, M., B. Bradley, and J. Wurgler,
“Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly,” Financial Analysts Journal, 67, no.1 (2011), 40-54.
II: This is meant to be an educational illustrative example and is not intended to represent investment returns generated by an actual portfolio. They do not
represent actual trading or an actual account, but were achieved by means of using the Acadian equity universe of securities as a whole. Results do not reflect
transaction costs, other implementation costs and do not reflect advisory fees or their potential impact. Hypothetical results are not indicative of actual future
results. Every investment program has the opportunity for loss as well as profit.
III: The HFRX Equity Hedge index is an equal-weighted average of hedge fund returns collected and analyzed by Hedge Fund Research, Inc. In general, funds
that have at least $50 million under management, that have at least a twenty-four-month track record, and that are open to new investment are eligible for
inclusion in HFR’s indexes. The HFRX Equity Hedge index is intended to be composite of many different equity strategies, but typically constituent funds have at
least 50% of their capital invested in equities. Returns aggregated into the index are net of the fees that are reported by the constituent hedge funds and that
may differ from fund to fund. Additional information may be available from HFR. Reference to the HFRX Equity Hedge index is for comparative purposes only.
8
For institutional investor use only. Not to be reproduced or disseminated.
APPENDIX A: RISK MISPRICING CAPTURED IN A BETA-NEUTRAL CONTEXT
CAPM suggests the view of the world depicted in the chart on the left. We believe, based on the empirical evidence, that
the more realistic view is closer to that illustrated by the dotted line in the right chart.
FIGURE A
Beta and Returns—Theory and Reality*
RETURN
RETURN
3.0%
3.0%
2.5%
2.5%
2.0%
2.0%
1.5%
1.5%
1.0%
1.0%
0.5%
0.5%
Expected
Beta-Return
Relationship
Realistic
Beta-Return
Relationship
0.0%
0.0%
0.0
0.5
1.0
1.5
2.0
0.0
0.5
1.0
BETA
1.5
2.0
BETA
One way to express cross-sectional relationship between stock betas bi and stock returns ri is:
          
where a is the intercept, and b is the overall slope of the beta-return relationship. If CAPM were to hold, we’d expect a
steady linear relationship between stock betas and their returns. Investors would be compensated more for the higher
risk they are taking. Instead, it appears that high beta stocks represent a risk that is undercompensated. Low-beta stocks,
on the other hand, appear to be consistently overlooked and have performed better than their risk estimates suggest, as
we have shown earlier in Figure 4. As a result, for example, in a mildly positive market, the beta-return relationship is
flatter than CAPM suggests. Conversely, the intercept a becomes more positive if risk within equities is mispriced. It
could be thought of as the risk mispricing component of stock return.
It is very instructive to express portfolio return in terms of this relationship between return and beta:
     
                
It is easy to see that the above amounts to:
           
The two components above are:
•• The intercept a (risk mispricing component). We should capture this component as the long as risk mispricing holds, and the
strategy has positive net $ exposure.
•• The slope b (market return component). We should not capture this component as long as our portfolio has no exposure to beta,
and, by design, it does not.
By decomposing the portfolio return into the above two components, it is easy to see that, by design (50% net long, beta
0), we aim to capture a portion of risk mispricing within equities while being neutral to beta.
Source: Acadian Asset Management LLC. For educational illustrative purposes only.
*
9
For institutional investor use only. Not to be reproduced or disseminated.
APPENDIX B: IMPLEMENTATION
The return of an individual stock, i, could be defined as a number of distinct components, relevant to our discussion:
Ri
RMarket* i
Fi
Mi
where RMarket = return of the market, βi = beta, Fi = fundamental component, and Mi = risk mispricing.
The market-neutral portfolio return is now defined as:
RP
RMarket * L
$150
FL
$100
ML
RMarket * S
FS
MS
We can rearrange these components into long-short market return component, and the $150+$100=$250 notional portfolio
(P) exposure to fundamental stock selection and risk mispricing. Here, for convenience, we write $150 long exposure to
positive fundamentals, minus $100 short exposure to negative fundamentals $150*FL-$100*FS, as total of $250 exposure to
fundamental stock selection at the portfolio (P) level: $250*FP. Same is true for risk mispricing MP.
By construction, our long book beta-adjusted dollar value is the same as that of the short book; therefore, the market beta
component cancels out. (Figure B)
RP
RMarket
$150
L
$100
S
$250
FP
MP
The portfolio return is then composed of market-neutral stock selection plus some potential risk mispricing.
$250
RP
FP
MP
If beta is perfectly priced, the risk mispricing part of portfolio return is 0, and the portfolio return is now simply just
market-neutral stock selection.
RP
FP
$250
FIGURE B
Simplified portfolio overview*
Stock
Fundamentals
Dollar
Position
Weight
Position
Stock
Beta
Long Book
A
Attractive
$150
150%
0.8
1.2
$120
Short Book
B
Weak
($100)
-100%
1.2
-1.2
($120)
0.0
$0
Net
Total Book
Beta
Beta-Adjusted
Dollar Position
Source: Acadian Asset Management LLC. For educational illustrative purposes only.
*
10
For institutional investor use only. Not to be reproduced or disseminated.
HYPOTHETICAL LEGAL DISCLAIMER
GENERAL LEGAL DISCLAIMER
Hypothetical/Simulated performance results have many inherent limitations,
some of which are described below. No representation is being made that
any account will or is likely to achieve profits or losses similar to those
shown.
fact, there
frequently
differences
hypothetical
AcadianInprovides
thisare
material
as a sharp
general
overview between
of the firm,
our
performance
results
and the actual
performance
subsequently
processes and
our investment
capabilities.
It hasresults
been provided
for
achieved
by any
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trading
program.
informational
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only.
It does
not constitute or form part of any offer
can completely account for the impact of financial risk in actual trading.
For example, the ability to withstand losses or to adhere to a particular
trading program in spite of trading losses are material points which can also
adversely
affect actual
trading results.
are in
numerous
other systems
factors and
negative impact
on investment
results.There
We have
place control
related
to the
markets
in general
to theinimplementation
ofany
anysuch
specific
processes
which
are intended
to or
identify
a timely manner
errors
trading
program
which
cannotimpact
be fullyonaccounted
for in the
preparation of
which would
have
a material
the investment
process.
hypothetical performance results and all of which can adversely affect actual
Acadianresults.
Asset Management LLC has wholly owned affiliates located in
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One
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generally
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In may
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