Algorithm & Blues

Mike Vogel | 10/1/2010

Profiting from volatility

Crudely put, Intech's approach is to buy low and sell high, but what to buy and sell depends on Fernholz's bedrock theorem. Intech capitalizes on the volatility of stocks within a particular benchmark such as the S&P 500 by reweighting the companies in the index, selling the ones outrunning the index's return line and buying the underperformers. When the underperformers cycle up to outperformers, Intech sells them. "Math is Power" is the company slogan.

Former Princeton University mathematician Robert Fernholz started Intech in 1987.

"They're trying to modestly outperform without the volatility," says Morningstar analyst Courtney Goethals Dobrow, who follows three Intech funds.

Intech's flagship fund aims to beat the annualized return for its benchmark index by 2 percentage points before fees. The difference between an 8% annualized return and a 10% return on a $100-million investment compounded over 30 years works out to be the difference between $1 billion and $1.7 billion, Garvy says. "Those dollars end up paying for people's retirements," Garvy says — the difference between "filet mignon and cat food" for retirees.

Denver-based mutual fund giant Janus Capital bought out Prudential's majority stake in 2002, and the filet mignon argument gained traction with retirement funds and others. But the company's eagerness for client business got it in trouble in 2009. That year, without admitting or denying fault, it paid a $300,000 penalty after the Securities and Exchange Commission faulted it for failing to properly disclose to clients from 2003 to 2006 that it was casting pro-labor votes on their behalf at companies' annual meetings. The SEC said Intech wanted to curry favor with potential and existing union clients.

Meanwhile, Intech landed the business of international institutional clients, including sovereign wealth fund clients, in Japan, Australia, Europe, China and Abu Dhabi. The cash poured in, averaging $12 billion a year in net inflows from 2004 to 2006, and Intech reached $69.7 billion in assets by year-end 2007. Intech remained a bright spot even as parent Janus struggled.

√Intech generally met or exceeded its goals until a combination of market conditions and poor performance hammered its portfolios. Assets under management fell from $69.7 billion in 2007 to around $40 billion today.

Amid that prosperity, Intech planned its move into the CityPlace Office Tower, becoming the signature tenant in the signature building in the signature development in downtown West Palm Beach. It was something of a departure from the anonymity Intech cultivated, in keeping with its publicity-adverse clients.

By the time it took occupancy in November 2008 in the midst of the great market meltdown, Intech was struggling. For much of 2006 through the huge 2009 rally, the approach that had worked so well performed poorly against benchmarks. Intech went from Janus' bright spot to its dark cloud. Its strategies — funds and accounts managed for individual institutions — lost billions in 2008: $26.5 billion as the market depreciated. Investors beat for the exits, taking more with them. As of June 30 this year, Intech was down to $39.8 billion in assets.

"It's certainly been a drag in terms of flows for Janus overall for quite a number of quarters, mostly driven by some performance issues they've had. In the past, it's been a big driver of growth for Janus at a time when the legacy business for Janus has been under some pressure, but now that's reversed," says Sandler O'Neill + Partners analyst Michael Kim.

It turns out that Intech's approach worked well when the overall level of market volatility remained relatively consistent but faltered when the market shifted radically from one amplitude of volatility to another. And because Intech generally depended on capturing the movement of smaller, more volatile players in a benchmark like the S&P, it didn't do as well when investors began to pile into the largest stocks.

√Intech doesn't care whether a company has a new product or is in a declining industry — its investment decisions are driven by mathematics that predict stocks' behavior based on their value relative to other stocks and the index.

To respond to the changing market conditions, Fernholz's theorem can no more be changed than the ratio of a circle's circumference to its diameter. But fund managers can tweak how they act upon his theorem — how many years of prior volatility data inform their buy-and-sell decisions. Garvy says that over the decades, the firm has made infrequent, tiny adjustments to increase return or lower risk, but they amount to a just a handful of basis points in performance.

"There will be periods, no matter how good you are, when you will underperform," Garvy says. Intech has spent 2010 explaining to investors that it's still good rather than no longer lucky.

Tags: Banking & Finance