We spoke recently to Dr. Sebastián Ceria, the Chief Executive Officer of Axioma Inc., the software development firm known for its Axioma Portfolio Optimizer and the daily updates to its Axioma Robust Risk Models. Dr. Ceria (pictured) founded Axioma in 1998. He told us, “The first thing that is true of all entrepreneurs is craziness; we never know what we’re getting into.” He was inspired he said, by the increasing use in the 1990s of computer software for supply-chain management logistics. He was an Associate Professor of Decision Risk and Operations at Columbia Business School at the time, but he wondered, “Why not try to replicate that for the financial sector?”
Ceria was joined for our talk by Melissa Brown, Axioma’s Senior Director, Marketing, and Chris Canova, Vice President of Product Management and Strategy. Brown is a former managing director and head of institutional business at Wintrust Capital Management. She also worked for 10 years at Goldman Sachs Asset Management.
Canova is a member of the Chicago Quantitative Alliance and, before coming to Axioma in 2006, he worked in various client support roles at Barra, subsequently MSCI Barra.
Q: Your website describes Axioma as a thought leader in risk management. Can you expand for me on what this means to you?
Axioma: It means we’ve assembled an expert staff, expert in both finance and software development and we do what no one else does. We look at the world from the point of view of portfolio managers, their need to diversify, their implementation challenges, their market risks, and we tailor research and analysis, as well as our products, to those needs.
What we did is ask ourselves about the decision maker. What are the specific problems that a given decision maker faces, and what can we offer that will solve those problems. That may sound pretty basic, but it really wasn’t being done before us.
Both in research and in products we work on all three of the principal players in any quantitative strategy: the alpha model, the risk model, and the constraints.
Q: Who do you see as your primary audience for both your products and your research work? Are you mostly working for the benefit of large investment banks? Are hedge funds in the mix? Family offices?
Axioma: Our customers are mostly large asset managers, beginning with the investment banks. Historically, our first customer was Goldman Sachs.
We focus on flexibility, providing materials uniquely adapted to our customers’ needs. We were for example the first provider to update its risk models on a daily rather than a monthly basis.
Q: Tell me more about those three parts in a quantitative strategy you mentioned: alpha, risk, constraints.
Axioma: The key here is to let managers know what they’re betting on. For example, we’ve just recently posted a research paper by Anthony Renshaw, on factor ETFs, and how they can set up a misalignment among those parts. There are “simple factor ETFs” that are supposed to provide exposure to, say, volatility, or beta, or momentum. But … these often contain unintended biases, so an asset manager who thinks he is getting a pure bet on volatility will actually be betting on a small-cap bias, say, or on exchange rates.
It can be tricky getting people to understand the misalignment issue. A lot of people are surprised; they think that a rule that, for example, they will have a certain percentage of their portfolio in a certain safe-seeming investment doesn’t raise any further issues. It may well leave them under diversified.
Some of the mandates that our clients have, such as long-only rules, can’t be touched. But to think that we’re just going to add a new product onto whatever their existing rules, procedures, or rules-of-thumb might be, without adaptation, as a sort of wrap-around, that is totally the wrong approach.
Q: As a first mover in its field, in these respects you’ve discussed, Axioma must draw a lot of imitation and that must make your life difficult.
Axioma: We are flattered by imitators. When you’re an innovator, and successful, at some point people imitate you. It pushes us to continue to innovate, to stay a step or more ahead of them. Every good runner knows you should always look forward, never look back at those in pursuit.
Q: Let me ask about correlations. As I read your recent quarterly risk reviews, it is becoming trickier over time for investors to create real diversification within their domestic equities markets, because stock pair correlations are rising. Is that fair? And, if that’s right, is that pressing institutions otherwise reluctant into internationalizing the equity portion of their portfolio?
Axioma: Correlations went up significantly in mid-2010, fell by the end of that year, but then rose to new highs in mid-2011. In addition to this cyclical pattern we have seen a secular increase in correlations as markets have become driven more by macroeconomic events and less by individual company performance. In that environment diversification does become more difficult, and using a risk model becomes even more important. Diversifying internationally is one potential solution, but it isn’t just country or industry that should help provide better risk management – diversifying across risk factors such as volatility, leverage and size, and avoiding unintended bets, becomes even more critical.
Q: What about Europe? Has the worst passed? Can I load up on Spain’s sovereign debt?
Axioma: We’re not predicting the direction of any particular market. But the risk connection with Eurozone sovereign debt has been significantly down since the European Central Bank’s long-term refinancing operations late last year. This provided inexpensive loans to Europe’s banks.
A final observation: Readers interested in the Renshaw paper mentioned above, “Neutralizing Unintended Bets in Factor ETFs,” may find it here.
For more on Axioma and how it sees the risk of factor misalignment, click here.