FTSE BIRR. ftserussell.com. FTSE Russell 1

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1 FTSE BIRR ftserussell.com Edwin Burmeister Research Professor of Economics Emeritus, Duke University Commonwealth Professor of Economics Emeritus, University of Virginia Former President, BIRR Portfolio Analysis, Inc. FTSE Russell 1

2 FTSE Russell is not an investment firm and this presentation is not advice about any investment activity. None of the information in this presentation or reference to a FTSE Russell index constitutes an offer to buy or sell, or a promotion of a security. This presentation is solely for informational purposes. Accordingly, nothing contained in this presentation is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of making any investment through our indexes. Views expressed by are subject to change. These views do not necessarily reflect the opinion of FTSE Russell or London Stock Exchange Group plc. FTSE Russell 2

3 Contents 1 The problem: Inadvertent Risk 2 A solution 3 About FTSE BIRR 4 How is BIRR used? 5 What type of investor uses BIRR? 6 User (Market) profile 7 Alternative approaches 8 The BIRR advantage 9 Some illustrations 10 Summary FTSE Russell 3

4 The problem: Inadvertent risk taking Risk is directly related to return Investment managers are always concerned about the riskiness of their portfolios But they often fail to recognize certain risks that are inherent to their portfolios and therefore make unintended bets This results in unexpected performance in the face of unanticipated macroeconomic events Underperformance of retail stocks when there is an unexpected downturn in the business cycle is one example FTSE Russell 4

5 The Solution Arbitrage Pricing Theory (APT) combined with decades of economic research identified five factors that drive portfolio volatility: Unexpected changes in inflation Unexpected changes in the business cycle Unexpected changes in the time horizons of investors Unexpected changes in investor confidence Market Timing (Market Sentiment) These five factors explain the majority of risk in a diversified equity portfolio (as measured by R 2 ) FTSE Russell 5

6 About FTSE BIRR BIRR enables managers to identify and control asset exposures to economy-wide surprises Every asset has a unique Risk Exposure Profile to such surprises (5 betas measuring sensitivities to each factor) BIRR is designed for risk management, performance attribution, and portfolio construction BIRR allows managers to understand their risks and potential returns as a result of these exposures BIRR offers portfolio construction, optimization, and performance attribution software FTSE Russell 6

7 How is BIRR used? To understand the macroeconomic risks inherent in a portfolio To explain past returns To identify what risks a manager is taking To quantify manager skill To design portfolios with targeted risk exposures relative to a benchmark To construct portfolios with specific risk profiles Tilted towards stocks with high confidence sensitivities Tilted towards stocks with low inflation sensitivities Tilted toward stocks with large sensitivities to business cycle risk FTSE Russell 7

8 What type of investors use BIRR? Risk Managers Risk Measurement Chief Investment Officers Asset Allocation Manager Selection Risk Measurement Benchmarking Traders Strategy development and risk measurement Portfolio Managers Portfolio construction, index tracking, rebalancing, risk measurement FTSE Russell 8

9 Usage breakdown* % Industry revenue generated per client segment 6% 5% 11% 63% 15% Asset Managers Broker Dealers Hedge Funds Asset Owners Other *Publicly disclosed data indicates a current user base of 2,230 firms for BIRR-type products, with multiple users at many firms. FTSE Russell 9

10 Alternative approaches Asset-specific financial characteristics models (Micro factors) Uses multiple accounting variables to compute measures such as P/E, P/B, and Size to explain (attribute) risk Models can include 70+ variables when industry sectors are included Statistical models Methods such as Principal Components Analysis identify factors While effective at identifying the sources of risk, it doesn t provide an intuitive framework for what the factors are (factors are unnamed) and these statistical factors change over time Value at risk Often assumes a lognormal distribution to show potential maximum losses at given probabilities Value at Risk can be employed as a complement to the BIRR approach FTSE Russell 10

11 The BIRR advantage Provides an intuitive explanation of risk Simple, but not simple-minded Provides a superior explanation of stock returns with R 2 values that are almost always substantially higher than other approaches Better isolates the stock-specific effects that result from a manager s stock selection process Identifies the attributes that point to a potential for superior future performance Combines micro factors (firm-specific financial characteristics) with macroeconomic factors for a more comprehensive understanding of returns FTSE Russell 11

12 A few illustrations Risk Exposure Profiles for FTSE 100, FTSE USA, and FTSE Asia Pacific Evidence for global integration Cumulative wealth comparisons Value at Risk Optimal selection of FTSE Indexes FTSE Russell 12

13 Risk exposure profiles for FTSE 100, FTSE Asia Pacific, and FTSE USA 4.00 Risk Exposures: FTSE 100, FTSE Asia Pacific, FTSE USA Period to Confidence Time Horizon Inflation Bus.Cycle Market Timing CAPM Beta FTSE 100 FTSE Asia Pacific FTSE USA FTSE Russell 13

14 Evidence for global integration: FTSE 100 Dependent Variable: FTSE100N Method: Least Squares Date: 07/28/10 Time: 20:41 Sample: 2004: :06 Included observations: 72 Variable Coefficient Std. Error t-statistic Prob. C G G G G G R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob (F-statistic) FTSE Russell 14

15 Evidence for global integration: FTSE Asia-Pacific Dependent Variable: FTSE ASIA PACIFIC Method: Least Squares Date: 07/28/10 Time: 19:55 Sample: 2004: :06 Included observations: 72 Variable Coefficient Std. Error t-statistic Prob. C G G G G G R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob (F-statistic) FTSE Russell 15

16 Cumulative wealth comparisons Cumulative Wealth: FTSE 100, FTSE Asia Pacific, FTSE USA Period to FTSE USA FTSE Asia Pacific FTSE 100 FTSE Russell 16

17 VaR comparisons Value at Risk At 95%: FTSE 100, FTSE Asia Pacific, FTSE USA Sample period to Mos Mos. FTSE 100 FTSE Asia Pacific FTSE USA FTSE Russell 17

18 Optimal FTSE index mix Index Weight (%) E[Return] Std. Deviation FTSE Asia Pacific FTSE USA FTSE Europe FTSE Optimal Mix FTSE Russell 18

19 Efficient FTSE index frontier: An illustration FTSE Russell 19

20 In summary: Why BIRR? It outperforms alternative approaches It produces higher R 2 values, better accounting for the behavior of stock returns than alternative risk models It better isolates the specific performance resulting from manager stock selection It s based on sound economic theory (APT) Competing models are flawed Accounting rules differ across firms and aren t backed by theory, negating the value of accounting-based models Statistical models are difficult to interpret and change over time BIRR is backed by theory, produces superior results, is competitively priced, and is easy to use FTSE Russell 20

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