R-Squared Risk Management Limited

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1 Risk Management Limited Authorised and regulated by the Financial Conduct Authority RISK REPORT. R-Squared Global Model in USD Global Equity Index v Cash 30 January 2014 Highlights Positive exposures to large US stocks dominates overall risk, with a significant contribution from positive exposure to the Euro factor. These exposures reflect the importance in the US of Energy Equipment & Services, driven by growth in extraction of unconventional oil and gas; and established stocks such as Apple, Intel, Cisco and Broadcomm. Exposure to the Euro reflects the importance of this market in USDollar terms to US exporters. Factor Risk (s.d.) Stock Risk (s.d.) 0.83 Total Risk (s.d.) Global Currency factor risks Local Currency factor risks 9.28 Style factor risks Country factor risks Industry factor risk Statistical factor risks % Factor Risk (RSQ) % Stock Risk 0.22 % Total Risk Also in this report: Factor risk analysis Stock-level risk analysis Independent Bets analysis Currency exposure analysis Diversification Ratio 1.67 Number of Holdings 2,434 Total risk of 17.80% per annum is consistent with a well-diversified portfolio of equities. Its 2,434 stocks are weighted by current market capitalisation. The high percentage of risk (99.78%) explained by the model s risk factors confirms that this is a well-diversified index, as residual, stock-specific risk is largely diversified away. Return Enhancement through Risk Management 1

2 Factor Risk Analysis This section identifies the most important factor exposures, expressed as the portfolio beta to individual factors and as the impact each factor exposure has on the overall risk of the index. Note that the risk factors shown on the x-axes are identical in top and bottom for left and right hand charts respectively. The left hand factors are ordered in descending order of their contributions to portfolio risk, with the corresponding portfolio factor to beta underneath; while the right hand charts show the five highest and lowest factor betas, with their corresponding contribution to risk underneath. The most significant contributors to the Global index s risk are its positive exposures to large US stocks with 11.5%, and the Euro currency with 6.4%. The rest of the index s risk is relatively evenly spread among the other model risk factors. Notable is that the index has significant exposures to Style risk factors, which collectively reduce overall risk, albeit by a relatively small amount. The relatively even spread of risk across model risk factors is consistent with a well-diversified index. Return Enhancement through Risk Management 2

3 Stock-level Risk Analysis This analysis examines the top ten stocks in descending order of their contribution to the risk of the index. It compares stocks weighting in the index with their contributions to risk. While it is clearly important to know what the biggest bets in a portfolio are, it is actually the more extreme bets that should generate the best performance. We identify extreme bets by looking at the ratio of a stock s risk contribution to its holding size. For the most concentrated exposures, the most significant factor betas are shown. Not coincidentally, they correspond to the factors that contribute most to overall risk. Company Name Country Contribution to Risk Holding Holding Rank Volatility Beta to US Large Stocks % % % APPLE INC United States GOOGLE INC United States BANK OF AMERICA United States JPMORGAN CHASE United States EXXON MOBIL United States GENERAL ELECTRIC United States HSBC HLDGS United Kingdom CITIGROUP United States WELLS FARGO United States MICROSOFT United States Of the top ten stock contributors to risk nine are US stocks, and therefore contributors to the U.S Large Stocks risk factor. None of these stocks has a significant beta to the Euro risk factor. Notable is the presence in the list of large banks, which, because of their relatively high volatility, contribute much more to the index s risk than can be explained by their holding sizes alone. This in turn highlights the distinction between the rankings of contribution to risk and holding size, with Bank of America and Citicorp punching well above their weights. Return Enhancement through Risk Management 3

4 Independent Bets Recognising that even the best multi-factor risk models have correlations between the defined risk factors, this report identifies combinations of portfolio exposures that are statistically independent by applying Principal Components Analysis and adding economic interpretation to the resulting statistically independent eigenvectors. The chart below shows the contribution to risk, in descending order, of each of the first ten eigenvectors. Portfolios typically exhibit only 3 or 4 truly independent bets. Nearly three quarters of the overall portfolio risk is attributable to the first two independent bets. PC1, which explains 53% of the index s risk, is dominated by the index s positive exposure to U.S Large Stocks, in turn due to contributions from a mix of businesses; the Euro factor, due mostly to European banks; and U.S Energy Equipment & Services, reflecting the importance of the growth of extraction of unconventional oil and gas in the US. Positive contributions to PC1 are partially offset by negative contributions from Style factors, particularly in the US. PC2, which explains a further 20% of risk, also reflects risk contributions from U.S Large Stocks and U.S Energy Equipment and Services, but with other currency effects, notably from the Euro and British Pounds, netted out, which leaves a purer US market and industry group effect. PC2 underlines the importance of global currency exposures to Global market volatility. Return Enhancement through Risk Management 4

5 Currency Exposure Analysis Currency exposures are usually important sources of risk for most portfolios, so a successful hedging strategy must start with currency exposures, given by the portfolio exposure to each currency factor. For example, a beta of 0.15 can be neutralised by hedging 15% of the portfolio s value. This report highlights the distinction between currency of exposure and currency of denomination. The chart shows weighting and exposure to each model currency. Most stocks in the index are denominated in Euro (which is not a risk factor, being the base currency). This analysis further highlights the importance of global currencies and the distinction between exposure, as measured by betas to risk factors, and simple holding weights. The British Pound factor is dominated by British stocks, notably financial services firms, which tend to be more volatile than other stocks, with the largest of them deriving a large part of their revenues from domestic business. The index s exposure to the Euro factor is dominated by exposures to European banks and financial services firms, augmented by contributions from large manufacturers, such as Alcatel- Lucent and Finmeccanica with operations outside the Eurozone, but who sell into the Euro market and therefore benefit from Euro strength. Negative exposure to the Japanese Yen reflects the export orientation of large Japanese stocks, including Sony, Panasonic and Toyota. Return Enhancement through Risk Management 5

6 Frances Cowell Director of Risk Consulting. Frances direct investment management experience began in 1983, when she established an investment research function at Aetna Life & Casualty in Australia. From 1984 to 1991, she developed her derivatives skills to derive arbitrage rents by managing principal portfolios of exchange-traded and over-the-counter derivatives and physical assets in investment banking. From 1991 to 1997, she was a portfolio manager for domestic and global equities and balanced funds, using risk management technology combined with futures, swaps and options to match risk and expected return to stated investment objectives. In 1994 she became Head of Enhanced Passive Investments at NatWest Investment Management in Australia and subsequently headed the Quant team. Since coming to the UK she has specialised in risk management. From 1998 to 2002, Frances worked at QUANTEC, consulting to investment management clients on the application of portfolio risk analyses and risk management. In 2002 she served as Head of Portfolio Risk at Morley Fund Management (now Aviva Investors), managing a team of six risk management professionals, a role that included membership of a range of governance bodies, including the Aviva Derivatives Committee. From 2003 to 2007 she established and managed risk management for in-house hedge funds and derivatives at Morley. Prior to joining R-Squared she was Head of Investment Risk at CCLA Investment Management from 2007 to Frances is a founding member of the London Quant Group, an occasional contributor to investment management journals and a member of CFA UK. Frances experience and expertise in portfolio risk management spans the following areas: Fifteen years managing the investments of pension and institutional funds, including the third largest equity portfolio in Australia as well as balanced funds and hedge funds. Extensive cross-asset class and derivatives experience in all market conditions. The combination of a risk-based approach, tactical use of derivatives for risk control and frequent conversations with fund directors and fund investment committees. First-hand experience of serving on governance bodies and overseeing procedures and reporting. A sound understanding of the principles of various modelling techniques, and familiarity with all commercially-available risk measurement systems and techniques. Industry best practice: what works and what doesn t: For all investors For all asset mixes For all portfolio strategies In all market conditions Fund director The Nexus Building, Broadway, Letchworth Garden City, Hertfordshire SG6 3TA, United Kingdom UK Sales Grosse Pointe, MI, USA UK Support Grosse Pointe, MI, USA Paris, France Greenwich, CT, USA info@rsqrm.com v1.1