CEMP Volatility Weighted Indexes

Transcription

1 CEMP Volatility Weighted Indexes Fundamental Criteria with Volatility Weighting in Index Construction By: Stephen M. Hammers, CIMA Chief Investment Officer/Co-Founder An Efficient Solution to Broad Market Indexing June 30, 2012

2 Summary Benefits of Using Fundamental Criteria and Volatility Weighting in Index Construction 1. Cap-Weighting Bias 2. An Efficient Solution CEMP Enhanced Indexing Methodology 1. Universe 2. Consistent Earnings 3. Size 4. Volatility Weighting 5. Index Reconstitution 6. Corporate Actions

3 Summary Cont. Total Return, Risk and Risk Adjusted Returns Performance Over Market Cycles 1. Bear Market of Early 2000 s 2. Bull Market of Financial Crisis of Bull Market of Market Volatility of Standard Deviation and Beta 7. Risk Adjusted Returns 8. S&P 500 Index A Market Benchmark?

4 Cap-Weighting Bias S&P 500 Index Over $1 Trillion tracking its performance Despite its widespread acceptance, it appears to contain some inefficiencies that have been chronicled in various studies of its appropriateness as a market benchmark The largest market capitalization companies receive the vast majority of the weightings in the index 2011 The top 25% of the index holdings represented approximately 78% of the return. The bottom 25% of the index holdings represented 1.4% of the index s total return. Is the S&P 500 Index truly a broad market index? The index over weights markets fad s such as Technology in the late 1990 s and Financials in 2006 and 2007 Indexes are unmanaged and investors are not able to invest directly into any index.

5 An Efficient Solution CEMP Indexing Methodology Emphasizes a target weighting of different holdings by their riskiness and not by their market cap or by their fundamentals. Security risks include economic risk, liquidity risk, trading risks, and management risks to name a few. As these different risks fluctuate over time, it can be difficult to gauge what impact on performance they may have. However, CEMP believes price volatility is a clear and observable variable that tracks these risks in the aggregate. The core principle of CEMP Volatility Indexing methodology is consistent earnings and each index member receives an equal weighting on the basis of volatility.

6 An Efficient Solution What makes the CEMP Volatility Indexing methodology unique is in how it combines aspects of earnings and risk control with return enhancement. Some of the other popular non-traditional indexes publicly available either focus on risk control within its own indices such as the MSCI Risk-Weighted index series or focus solely on fundamental data weighting such as the FTSE RAFI indices or the Wisdom Tree Indexes. While each of these types of indexes has their own merits, they only focus on either the fundamental or the volatility relationship, not the enhancement of both. By looking at risk and return together with fundamentals in the context of index construction, the result is efficient indexing that provides a more broad representation of companies making money along with risk oversight. The end result has produced a believed superior risk-adjusted returns over time.

7 CEMP Indexing Methodology A Closer Look Universe The CEMP U.S. Large Cap 500 Volatility Weighted Index, considers all publicly traded companies incorporated in the United States for which at least four quarters of publicly available accounting data exists. Earnings The next level of scrutiny is to include only those companies who have posted four consecutive quarters of positive earnings per share as of their most recent filing.

8 CEMP Indexing Methodology A Closer Look Earnings There is ample research and data which shows that fundamental-based indexing generates a positive Alpha relative to cap-weighting only indexes over time. A simple example of an earnings criterion is to compare the performance of the S&P 600 Small Cap Index with that of the Russell 2000 Index. Both indices use a market-cap weighting methodology to track the universe of U.S. small cap equities; however the S&P 600 includes an earnings criterion for any qualified company to be an index member whereas the Russell 2000 does not. 9/30/00 to 12/31/11 5 Years 10 Years Cumulative Alpha S&P 600 Index 1.69% 7.66% % 2.54% Russell 2000 Index 0.09% 6.18% 64.83% Source: Bloomberg, Inc., and Zephyr & Assoc. Inc.

9 CEMP Indexing Methodology A Closer Look Company Size Once the universe of profitable companies has been identified, the next step is to take the 500 largest companies based on their market capitalization on the date of rebalancing. This helps ensure the index is capturing its target universe of large cap equities. Volatility Weighting The next step is to analyze the price volatility of the resulting 500 securities. Volatility in this context is defined as the annualized standard deviation of daily price changes over the prior 180 trading days.

10 CEMP Indexing Methodology A Closer Look Volatility Weighting Weights are assigned to index members based on their own volatility relative to the average volatility of all index members. Companies with greater price volatility will be assigned lower index weighting and companies with less price volatility will be assigned a larger weighting. Top 10 Holdings Market Cap Index Weight Bottom 10 Holdings Market Cap Index Weight Southern Company 38.4 Billion 0.47% GMCR, Inc Billion 0.07% Kimberly-Clark Corp Billion 0.44% Netflix, Inc. 6.2 Billion 0.08% Procter & Gamble Billion 0.42% Illumina, Inc. 6.3 Billion 0.08% General Mills 24.6 Billion 0.41% MetroPCS Comm., Inc. 3.9 Billion 0.09% Southern Union Co. 5.5 Billion 0.41% Walter Energy, Inc. 4.1 Billion 0.09% Kraft Foods, Inc Billion 0.39% Riverbed Technology 4.6 Billion 0.09% The Hershey Co Billion 0.38% Cree, Inc. 3.5 Billion 0.10% Duke Energy Corp Billion 0.38% Polycom, Inc. 3.6 Billion 0.10% Johnson & Johnson Billion 0.38% Jefferies Group 3.6 Billion 0.11% McDonald s & Co Billion 0.38% Citigroup Billion 0.11%

11 CEMP Indexing Methodology A Closer Look Volatility Weighting Example Aggregate Volatility (STD) 15% XYZ Co. Volatility (STD) 30% Reduce Increase Equalize the Risk XYZ Co. has 266% greater volatility/risk than ABC Co. ABC Co. Volatility (STD) 8%

12 CEMP Indexing Methodology A Closer Look Index Reconstitution The index is rebalanced and reconstituted once every six months, during the months of March and September. The reason for these dates is based upon allowing sufficient time for enough companies to report prior quarterly earnings results. Most companies will have reported results for fiscal Q4 and Q2 respectively by those dates. The index weightings are allowed to freely float until the next rebalancing date to represent the performance of the underlying securities and the broad market.

13 CEMP Indexing Methodology A Closer Look Corporate Actions Occasionally, some type of corporate action may impact a member s status in the index. Examples of these events include mergers, acquisitions, and spinoffs. The default response to any of these actions is to remove any index member that may not qualify and to reassign its index weight proportionately across the remainder of the index. Since these types of events occur with regularity, index members will be immediately removed on the day the corporate action is put into action rather than waiting for the next rebalancing date.

14 Index Performance Index Average Annual Returns 9/30/00-12/31/11 3 Years 5 Years 7 Years 10 Years Since 9/30/00 Cumulative CEMP U.S. Large Cap 500 Volatility Weighted 17.97% 2.65% 5.30% 7.58% 7.38% % S&P % -0.25% 2.64% 2.92% 0.71% 8.31% CEMP U.S. Small Cap 500 Volatility Weighted 18.0% 2.85% 5.12% 8.61% 9.42% % Russell % 0.15% 3.20% 5.62% 5.54% 64.83% CEMP International 500 Volatility Weighted 11.92% -2.40% 5.13% 10.07% 7.40% % MSCI EAFE 8.16% -4.26% 2.18% 5.12% 2.11% 26.44% CEMP Emerging market 500 Volatility Weighted 27.37% 12.74% 17.58% 18.93% 17.14% % Dow Jones Emerging Market 20.11% 1.45% 9.11% 13.03% 10.26% % Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Past performance is no guarantee of future results.

15 Index Performance Annual Over the 11 annual periods below, the CEMP U.S. Large Cap 500 Volatility Weighted Index outperformed the S&P 500 Index 10 out of 11 of those years was the only year of underperformance by a mere 0.68%. CEMP U.S. Large Cap 500 Volatility Weighted Index % 21.78% 29.71% % 5.56% 15.11% 9.44% 18.14% 32.29% -7.42% 0.53% S&P 500 Index % 15.06% 26.46% % 5.49% 15.79% 4.91% 10.88% 28.68% % % Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. This is an important outcome as the CEMP indexing methodology demonstrates that not only is it robust in its performance compared to traditional market indexes, but it is also consistent in generating this outperformance over time. Past performance is no guarantee of future results.

16 Index Performance Over Market Cycles Bear Market of the Early 2000 s The early 2000 s saw significant market declines after going through both the bursting of the technology stock bubble and also the September 11 th terrorist attacks. October December 2002 Percentile S&P 500 CEMP US Large Cap 500 Market Cap Avg. Weight Total Return CTR* Avg. Weight Total Return CTR* Largest 25% 84.61% % % 28.35% % -6.37% 25-50% 11.84% -0.51% -0.58% 28.50% 2.84% 1.67% 50-75% 2.62% 15.76% 0.11% 28.50% 15.72% 4.70% Smallest 25% 0.68% 19.40% 0.04% 14.25% % -0.63% Index % % -0.63% -0.63% CTR* Contribution to the Total Return Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Past performance is no guarantee of future results.

17 Index Performance Over Market Cycles Bull Market of There were significant gains across all sectors of the U.S. stock market from 2003 to Similar to the bear market that preceded it, the broader large cap quartiles in the S&P 500 significantly outperformed the largest (over weighted) quartile. January December 2007 Percentile S&P 500 CEMP US Large Cap 500 Market Cap Avg. Weight Total Return CTR* Avg. Weight Total Return CTR* Largest 25% 81.89% 71.31% 61.55% 38.01% 82.02% 32.53% 25-50% 13.52% % 16.09% 30.44% % 31.66% 50-75% 2.83% % 3.07% 21.80% % 28.33% Smallest 25% 0.89% % 1.28% 8.17% % 13.57% Index 81.99% 81.99% % % CTR* Contribution to the Total Return Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Past performance is no guarantee of future results.

18 Index Performance Over Market Cycles Financial Crisis of The market turmoil that began with the meltdown in the housing market in 2008 which spilled into every asset class and market sector, creating an environment of pronounced risk aversion and a flight to quality. January February 2009 Percentile S&P 500 CEMP US Large Cap 500 Market Cap Avg. Weight Total Return CTR* Avg. Weight Total Return CTR* Largest 25% 77.99% % % 33.86% % % 25-50% 15.16% % -8.01% 26.06% % % 50-75% 4.59% % -2.40% 25.62% % % Smallest 25% 1.73% % -0.90% 14.46% % -6.64% Index % % % % CTR* Contribution to the Total Return Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. One feature to note from this time period was the benefits of employing an earnings criteria. The total return from each market cap quartile in the CEMP U.S. Large Cap index outperformed its respective quartile in the S&P 500 by anywhere from 3% to 9% for the period. Past performance is no guarantee of future results.

19 Index Performance Over Market Cycles Bull Market of After the financial crisis of 2008 and early 2009, financial markets significantly rebounded as risk aversion faded and the flight to quality began to unwind. The contribution of each market cap quartile in the CEMP U.S. Large Cap 500 Index ranged anywhere from 13.5% to 28.2 %, a much more balanced spectrum of return contribution. March February 2011 Percentile S&P 500 CEMP US Large Cap 500 Market Cap Avg. Weight Total Return CTR* Avg. Weight Total Return CTR* Largest 25% 81.51% 77.27% 65.82% 33.81% 76.93% 27.47% 25-50% 13.39% % 15.46% 27.34% 98.15% 26.63% 50-75% 3.70% % 5.12% 25.19% % 28.20% Smallest 25% 1.36% % 2.10% 13.45% % 13.50% Index 88.50% 88.50% 95.80% 95.80% CTR* Contribution to the Total Return Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Past performance is no guarantee of future results.

20 Index Performance Over Market Cycles Market Volatility of 2011 The year of 2011 represented a unique market environment from a historical perspective, with significant movements to both the upside and the downside, yet with no meaningful follow-through in either direction. January December 2011 Percentile S&P 500 CEMP US Large Cap 500 Market Cap Avg. Weight Total Return CTR* Avg. Weight Total Return CTR* Largest 25% 77.59% 2.58% 2.02% 33.35% 3.79% 1.27% 25-50% 15.50% 0.54% 0.07% 27.46% 3.59% 1.00% 50-75% 5.44% 0.76% 0.05% 24.28% 3.87% 0.90% Smallest 25% 1.38% -2.07% -0.03% 14.91% 3.91% 0.74% Index 2.11% 2.11% 3.91% 3.91% CTR* Contribution to the Total Return Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc included significant concerns regarding Europe and the unreasonable amount of debt and out of control spending within the Developed markets around the world. Larger names outperformed smaller names and high quality assets generally outperformed low quality assets for the year. The CEMP Index methodology again confirms its broader diversification and consistent earnings criteria. Past performance is no guarantee of future results.

21 Standard Deviation and Beta The CEMP Enhanced Indexing methodology has produced consistently less volatility than the traditional cap weighted index over time. Standard Deviation Since 3 Years 5 Years 7 Years 10 Years 9/30/00-12/31/11 9/30/00 CEMP U.S. Large Cap 500 Volatility Weighted 17.48% 18.46% 16.05% 14.94% 14.90% S&P % 18.88% 16.37% 15.93% 16.28% Beta Since 3 Years 5 Years 7 Years 10 Years 9/30/00-12/31/11 9/30/00 CEMP U.S. Large Cap 500 Volatility Weighted S&P Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Past performance is no guarantee of future results.

22 Risk Adjusted Returns Risk and return represents two sides of the same coin; there cannot be one without the other. An investor should not evaluate one without the other. Risk adjusted returns should be evaluated to determine value. Cost is typically an issue in the absence of value; therefore, value should always be quantified. Alpha Since 3 Years 5 Years 7 Years 10 Years 9/30/00-12/31/11 9/30/00 CEMP U.S. Large Cap 500 Volatility Weighted 4.61% 2.84% 2.63% 4.62% 6.38% S&P % 0.00% 0.00% 0.00% 0.00% Sharpe Ratio Since 3 Years 5 Years 7 Years 10 Years 9/30/00-12/31/11 9/30/00 CEMP U.S. Large Cap 500 Volatility Weighted S&P Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Past performance is no guarantee of future results.

23 S&P 500 Index A Market Benchmark? With over one trillion U.S. Dollars following the performance of the S&P 500 Index, why do so many investors wish to perform like the S&P 500? Why do so many investors compare money managers to the S&P 500 which over weights the vast majority of its performance toward a select few large cap stocks versus the broader stock market? Large Cap Core money managers are still underperforming the S&P 500 Index. Why? Opinion Risk Percentage of the Morningstar Large Cap Blend mutual fund managers that have under performed the CEMP U.S. Large Cap 500 Volatility Weighted Index and the S&P 500 Index Represents the number of Mutual Fund Managers that under perform the indexes 1 Year 3 Years 5 Years 7 Years 10 Years below. Active Fund Managers in Peer Group 1,836 1,736 1,630 1,457 1,243 CEMP U.S. Large Cap 500 Volatility Weighted 89.89% 94.07% 96.08% 97.36% 99.81% Index S&P 500 Index 83.25% 73.48% 69.24% 67.42% 61.66% Source: Dow Jones, Inc., Bloomberg, Inc., and Zephyr & Assoc. Inc. Source: Compass EMP, Zephyr & Assoc. and Morningstar, Inc. Past performance is no guarantee of future results.

24 CEMP Volatility Weighted Indexes The CEMP Volatility Weighted Indexes are presented as a broad market enhancement to traditional cap weighted and even fundamental weighted indexes. By combining the aspects of fundamentals as an initial criterion for company inclusion and ultimately equalizing the risk contribution to the index, CEMP believes its indices are the ultimate enhancement to passive indexing. We believe the evidence validates the theory..and the historical risk and return is the evidence.

25 Notice and Disclaimer Investing involves risk including the potential loss of principal. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Index returns do not include any expenses. Investors cannot invest directly in an index. Index performance information other then the CEMP Enhanced Indexes herein is believed to be reliable, but Compass Efficient Model Portfolios, LLC does not guarantee its accuracy. The CEMP Indices are calculated by Dow Jones Indexes, the marketing name of CME Group Index Services LLC, and are patent pending (Serial No. 61/645,370).The CEMP Volatility Weighted Indices or the information contained herein may not be replicated or utilized unless there is written consent from Compass Efficient Model Portfolios, LLC. Past returns do not guarantee future results. Index returns do not include any expenses. Investors cannot invest directly in an index. The S&P 500 Index (used as a comparison) consist of 500 of the most widely held stocks weighted based on their market capitalization. "Dow Jones " and "Dow Jones Indexes" are service marks of Dow Jones Trademark Holdings LLC, and have been licensed for use by CME Group Index Services LLC. This document and all of the information contained in it, including without limitation all text, data, graphs, charts (collectively, the Information ) is the property of Compass Efficient Model Portfolios, LLC. The information herein is provided for informational purposes only. The Information may not be reproduced or disseminated in whole or in part without prior written permission from Compass Efficient Model Portfolios, LLC. The Information herein may not be used to create indices, databases, risk models, analytics, software, or in connection with the issuing, offering, sponsoring, managing or marketing of any securities, portfolios, financial products or other investment vehicles utilizing or based on, linked to, tracking or otherwise derived from the Information or any other CEMP data, information, products or services. The user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. Without limiting any of the foregoing and to the maximum extent permitted by applicable law, in no event shall any Information Provider have any liability regarding any of the Information for any direct, indirect, special, punitive, consequential (including lost profits) or any other damages even if notified of the possibility of such damages. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), any security, financial product or other investment vehicle or any trading strategy. Compass Efficient Model Portfolios, LLC is a Registered Investment Adviser under the Investment Advisers Act of Any use of or access to products, services or information of the CEMP Enhanced Indexes requires a license from CEMP and Compass Efficient Model Portfolios, LLC. For additional information, product development or licensing please contact

26 The MSCI EAFE Index is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of the developed markets excluding the United Sates. Dow Emerging Markets Index covers approximately 95% of the market capitalization of the represented countries. The industry indexes are created according to definitions used by Dow Jones Indexes proprietary classification system and are maintained at both the country and regional level. More-granular sector indexes are also available. The size-segment indexes (large-cap, mid-cap and small-cap) are defined by cumulative market capitalizations. They are maintained at both the country and regional level. The CEMP U.S. Large Cap 500 Volatility Weighted Index consists of 500 of the largest U.S. stocks with consistent positive earnings and with an equal weighting of risk among all 500 stocks. The CEMP U.S. Small Cap 500 Volatility Weighted Index consists of 500 of the largest U.S. small cap stocks $3 Billion or less with consistent positive earnings and with an equal weighting of risk among all 500 stocks. The CEMP International 500 Risk Weighted Index consists of 500 of the largest developed country stocks with consistent positive earnings and with an equal weighting of risk among all 500 stocks. The CEMP Emerging Market 500 Volatility Weighted Index consists of 500 of the largest emerging market country stocks with consistent positive earnings and with an equal weighting of risk among all 500 stocks. The MSCI Risk Weighted Indices belong to the MSCI family of alternatively weighted indices designed to mitigate risk in a disciplined and low cost manner. FTSE is a range of non-market cap weighted indices, index constituents are selected and weighted using four fundamental factors- total cash dividends, free cash flow, total sales and book equity value. Wisdom Tree Indexes are a family of fundamentally weighted indexes The S&P 600 SmallCap Index covers a broad range of small cap stocks in the United States. The index is weighted according to market capitalization and covers about 3-4% of the total market for equities in the United States. The Russell 2000 Index is a market-cap weighted index composed of 2000 U.S. small-cap common stocks. The S&P 500 Index is 500 of the largest market capitalization companies receive the vast majority of the weightings in the index