The Power of Sector Neutrality in Controlling Portfolio Risk

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1 2008 Risk Management Conference The Power of Sector Neutrality in Controlling Portfolio Risk Andrew Marchese Portfolio Manager and Director of Research Pyramis Global Advisors (P) (F) Why focus on sector exposure? There are many ways to control portfolio risk One effective way is to manage sector exposures A large amount of return variance is explained by sector exposure, much more than Barra s international risk factors 2 1

2 Sectors explain a large amount of return variance Sector factors explain more cross-sectional return variance than the four risk factors combined in Barra s international risk model Barra factors include: size, success, variability in the markets, value Analyzing Canadian market data from Jan, 1995 March, 2008: Average Cross-Sectional Return Variance Explained Average Time-Series Return Variance Explained Sector Variance 31% 5 Factor Variance (aggregate) 9% 13% Data calculated from the time period 01/95-03/08 using weekly return data and excluding stocks less than $100M market cap. Source: Factset. 3 The results are consistent over time AVERAGE CANADIAN CROSS-SECTIONAL RETURN VARIANCE EXPLAINED 6 5 Sector Variance Factor Variance Data calculated from the time period 01/95-03/08 using 24 week moving averages and excluding stocks less than $100M market cap. Source: Factset. 4 2

3 The same results hold true for other G7 countries AVERAGE CROSS-SECTIONAL RETURN VARIANCE EXPLAINED Sector Variance Factor Variance 41% 31% 33% 37% 36% 21% 25% 9% 5% 7% 7% 8% 9% 5% Canada US UK Italy Germany France Japan AVERAGE TIME-SERIES RETURN VARIANCE EXPLAINED 8 Sector Variance Factor Variance 6 61% 5 51% 58% 4 38% 54% 46% 2 13% 11% 12% 18% 15% 14% 17% Canada US UK Italy Germany France Japan Data calculated from the time period 01/95-03/08 using weekly return data and excluding stocks less than $100M market cap. Source: Factset. 5 Managing sector exposure is not only effective, but an easier way to manage risk One can control sector factors easier than other factors Stock sector classification changes infrequently Factor exposures can change a lot from one period to the next 6 3

4 While return variance indicates opportunity to add value, sector selection it is difficult to predict HIGH Stock Selection PROBABILITY OF SUCCESS Sector Selection Country Allocation Regional Asset Allocation Currency Anticipation LOW IMPACT ON RETURN HIGH 7 Relaxing sector constraints using supersectors increases ability to add value while controlling portfolio risk Supersectors are groups of GIC sectors Using 4 supersectors with a minimum of 2 GIC sectors per supersector, the analysis used the following supersectors: Consumer = Discretionary, Staples, Healthcare Industrials = Industrials, Information Technology Resources = Energy, Materials Interest Sensitive = Financials, Telecom Services, Utilities Supersectors combine the risk benefits of sector neutrality while increasing the opportunity to add value 8 4

5 Loosening constraints using supersectors is not that risky The cross-sectional variance of a supersector neutral portfolio in Canada carries similar risk to that of a sector neutral portfolio in the U.S. Canada U.S. Sector Variance 31% 21% Supersector Variance 21% 15% Data calculated from the time period 01/95-03/08 using weekly return data and excluding stocks less than $100M market cap. Source: Factset. 9 Supersectors also explain a material amount of return variance Sector Variance Supersector Variance Factor Variance (aggregate) Average Cross-Sectional Return Variance Explained 31% 21% 9% Average Time-Series Return Variance Explained 5 39% 13% Data calculated from the time period 01/95-03/08 using weekly return data and excluding stocks less than $100M market cap. Source: Factset. 10 5

6 The results are consistent over time AVERAGE CANADIAN CROSS-SECTIONAL RETURN VARIANCE EXPLAINED 6 Sector Variance 5 Factor Variance Supersector Variance Data calculated from the time period 01/95-03/08 using 24 week moving averages and excluding stocks less than $100M market cap. Source: Factset. 11 Picking correct stocks within sectors is rewarded by the market DISPERSION OF RETURNS IN THE S&P/TSX COMPOSITE INDEX BY SECTOR % change 3 years to 06/30/ Highest stock return Median Lowest stock return -20 Consumer Consumer Discretionary Staples Energy Financials Health Care Industrials Information Materials Technology Telecom Services Utilities Dispersion of stock returns: The maximum and minimum returns (in CAD) of constituents of the S&P/TSX Composite Index as at 06/30/2008, grouped by MSCI Sector, excluding the top 2 performing stocks in the Materials sector (Timminco +3,81 and Gold Eagle Mines +3,239%). Sector dispersion shows the maximum and minimum returns for the 10 MSCI sector indices. Source: Bloomberg 12 6

7 Picking correct stocks within supersectors is rewarded by the market DISPERSION OF RETURNS IN THE S&P/TSX COMPOSITE INDEX BY SUPERSECTOR 120 % change 3 years to 06/30/ Highest stock return Median Lowest stock return -20 Consumer Industrials Interest Rate Sensitive Resources Dispersion of stock returns: The maximum and minimum returns (in CAD) of constituents of the S&P/TSX Composite Index as at 06/30/2008, grouped by MSCI Super Sector, excluding the top 2 performing stocks in the Materials sector (Timminco +3,81 and Gold Eagle Mines +3,239%). Sector dispersion shows the maximum and minimum returns for the 10 MSCI Super Sector indices. Source: Bloomberg 13 The Power of Sector Neutrality Sectors explain a large amount of return variance for all G7 countries Controlling sector exposure is an effective tool for controlling portfolio risk Using a supersector neutral approach relaxes the sector constraints and increases the opportunity to add value while maintaining risk controls 14 7

8 Important information The business unit of Pyramis Global Advisors (Pyramis) consists of: Pyramis Global Advisors Holdings Corp.; Pyramis Global Advisors Trust Company, a New Hampshire limited purpose trust company (PGATC); Fidelity Management Trust Company, a Massachusetts trust company (FMTC); Pyramis Global Advisors, LLC, a U.S. registered investment adviser (PGA LLC); Pyramis Canada ULC, an Ontario registered investment adviser; PYR-UK Limited, a U.K. research provider; and Fidelity Investments Canada ULC (FIC). Investment services are provided by PGATC, FMTC, PGA LLC and/or Pyramis Canada ULC. "Fidelity Investments" refers collectively to FMR LLC, a U.S. company, and its subsidiaries, including but not limited to Fidelity Management & Research Company (FMR Co.), Fidelity Management & Research Company, Inc. (FMR Co. Inc.) and Pyramis. FIL Limited refers collectively to FIL Limited, a non-u.s. company, and its subsidiaries. Fidelity refers collectively to Pyramis, Fidelity Investments and/or FIL Limited. Unless otherwise specifically noted in this presentation, the information set forth herein has been supplied by Pyramis and/or Fidelity Investments. Unless otherwise indicated, data relating to research professionals include research analysts and research associates. Certain data and other information in this presentation have been supplied by outside sources and are believed to be reliable as of the date of this document. Data and information from third-party databases, such as those sponsored by evestment Alliance and Callan, are self-reported by investment management firms that generally pay a subscription fee to use such databases, and the database sponsors do not guarantee or audit the accuracy, timeliness or completeness of the data and information provided including any rankings. Pyramis has not and cannot verify the accuracy of information from outside sources, and potential investors should be aware that such information is subject to change without notice. Information is current as of the date noted. Pyramis has prepared this presentation for, and only intends to provide it to, institutional and/or sophisticated investors in one-on-one or comparable presentations. Do not distribute or reproduce this report. All trademarks and service marks included herein belong to FMR LLC or an affiliate, except third-party trademarks and service marks, which belong to their respective owners. Pyramis does not provide legal or tax advice and we encourage you to consult your own lawyer, accountant or other advisor before making an investment. 15 Thank You! 8