Benchmarking & the Road to Unconstrained 24 April 2012 PIA Hiten Savani Investment Director hiten.savani@fil.com +44 (0) 20 7074 5234
Agenda Two Important Trends Increasing polarisation of demand between low-cost beta (passive) and high-alpha active, with reducing interest in low-alpha active Growing interest among professional investors in alternative index weighting schemes and strategies, such as fundamental indexing and minimum variance Questions Can alternative benchmarks offer a better beta and so contribute to higher risk-adjusted returns for investors? Or are the problems with benchmarks so entrenched that we need a more radical approach, such as unconstrained investing? If so, what does this mean for portfolio construction, risk management and performance evaluation? 2
Market Cap-Weighted (CW) Indices Advantages Theoretical mean-variance efficiency arguments but dependent on a series of assumptions Emphasis on large companies, which typically have the most liquid shares Low turnover low cost for index-tracker funds to replicate CW index = the only portfolio that all investors can simultaneously hold Disadvantages Give higher weight to over-priced stocks, e.g. Vodafone during TMT bubble Accidents of geography, e.g. 30% of FTSE All Share is in energy + materials Excessive concentration at stock level, e.g. AEX Instances of closet index-hugging by portfolio managers (misaligned incentives?) Implications CW indices can perform badly when anomalies unwind, and over the long term Following a CW index closely only makes sense if one expects larger caps to perform well, or if there are good reasons to control benchmark-relative risk 3
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Alternative Benchmarks Purposes of a Benchmark Yardstick: for comparison of return and risk Indicator of primary area of investment: the opportunity set Reference or default portfolio: holdings in the absence of views Examples of Types of Alternative Benchmark Equal-weighted Risk-based Fundamental-weighted Rationale Logical starting points for portfolio construction, depending on risk/return goals Better performance higher return &/or lower absolute risk by avoiding problems of CW indices Risk premia strategies, attempting to capture systematic excess return vs CW indices 5
Equal-Weighted Indices Features A list of stocks, weights (1/N) independent of price, size, value, risk... Less concentrated than the equivalent CW index, with a lower-cap tilt Potential liquidity issues, depending on the choice of cut-off EW vs CW index performance: varies over time (1990s vs 2000s) and between sectors 170 160 150 140 130 120 110 100 90 80 70 Relative Return of EW vs CW Price Indices for Europe & US 170 160 150 140 130 120 110 100 90 80 70 60 50 Relative Return of EW vs CW Price Indices for S&P500 Sectors STOXX EUROPE 600 S&P 500 S&P 500 - INFO TECHNOLOGY S&P 500 - ENERGY S&P 500 - FINANCIALS Source: Fidelity calculations using data sourced from Datastream 6
Risk-Based Indices Various Types Risk-weighted: stock weights are inversely proportional to risk Equal risk contribution (ERC) Minimum variance Max. diversification ( min. correlation) Underperformance of High-Volatility Stocks Benefits Risk aware by construction and still provides access to the Equity Risk Premium Typically have low volatility Outperform when sentiment worsens Caveats Portfolios can be highly concentrated in a few industries Significant exposure to ex-post co/variance Low-risk stocks can become expensive Source: MSCI Barra, European Risk Model 7
Minimum variance outperforms when sentiment deteriorates Source: RBS Global Quantitative, Perspectives on Minimum Variance, Aug 2011. Cumulative performance of a minimum variance portfolio relative to FTSE Europe Index, Jan 1990-Dec 2010. Up/down sentiment defined in terms of the 2-year change in investor sentiment.
Fundamental Indices Rationale Gives higher weight to companies with a bigger economic footprint, without using stock price information Weighted by book value, earnings, sales or a composite measure Outperformance of Value factors over time Benefits Better reflect the underlying economic reality e.g. RAFI (Research Affiliates Fundamental Index) methodology: shows long-term outperformance Outperform when Value beats Growth Caveats Concentration issues can exist Fundamental changes in companies can take a while to filter into the index Source: MSCI Barra, European Risk Model 9
Alternative Benchmarks Compared PERFORMANCE OF PRINCIPAL APPROACHES (31/05/1988-31/12/2010) MSCI World MSCI World Equal Weighted MSCI World Risk Weighted MSCI World Minimum Volatility MSCI Value Weighted Annual Return ($, %) 7.14 8.87 9.95 7.64 9.13 Annual Volatility (%) 15.5 16.1 13.9 11.8 15.6 Sharpe Ratio 0.21 0.31 0.43 0.32 0.34 Tracking Error (%) 0.0 5.3 5.4 6.6 3.7 Maximum Drawdown (%) -53.7-55.3-50.9-42.6-57.5 Annual Turnover (%) 3.9 23.4 24.6 20.0 18.6 Harvesting Risk Premia with Strategy Indices, MSCI, September 2011 Risk-adjusted returns from risk premia strategies have been generally strong Performance tends to be cyclical, largely driven by inherent factor tilts Alternatives are useful reference points for intentionally style-oriented portfolios A policy of close adherence to any one strategy may restrict a diversified investment strategy a well thought through combination of risk premia could potentially outperform an allocation to a single strategy. (MSCI) Unconstrained investing can be one way to deliver strong results 10
Key questions to consider Is the risk premium likely to persist and how is it expected to behave over the investment time horizon? Is the methodology capturing the underlying risk premium in a robust and effective manner? Are the investment beliefs behind the index methodology based on sound economic and financial rationales? Can the strategy be replicated cost effectively? Is absolute risk being addressed or does the source of risk simply move from the imposition of one benchmark to another?
Unconstrained Investing: Overview Definition Investing without near-term reference to a benchmark Rationale PM uses research to the maximum, only holding stocks where he/she has a positive view In many cases absolute risk is more relevant than benchmark-relative risk, especially in the context of broader asset allocation Benefits Accountability: PM is responsible for everything style, sector & stock selection and is free to try to beat the market No need for portfolio to have passive exposures to factors driving benchmark performance Increased active risk should increase value-added for end-investors 12
BENCHMARK WEIGHT BENCHMARK WEIGHT Unconstrained Investing: Portfolio Construction High conviction ideas, each chosen on their own merits, many large caps not held Relatively even distribution of weights to manage stock-specific risk Typically bigger weights in less volatile stocks to manage portfolio risk Holdings well spread across sectors (&/or countries) to manage correlation Probable size bias vs CW-index Constrained Unconstrained TOP 30 BENCHMARK WEIGHTS (15 held) TOP 30 BENCHMARK WEIGHTS (7 held) 9 10 8 9 7 8 6 5 4 3 2 1 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 10 PORTFOLIO WEIGHT 0 0 1 2 3 4 PORTFOLIO WEIGHT 13 Source: Fidelity
Unconstrained Investing: Risk Considerations Benchmark-agnosticism more chance of unusual or unintended systematic risks PM needs to manage portfolio risk, e.g. stock and sector contributions, style bias 3 key factors: distribution of weights, volatility, correlation Capacity issues are possible An Unconstrained Fund would aim to have: Higher expected return Potentially higher tracking error Lower absolute risk (usually) Higher expected Sharpe ratio Source: Fidelity 14
Case Study: Before & After Jul-2011 Nov-2011 W e i g h t i n g ( % ) 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 6 11 16 21 26 31 36 41 46 Number of stocks W e i g h t i n g ( % ) 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 More even distribution of weight 1 6 11 16 21 26 31 36 41 46 Number of stocks Key figures Jul-2011 Nov-2011 Old fund Current fund Number of holdings 46 48 Top 10 holdings as a percentage of portfolio 49% 28% Number of underweight holdings vs cap-weighted benchmark 7 3 Active Money vs cap weighted benchmark 54 79 Tracking Error ex ante vs cap weighted benchmark 3.0% 6.0% Difference between fund volatility & benchmark volatility (%) -0.2% -0.9% Weighted median market cap USD 14.5 bn USD 1.9 bn Source: Fidelity 15
Unconstrained Investing: Observations Total number of stocks unchanged, but more of them are outside the benchmark Lower median market cap (very likely result) More even distribution of portfolio weights (likely) Higher active money (very likely) and tracking error (not targeted) Lower fund/index correlation (very likely) and lower relative volatility (likely A final thought If alternative weighting approaches provide improved but still inflexible ways of capturing underlying sources of investment return, unconstrained portfolios may stand out by their ability to take a more active approach that is guided by research and free from the shackles of benchmark relative risk. 16
Appendix
Appendix: Unconstrained Investing: Performance Evaluation High-Level Competition from actively managed peers and ETFs it remains important to beat CW index and other alternative benchmarks But need a longer period of evaluation (3-5 years or more) due higher active risk Details Key question: Did the PM pick stocks that beat the average (or median) stock? EW index return is a proxy for the average stock (if mean median), but portfolio is not managed vs EW index The nature of the market opportunity set varies over time, e.g. Weak markets: large caps often outperform Strong market recoveries: the mean stock return is well above the median 18
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