Factor Investing & Smart Beta Raina Oberoi VP, Index Applied Research MSCI 1
Outline What is Factor Investing? Minimum Volatility Index Methodology Historical Performance and Index Characteristics Risk Premia: Combining Minimum Volatility with Other Factor Indexes MSCI Quality Mix Indexes 2
What is Factor Investing? 3
What is Factor Investing? Factor investing is the investment process that aims to harvest risk premia through exposure to factors A large body of academic research highlights that long term equity portfolio performance can be explained by systematic factors. Some factors represent exposure to systematic risk and have historically earned a long term risk premium We currently identify six risk premia factors. They are grounded in academic research and have solid explanations as to why they have provided a premium 6 KEY FACTORS Low Size Value Momentum Quality Yield Low Volatility 4
Yesterday s Alpha is Today s Beta 1970s 1980s 2000s Alpha Portfolio Return Alpha Factor Beta Low Size Value Quality Momentum Yield Low Volatility Regional Beta Beta Country Beta Sector Beta 5
What Attracts Investors to Factor Investing? 12.00% Performance Characteristics (November 2001 to August2014) (Gross Total Return in USD) 11.00% Risk Weighted Annualized Return 10.00% 9.00% 8.00% Min Vol Quality Momentum HDY Equal Wtd Value Wtd 7.00% World 6.00% 11.00% 12.00% 13.00% 14.00% 15.00% 16.00% 17.00% 18.00% 19.00% Annualized Risk * Simulated history from December 1998 to April 2008; Index was launched in April 2008. 6
What Causes Risk Premia and How Persistent Are These Effects? There are two main views on why these excess returns exist, which result from different perspectives on market efficiency: 1. Systematic Risks 2. Systematic Errors Certain stocks are highly correlated with the economic cycle and earn a risk premium Certain stocks may be systematically under priced and subsequently earn a high return The important question for long term investors considering an allocation to risk premia strategies is not only which theory explains them but whether they are likely to persist Both theories attempting to explain historical return regularities may allow for risk premia to persist, provided that the same historical behavior persists in the future Factors are cyclical and there may be periods of prolonged underperformance 7
The Trade-Off Between Exposure and Investability Exposure Pure Factors Mkt Neutral Factor Indexes Long Short Factor Indexes MSCI Market Neutral Barra Volatility MSCI Momentum Tilt (130/30) High Exposure Factor Indexes MSCI Quality High Capacity Factor Indexes MSCI Value Weighted Cap Weighted Parent Indexes MSCI ACWI IMI Investability 8
Minimum Volatility Index Methodology 9
MSCI Minimum Volatility Index Methodology Parameter Methodology Comments Universe Optimization Parent index constituents MSCI s market leading Barra Global Equity Model (GEM2) Derived indexes benefit from parent index construction rules Account for Factor volatility and correlation Comprehensive and robust risk measures Weighting Minimize index volatility subject to constraints Ensure high investability and liquidity Constraints Number of Constituents Rebalancing Stocks: Lower of 1.5% or 20x the cap-weight, with a minimum of 5bps Sectors:-/+5% relative to the parent index Countries: -/+5% or 3x relative to the parent index Style: -/+ 0.25 relative to Barra factor of the parent index (except for Volatility) Turnover: Maximum 10% one-way turnover per rebalancing Subset of parent index, number will vary Semi-annual (May and November) Stock weight cap ensures adequate capacity and replicability Style and Sector caps ensure no unintended exposure Turnover limit ensures lower cost replication High level of diversification achieved by a subset of parent index Timely data updates, consistent with MSCI rebalancing calendar 10
Historical Performance and Characteristics 11
Relative Performance of the MSCI World Minimum Volatility Index * Crisis periods are typically characterized by spikes in market volatility The MSCI World Minimum Volatility Index has historically outperformed the MSCI World Index across the periods of market crisis Cumulative outperformance 150 140 130 120 110 100 90 MSCI World Minimum Volatility (USD) Relative Performance US Savings and Loan Crisis Tech Burst Sub Prime Crisis Eurozone Crisis 80 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Period: May 1988 August 2014 * Simulated history from December 1988 to April 2008 and the Index was launched in April 2008. 12
Historical Performance from December 1998 to August 2014 Historical Gross Total Returns, USD MSCI World MSCI World Minimum Volatility Annualized Return (%) 5.1 6.6 Annualized Risk (%) 15.8 11.1 Return/Risk 0.32 0.59 Sharpe Ratio 0.17 0.38 Tracking error (%) 0.0 7.7 Correlation 1.0 0.90 Historical Beta 1.00 0.63 Information Ratio NA 0.20 Max Drawdown (%) 57.5 47.7 Avg. Annual Turnover (%) 3.2 20 Price to Book 2.2 2.5 Price to Earnings 18.6 18.7 Div. Yield (%) 2.3 2.6 December 1998 - August 2014 * Simulated history from December 1998 to April 2008; Index was launched in April 2008. 13
Active Style Factor and GICS Sector Exposures From December 1998 to August 2014 using Barra GEM2 based on simulated history from December 1998 to April 2008 and the Index was launched in April 2008. Historically, the MSCI World Minimum Volatility Index has substantially lower active exposure to Volatility The MSCI World Minimum Volatility Index over-weighted defensive sectors such as Utilities, Consumer Staples and Health Care while underweighting cyclical sectors such as Materials, Financials and Information Technology 14
Minimum Volatility Indexes Across Regions in the Past 10 Years Historical Gross Total Returns, USD MSCI ACWI MSCI ACWI Minimum Volatility MSCI World MSCI World Minimum Volatility MSCI EM MSCI EM Minimum Volatility MSCI USA MSCI USA Minimum Volatility MSCI Europe MSCI Europe Minimum Volatility Total Return* (%) 8.4 10.2 8.2 8.9 12.9 16.2 8.6 9.5 8.0 10.0 Total Risk* (%) 16.5 11.1 16.0 11.6 23.7 19.0 14.7 11.3 19.9 16.0 Risk Adjusted Return 0.5 0.9 0.5 0.8 0.5 0.9 0.6 0.8 0.4 0.6 Active Return* (%) 0.0 1.8 0.0 0.7 0.0 3.3 0.0 1.0 0.0 2.0 Tracking Error* (%) 0.0 7.5 0.0 7.0 0.0 6.2 0.0 5.8 0.0 5.7 Information Ratio NA 0.2 NA 0.1 NA 0.5 NA 0.2 NA 0.4 Historical Beta 1.00 0.62 1.00 0.67 1.00 0.79 1.00 0.72 1.00 0.78 Risk Reduction (%) NA 32.6 NA 27.4 NA 19.7 NA 23.2 NA 19.9 * Annualised from August 2004 to August 2014 Historically, the MSCI Minimum Volatility Indexes demonstrated around 21 33 % reduction in risk, across regions, during the observed period The most effective risk reduction was in the ACWI Index and the World Index 15
Risk Premia: Combining Minimum Volatility and Other Factor Indexes 16
Is there a Free Lunch? 190 Relative performance of MSCI World Factor Indexes 170 150 130 110 90 70 MSCI World Equal Weighted/MSCI World MSCI World Quality/MSCI World MSCI World Min Vol/MSCI World MSCI World Risk Weighted/MSCI World MSCI World Value Weighted/MSCI World MSCI World HDY/MSCI World 50 17
Deploying Multi-Factor Indexes Global Equity Beta Added Value Passive Investing Factor Investing Active Management Benchmark Indices Multi-Factor Index Active Mandates Strategic Factor Tilts ACWI IMI Value Size Yield Quality Volatility Momentum Tactical Asset Allocation Security Selection Market Timing Tactical Factor Tilts & Overlay Strategies ESG Beliefs & Constraints 18
Considerations for Combining Factor Indexes Factor Risk Correlation Business Cycle Value Comparable to market Low with Momentum and Quality Momentum Comparable to market Low with Value, Yield, and Quality Low Size Higher than market Low with Min Volatility, Yield, and Quality Quality Lower than market Low with Value, Size, Yield and Momentum Pro-cyclical Pro-cyclical Pro-cyclical Defensive Low Volatility Lower than market Low with Value and Momentum Defensive Yield Lower than market Low with Size, Quality and Momentum Defensive 19
Value and Volatility Experienced Different Performance Cycles MSCI World Minimum Volatility (USD) and MSCI World Value Weighted Relative Performance 120 Value outperformance, Minimum Volatility underperformance 120 Cumulative Outperformance 110 100 Minimum Volatility performed defensively, Value performed cyclically 110 100 90 90 2002 2004 2006 2008 2010 2012 MSCI World Minimum Volatility / MSCI World MSCI World Value Weighted / MSCI World Period: October 2002 August 2014 20
Combined Factor Index Strategy Achieved Superior IR in the Past 10 Years Historical Performance* Gross Total Return, USD MSCI World Index MSCI World Minimum Volatility (USD) Index MSCI World Value Weighted Combined 50/50 Total Return** (%) 7.4 7.8 7.0 7.6 Total Risk** (%) 16.2 11.7 17.7 14.3 Risk Adjusted Return 0.46 0.67 0.40 0.53 Active Return** (%) 0.0 0.4-0.3 0.2 Tracking Error** (%) 0.0 7.2 2.7 3.3 Information Ratio NaN 0.06-0.12 0.05 One-Way Turnover** 2.5 20 15.6 21.9 Transaction Cost (bps) 50 50 50 50 Impact on Return ** -0.01-0.10-0.08-0.11 Max Drawdown (%) 57.5 47.7 61.6 54.9 1-Month 95% VaR (%) -8.6-5.7-9.8-7.7 Historical Beta 1.00 0.66 1.09 0.87 * Simulated history : MSCI World Minimum Volatility (USD) from Nov 2004 to Apr 2008 and MSCI World Value Weighted from Nov 2004 to Nov 2010 Historical Analysis November 2004 to August 2014 MSCI World Index MSCI World Minimum Volatility (USD) Index * August 2004 to August 2014 ** Annualised in % MSCI World Value Weighted Separate 50/50 Combined 50/50 Annual One-way Turnover (%) 2.5 20.0 15.6 24.8 21.9 Transaction Cost (%) 0.50 0.50 0.50 0.50 0.50 Annual Impact on Return (%) -0.01-0.10-0.08-0.12-0.11 21
MSCI Quality Mix Indexes 22
MSCI Quality Mix Indexes Equal weighted combination of the MSCI Value Weighted, Minimum Volatility and Quality Indexes MSCI Quality MIX MSCI Value Weighted Index MSCI Quality Index MSCI Minimum Volatility Index Re weights parent index according to four fundamental variables: Sales, Earnings, Cash Flow, Book Value Semi-annual rebalancing Identifies quality growth stocks within parent index by calculating a quality score based on: high return on equity, stable earnings growth and low leverage Semi-annual rebalancing Identifies stocks from the parent index with the potential to provide lowest total risk and superior risk-adjusted performance Constructed using minimum variance optimization Semi-annual rebalancing 23
Quality, Value and Volatility Have Different Performance Cycles MSCI World Quality, MSCI Minimum Volatility (USD) and MSCI Value Weighted Relative Performance During the long bull-run, Value Weighted outperformed, Minimum Volatility tracked the benchmark and Quality lagged Both Minimum Volatility and Quality outperformed during the recent crisis, Value Weighted performed cyclically Performance through April 2014 24
Relative Performance of the MSCI Quality Mix Indexes MSCI World Quality Mix Index has historically outperformed MSCI World Combining the 3 Factor Indexes diversified returns during periods of volatility MSCI World Quality Mix Index Relative Performance 200 180 Sub Prime Global Financial Crisis Cumulative outperformance 160 140 120 US Savings & Loans Tech 100 80 1988 1991 1993 1995 1997 2000 2002 2004 2006 2009 2011 2013 Simulated history from May 1988 to February 2014. 25
MSCI World Historical Performance from 1998 to 2014 Simulated history from Dec 1998 to April 2014. 26
Questions? 27
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