Risk Management Limited Authorised and regulated by the Financial Conduct Authority RISK REPORT. R-Squared Europe Model in EUR Europe Equity Index v Cash 1 May 2013 Highlights Exposure to the Australian dollar dominates overall risk. This factor represents a number of effects, including imports of commodities by European firms, Australia s exposure to the emerging economies of Asia and an interest rate differential effect. The other significant contribution to risk is a large positive exposure to the Swiss franc, reflecting capital flows as well as the effect on competitiveness of relative weakness in the Euro. Also significant are exposures to large capitalisation effects in Germany, France and Spain. Sector risk contributions are driven mainly by export-oriented industries, reinforcing currency effects. Factor Risk (s.d.) 18.89 Stock Risk (s.d.) 1.50 Total Risk (s.d.) 18.95 Local Currency factor risks 26.92 Global Currency factor risks 0.32 Style factor risks - 1.78 Country factor risks 33.44 Industry factor risk 40.38 Statistical factor risks 0.09 % Factor Risk (RSQ) 99.38 % Stock Risk 0.62 % Total Risk 100.00 Also in this report: Factor risk analysis Stock-level risk analysis Independent Bets analysis Currency exposure analysis Diversification Ratio 1.58 Number of Holdings 328 Total risk of 18.95% per annum is consistent with a well-diversified portfolio of equities. Its 328 stocks are weighted by current market capitalisation. The high percentage of risk (99.38%) explained by the model s risk factors confirms that this is a welldiversified index, as residual, stock-specific risk is largely diversified away. Return Enhancement through Risk Management
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 Europe index is dominated by its negative exposure to the Australian dollar, which contributes 11.6% of the index s risk of 18.9%. This reflects demand for commodities by firms such as Nestlé, Siemens, Total and Daimler, as well as interest rate differential effects and an Asia effect, as discussed in the section on Independent Bets. The volatility of the Australian dollar against the euro is 11.5%. Its positive exposure to the Swiss franc represents 6.2% of overall risk, reflecting the importance of the European market to Swiss firms as well, of course, as capital flows. High portfolio exposures to Liquidity, Quality and Dividend Yield contribute relatively little to the overall risk of the index, as does the negative exposure to Growth stocks. In fact, smaller exposures to the Japanese yen and large cap effects are more important to the risk of the index. See the Currency Exposure Analysis for more commentary. Return Enhancement through Risk Management 2
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 Australian Dollar % % % NESTLE SA/AG Switzerland 3.37 4.46 1 19.60-0.46 NOVARTIS AG Switzerland 2.62 3.40 2 22.92-0.61 BASF SE Germany 2.35 1.74 7 31.61 0.00 SIEMENS AG Germany 2.09 1.76 6 28.81-0.74 ALLIANZ SE Germany 2.02 1.36 12 34.22 0.00 BANCO SANTANDER Spain 1.99 1.46 10 35.12 0.00 TOTAL SA France 1.94 2.12 4 21.95-0.43 SANOFI France 1.89 2.59 3 20.36-0.76 DAIMLER AG Germany 1.85 1.04 18 40.96-1.37 While contributions to risk from Nestlé and Novartis are broadly in line with their weighting in the portfolio, Total and Sanofi contribute relatively little, given their weights. Daimler, by contrast, contributes well above its weight, primarily on account of its high volatility of 41%. Nestlé and Novartis have positive betas to the Swiss franc of 1.3 and 1.9, reflecting the fact that they benefit from a rise in the Swiss franc, which would cause their asset prices to rise in Euro terms. Return Enhancement through Risk Management 3
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. In this case there are really only 3 or 4 truly independent bets in this portfolio. About three quarters of the overall portfolio risk is attributable to the first three independent bets. PC1 is dominated by the European index s positive exposure to the Australian dollar, large German, French and Spanish stocks and banks as well as negative exposure to the US dollar, Japanese yen and Swiss franc. PC2 can be interpreted, from its exposure to the Swiss franc, US dollar, Japanese yen and negative exposure to the Australian dollar and Price Momentum, as an interest rate differential effect, which benefits European competitiveness. PC3 is a currency effect given by negative betas to the Swiss franc and the Australian dollar. This analysis confirms the risk profile given by the risk model factors: specifically that the risk of the European index is dominated by its exposure to the Australian dollar and the Swiss franc, which in turn are driven by demand for commodities, capital flows with Switzerland and sensitivity to interest rate differentials, which drive relative competitiveness through the currency effect. Return Enhancement through Risk Management 4
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). The large negative exposure to the Australian dollar reflects imports of commodities by Europe and, to some extent, European firms exposure to China. The difference between the exposure and weighting in the Swiss franc reflects the heavy representation in that currency of banks (which are highly leveraged) as well as capital flows between the Euro and the Swiss franc, which have been higher recently than normal. Positive exposures to the US dollar and the Japanese yen reflect trade in manufactured goods, which benefit from a weaker Euro versus other major currencies and commodities, which are usually priced in US dollars. Return Enhancement through Risk Management 5
. R-Squared 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 2009. 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 +44 20 3239 7402 France +33 1 43 67 37 86 US +1 313 469 9960 Head Office +44 1462 688326 enquiries@rsqrm.com www.rsqrm.com