TAKE CONTROL OF YOUR INVESTMENT DESTINY Increasing control over your investments. To appreciate the power of Factors, consider this: Humankind is formed from just 23 Chromosome pairs CMINST-13427 2 1
Yet, they are capable of building a whole world of diversity. 3 Similarly, we believe that investment factors can help investors build the portfolio they need. 4 2
Challenge for Investors Case for Factor-based Investing What Next? The Real World Economic and Market Outlooks are Constrained Economic Growth Forecasts Volatility Risk is to the Downside 2015 2016 Developed Global 3.1% 3.3% US 2.5% 2.5% Eurozone 1.5% 1.7% Japan 0.8% 1.2% Emerging Markets 4.2% 4.1% SSGA forecasts, as of 31 December 2015. The above estimates are based on certain assumptions and analysis made by SSGA. There is no guarantee that the estimates will be achieved. Low economic growth will impact profitability, and therefore equity returns Weakness in global trade and strong US dollar will weigh on EM equities Ripple effect of decelerating growth in China Continued weakness in commodity prices Geopolitical risks 6 3
Creating a Mismatch Between Expected and Required Returns Equity Return Forecasts are Low State Retirement Systems Target 1-Year 10-Year Developed Global 2.1% 6.1% US LC 1.4% 6.0% Europe 2.6% 6.1% UK -0.4% 6.4% Japan 5.9% 6.4% Emerging Markets 1.2% 6.9% SSGA forecasts, as of 31 December 2015. The above estimates are based on certain assumptions and analysis made by SSGA. There is no guarantee that the estimates will be achieved. 7.68% Source: NASRA, Public Pension Plan Investment Return Assumptions, September 2015. 7 Investors are Looking for Ways to Close the Gap SEEKING HIGHER RETURN OPTIONS More active management Illiquid assets Tactical overlays MANAGING RISK Minimize drawdowns Liability matching Manage risk budget EVALUATING COSTS Align costs with value Manage implementation Consider soft costs Factor-based investing strategies can help meet each of these aims. 8 4
Challenge for Investors Case for Factor-based Investing What Next? The Real World Firmly Grounded in Academic Research 1980 s 1990 s 2000 s 2010 s Cap-weighted e.g. S&P 500 Style aware e.g. Value, Growth, Small Alternative weighting e.g. Fundamental Factor-targeted e.g. Smart Beta Black, Jensen and Scholes, The Capital Asset Pricing Model: Some Empirical Tests (1972) Rosenberg, Reid & Lanstein Persuasive Evidence of Market Inefficience (1985) Fama & French, Common risk factors in the returns on stocks and bonds (1992) Arnott, Hsu & Moore, Fundamental Indexation (2005) Ang, Goetzmann & Schaefer Evaluation of Active Management (2009) Baker, Bradley & Wurgler Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly (2011) 10 5
What Are Factors? Factors are the underlying drivers of the risks and return of an asset class. They re the building blocks that enable investors to shape investment returns. Sample Equity factors include: Value Size Volatility Quality Momentum Premium in Low Valuation stocks. Smaller cap stocks tend to outperform. Lower volatility stocks tend to generate a higher riskadjusted return. Quality companies are rewarded with stronger share prices. Stocks which have done well recently tend to carry on doing well in the near term. 11 Factors Can Generate Positive Excess Annual Returns Value Size Volatility Quality Momentum Annualized Excess Returns Over Developed Equities Since 1993 Source: SSGA as of 29 February 2016. Figures show the mean annualized excess returns over the MSCI Developed Equities Index since 1993. Back-tested data tilted strategies, excess return relative to MSCI World Index. You cannot invest directly in an index. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. The calculation method for value added returns may show rounding differences. Data is from April 1, 1993 through December 31, 2015. 12 6
Factors are Present Across Asset Classes, Not Just Equity EQUITY Value Size Volatility Quality Momentum FIXED INCOME Value Size Volatility Quality Momentum Term Premium CURRENCY Value Trend Carry 13 Challenge for Investors Case for Factor-based Investing What Next? The Real World 7
How Can investors Use Factors Effectively? Value? Size? Momentum? Quality? 15 You re Already a Factor investor, but You Can Increase Your Control Factor exposures are a significant component of active management returns. On average, 50% of active management excess returns can be accounted for by exposure to factors. PORTFOLIO RETURN = Cap-Weighted Index Return Factor Returns Manager Skill Passive Return Active Return Source: Bender, Hammond and Mock; Journal of Portfolio Management, May 2013 16 8
Factors Returns Vary Under Different Environments Downturn Recession Recovery Boom Positive Economic Growth but Slowing Negative Economic Growth and Slowing Negative Economic Growth but Improving Positive Economic Growth and Improving MARKET CYCLE VALUE Mixed SIZE VOLATILITY QUALITY MOMENTUM Mixed Mixed Source: Russell, SSGA. Example for illustrative purposes only. Past performance is not a guarantee of future results. 17 Factor Valuations What Looks Good Now? Base = 0 6 Current Average 4 Attractive Attractive Attractive 2 0-2 Attractive Attractive Expensive Expensive Expensive -4 Expensive -6-8 Expensive VALUE Looks expensive SIZE Looks reasonable VOLATILITY Looks fairly attractive QUALITY Looks attractive MOMENTUM Looks well priced Source: SSGA, FactSet based on estimates. As of December 31, 2015. Universe: MSCI World Index. For each factor, spreads calculated by subtracting the median Book-to-Price (B/P) of bottom quintile (lowest ranked stocks) from the median B/P of top quintile (highest ranked stocks). Quintiles contain equal weighted number of securities. Average Spread represents the average median B/P spread over previous 120 months. Valuation spread data is as of the date indicated, are subject to change, and should not be relied upon as current thereafter. Valuation spreads may be different when measured within different equity universes. 18 9
3 Approaches to Implement Your Factor Convictions APPROACH 1 APPROACH 2 APPROACH 3 Value Value Quality Size Volatility Value Momentum Quality SINGLE FACTOR Focus on individual factors MULTI-FACTOR or combine factors such as Value and Quality. ACTIVE QUANT Dive deeply into advanced factor definitions. 19 Challenge for Investors Case for Factor-based Investing What Next? The Real World 10
What Problems Can Factor Investing Solve? Managing Downside Volatility The Search for Yield The Need for Excess Returns Getting the Most Out of Fees Uncorrelated Returns 21 In Our Recent Global Survey of 400 Institutional Investors 76% of respondents who had implemented Smart Beta reported moderate to significant improvement in meeting their long-term aims. Source: SSGA, FT Remark, The Great Divide. March 2016. About this study: FT Remark, in association with State Street Global Advisors (SSGA), surveyed senior executives with asset allocation responsibilities at 400 institutional investors (with at least $200Mn AUM). The Respondents are distributed: 24% Asia, 38% Americas, 38% EMEA. The survey included a combination of qualitative and quantitative questions and all interviews were conducted by phone. The results were analyzed and collated by FT Remark and all responses are anonymized and presented in aggregate. 22 11
CASE 1 Improving passive exposure CASE 3 Replacing/reducing active manager allocations CLIENTS CASE 2 Taking the desired risk exposures 23 Improving Passive Exposure CASE STUDY CHALLENGE Remain passive but achieve better risk-adjusted returns. SOLUTION Reduce risk and improve return with a multi-factor allocation. 100% MSCI World Index (Passive Strategy) 25% MSCI Quality Mix Index (Smart Beta) 75% MSCI World Index (Passive Strategy) Return PA Sharpe Ratio Return PA Sharpe Ratio 5.51 0.20 6.02 0.24 RESULTS BETTER RETURNS, BETTER SHARPE RATIO Source: State Street Global Advisors. The information contained above is for illustrative purposes only. 24 12
Taking the Desired Risk Exposure CASE STUDY CHALLENGE US Defined Benefit Fund needed to improve fixed income performance relative to liabilities without jeopardizing funding status. SOLUTION Optimize portfolio s credit risk premium. Assess Quality versus Value and capture mispriced credit risk. Return 48BPS RESULTS FUNDING PRESERVED, BETTER RETURNS Source: State Street Global Advisors. The information contained above is for illustrative purposes only. 25 Reducing Active Manager Allocations CASE STUDY CHALLENGE 50 % Passive 50 % Active Managers SOLUTION 75 % Active Beta Value Low Vol Size 25 % Active Managers Classic Core-Satellite Fundamental Characteristics Security Count 708 Active Risk 0.43 Portfolio Ending Active Share 23.63 Risk (%) Asset Specific Risk 57.33 Factor Risk 42.67 Total Fees (%) 0.28 Factorized Core Portfolio Fundamental Characteristics Security Count 737 Active Risk 1.21 Portfolio Ending Active Share 31.76 Risk (%) Asset Specific Risk 22.71 Factor Risk 77.29 Total Fees (%) 0.19 RESULTS FOCUSED EXPOSURES, REDUCED FEES Source: State Street Global Advisors. The information contained above is for illustrative purposes only. 26 13
WHY FACTOR INVESTING? Fee Productivity Flexibility Meet Challenges Control Cost-efficient implementation. You decide what matters. Aim for growth. Control volatility. Take control of your investment destiny. 27 Disclosures The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. Past index performance is not a guarantee of future results. Investing involves risk including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent. This information should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. 2016 State Street Corporation All Rights Reserved. CMINST-13427 1114 Exp. Date 31/03/2016 14
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