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Not All Benchmarks Are Created Equal March 2014

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  • 1. Not All Benchmarks Are Created Equal 1 Tuesday 25th March 2014
  • 2. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Benchmark Proliferation 2 How can we make sense of the apparent proliferation of benchmarks available? Which have merit to be used as benchmarks and which do not?
  • 3. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 LDI Hub Liquid Markets Liquid Credit Illiquid Credit Illiquid Markets Collateral Mgt. Equities (EM, DM) Sterling Credit (IG) Structured Finance Reinsurance Pooled vs. Seg DGFs Global Credit (IG) Infrastructure Debt Private Equity Leverage & Liquidity Style Premia HY/Loans Senior Direct Lending Infrastructure Overlay Strategies Risk Parity ABS Mezzanine Finance Real Estate CTA Emerging Market Debt Distressed Debt Global Macro Absolute Return Bonds Senior CRE Debt Equity Long-Short Total Return Sub-IG Credit Relative Value 3
  • 4. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Is Alpha Just Beta Waiting to be Discovered? 4 Time Alpha Alpha Equity Risk Premium Equity Risk Premium Equity Risk Premium Alpha Alpha Other Market Risk Premia Other Market Risk Premia Style Premia Prior to cap- weighted indices, all returns were effectively viewed as alpha With the introduction of CAPM, the equity market effect was separated from returns This was then extrapolated to include other asset classes such as bonds and commodities Now we can separate out a number of risk premia with much less being left as pure alpha Source: AQR
  • 5. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 What should a benchmark be trying to achieve ? Liquid Markets 5 • Access/capture the desired market “beta” in the most effective way • Transparent • No unintended biases • Sectors • Geography • Issuer • No unnecessary transaction costs in tracking the index • Captures evolution in market development • Different approaches to weighting components • Market capitalization – retains a lot of the above properties (but not always all) • Equal weighting/capped • Risk weighting • Optimized, eg minimum variance
  • 6. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 What characteristics do we look for in forming benchmarks for our clients ? Liquid Markets 6 • Performance metric for fund management • Assess the performance of fund managers relative to relevant benchmark net of fees • Basis for synthetic allocations • Total Return Swap and Futures exposures • Take liquidity considerations into account (other things being equal) as this affects pricing • Liquidity concentrated in market capitalization indices • Places a high “bar” on non-market capitalization approaches
  • 7. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 7 Style Premia Case Study
  • 8. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Neil Woodford: Style Premia in Practice 8 - Neil Woodford presents us with an intriguing practical look into style premia investing in the UK. - His track record is impressive – he has beaten the FTSE All Share over the past 12 years by 3.4% p.a. - But is this the correct benchmark to use to assess his performance? 0 50 100 150 200 250 300 350 Invesco Perpetual High Income Fund FTSE All Share
  • 9. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Applying Style Premia to Neil Woodford 9 0 50 100 150 200 250 300 350 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Regressed Invesco High Income Fund FTSE All Share Market Value Momentum Defensive Portfolio Weights 75% 13% 19% 52% Source: Deutsche Bank, Invesco, Bloomberg; Calculations: Redington Woodford’s performance can broadly be explained by: a lower than 100% weight to the market (represented by the FTSE All Share) along with allocations to value, momentum and defensive factors.
  • 10. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Major Style Premia Families Cutting Across Liquid Markets 10 Need to be able to go long, go short and to leverage across multiple asset classes •Involves buying assets that recently outperformed peers and selling those that recently underperformed •For example: go long stocks with highest 3 month return, go short stocks with lowest 3 month return Momentum •Consists of buying low-risk, high-quality assets and selling high-risk, low-quality assets •For example: go long high return-on-equity stocks, go short low return-on-equity stocks Defensive •Buying assets that are “cheap” relative to their fundamental value and selling “expensive” assets •For example: go long lowest price-to-book stocks, go short highest price-to-book stocks Value •Implies buying high-yielding assets and selling low- yielding assets •For example: go long highest yielding currencies, go short lowest yielding currencies Carry
  • 11. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Style Premia Decomposition of A Fundamental Index 11 Market Value Momentum Defensive Portfolio Weights 100% 21% 8% 0% Mostly market exposure gained along with some value and momentum style premia  Is this the most effective way of gaining these exposures ? 0 50 100 150 200 250 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Regressed RAFI Fundamental Index Source: Deutsche Bank, Research Affiliates, Bloomberg; Calculations: Redington
  • 12. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 What characteristics do we look for in forming benchmarks for our clients ? Multi-Asset 12 • Diversified Growth Fund • Static / Dynamic / Total Return / Absolute Return • Risk Parity • Fully Systematic / Systematic with active overlay • “Traditional” comparison often used is either “equity returns with lower volatility” or simple 60/40 equity bond asset mix which has a number of shortcomings • Allocations are more dynamic • Much greater range of assets/strategies employed • Credit • Options • Illiquid assets • Commodities • Global interest rates / FX • Relative value (market neutral) • Risk control  Is it possible to create a multi-asset benchmark suitable for assessing these products ?
  • 13. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 Conclusions 13 • Access/capture the desired market “beta” in the most effective way • Transparent • No unintended biases • No unnecessary transaction costs in tracking the index • Captures evolution in market development • Market capitalization indices satisfy a lot of these requirements (although not necessarily all of them, all of the time) • Makes market cap logical starting point • Although there are situations when an alternative is more appropriate • Be cognisant of tilts being introduced by new indices – are they just giving largely market exposure with small style tilts ?
  • 14. Teach-in Not All Benchmarks Are Created Equal 25 March 2014 14 Disclaimer For professional investors only. Not suitable for private customers. The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this document is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence. This presentation may not be copied, modified or provided by you , the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipient to any other party without Redington Limited’s prior written permission except as may be required by law. Redington Limited is an investment consultant company regulated by the Financial Conduct Authority. The company does not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional, tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. Registered Office: Austin Friars House, 2-6 Austin Friars, London EC2N 2HD. Redington Limited (reg no 6660006) is registered in England and Wales. ©Redington Limited 2014. All rights reserved. Contact Dan Mikulskis FIA Director Direct Line: 020 3326 7129 Dan.mikulskis@redington.co.uk
  • 15. msci.com©2014. All rights reserved. msci.commsci.com Not All Benchmarks are Created Equal: Building Better Benchmarks – The MSCI Way  Altaf Kassam – Managing Director
  • 16. msci.com©2014. All rights reserved. 16msci.com 16msci.com I. Introduction to MSCI II. Not All Benchmarks Are Created Equal III. Building Better Benchmarks IV. Evolution of Benchmarks V. Appendix Presentation Overview
  • 17. msci.com©2014. All rights reserved. 17msci.com 17msci.com I. Introduction to MSCI
  • 18. msci.com©2014. All rights reserved. MSCI is More Than Indexes  MSCI provide investors with world-class, investment decision support tools • Indexes • Risk and Portfolio Analytics • Corporate Governance Research & Innovation Index Analytics 2012 2010 2013 200420041969
  • 19. msci.com©2014. All rights reserved. 19msci.com 19msci.com II. Not All Benchmarks Are Created Equal
  • 20. msci.com©2014. All rights reserved. Why should anyone care about benchmarks?  The concept of a market portfolio plays an important role in many financial models, including the Capital Asset Pricing Model (CAPM). In theory, the market portfolio should be the portfolio of choice for a truly passive investor 1  Widely used in the investment process in several applications:  Tools for investment research and strategic asset allocation  Performance benchmarks for actively managed portfolios  Index-linked vehicles to capture the market beta (equity risk premium)  The broad acceptance of market cap weighted indices does not rely on (potentially flawed) academic theories, such as the CAPM; it stems from practical considerations linked to the institutional investment process:  Automatic rebalancing, replicate simple buy and hold strategy  Low turnover, implying low transaction / implementation costs  High trading liquidity and high (maximum) investment capacity 1 “Global Invested Capital Market”, Hewitt ennisknupp, February 2014
  • 21. msci.com©2014. All rights reserved.  Accuracy, timeliness and transparency  Consistent global framework: no gap, no overlap  Timely reflection of market changes  Transparent methodology and market classification framework  Investability and replicability  Systematic use of buffer zones to reduce turnover  Accurate implementation of corporate events  Stringent short and long term liquidity measures What Matters Most and How MSCI Builds Better Benchmarks 1. Accurate measures of markets 2. Fair benchmarks for managers 3. Cost effective solutions for index replication MSCI puts emphasis on:  Leading to MSCI indices being:
  • 22. msci.com©2014. All rights reserved. MSCI has been defining the Equity space for 40+ years DomesticLC&MC InternationalLC&MC EmergingMarketsLC&MC DomesticSC InternationalSC EMSC Home and size biases MSCI ACWI All Country World Index DomesticSC InternationalSC EMSC Removal of home bias MSCI ACWI IMI (45 countries) 99% coverage No GAPS & OVERLAPS Removal of home and size biases MSCI EM was created in 1988 MSCI EAFE was created in 1969
  • 23. msci.com©2014. All rights reserved. MSCI Index Families MSCI Country & Regional Indices All Country (DM+EM) Developed Markets (DM) Emerging Markets (EM) Frontier Markets (FM) Domestic -US -China -Australia Tradable -Asia APEX -EM 50 -FM 100 MSCI Size Indices Large Cap Mid Cap Standard (Large + Mid) Small Cap SMID (Small + Mid) IMI (Large+ Mid + Small) Micro Cap (DM Only) All Cap (DM Only) MSCI Style Indices Value Growth MSCI Sector Indices Sector Industry Sub-industry Real Estate MSCI Thematic Indices Economic Exposure Agriculture & Food Chain Commodity Producers Infrastructure Faith-Based - Catholic - Islamic MSCI ESG Indices Best-in-Class Socially Responsible Ex-Controversial Weapons Environmental MSCI Strategy Indices Risk Premia - Value Weighted - Risk Weighted - Equal Weighted - GDP Weighted - Minimum Volatility - Factor - High Div Yield - Risk Control - Quality - Momentum - Quality Mix Capped - 10/40 - 25/50 - Standard Capped Hedged & Currency - Hedged - FX Hedged - Global Currency Short & Leveraged (Daily) Custom Indices Equity Screening Custom Weighting Custom Currencies and Tax Rates Custom Delivery and File Format
  • 24. msci.com©2014. All rights reserved. 24msci.com 24msci.com III. Building Better Benchmarks
  • 25. msci.com©2014. All rights reserved. Key benefits that make MSCI the number one choice for global institutional investors include:  Emphasis on objectivity, accuracy and transparency: - Transparent market classification framework - Comparability of size segments across markets - Exclusion of non-equity like securities - Precise methodology to assign companies to markets  Emphasis on investability and replicability: - Precise free float factors - Stringent short and long term liquidity measures - Minimum foreign room requirements - Effective migration buffer mechanism - Predictable implementation of corporate events 25 How MSCI Does it
  • 26. msci.com©2014. All rights reserved.  The MSCI Market Classification Framework consists of three criteria: economic development, size & liquidity and market accessibility  In order to be classified in a given investment universe, a country must meet the requirements of all three criteria The MSCI Market Classification Framework Criteria Frontier Emerging Developed A Economic Development A.1 Sustainability of economic development No requirement No requirement Country GNI per capita 25% above the World Bank high income threshold* for 3 consecutive years B Size and Liquidity Requirements B.1 Number of companies meeting the following Standard Index criteria 2 3 5 Company size (full market cap) ** USD 449 mm USD 898 mm USD 1796 mm Security size (float market cap) ** USD 33 mm USD 449 mm USD 898 mm Security liquidity 2.5% ATVR 15% ATVR 20% ATVR C Market Accessibility Criteria C.1 Openness to foreign ownership At least some Significant Very high C.2 Ease of capital inflows / outflows At least partial Significant Very high C.3 Efficiency of the operational framework Modest Good and tested Very high C.4 Stability of the institutional framework Modest Modest Very high * High income threshold for 2010: GNI per capita of USD 12,276 (World Bank, Atlas method) ** Minimum in use for the May 2012 Semi-Annual Index Review, updated on a semi-annual basis
  • 27. msci.com©2014. All rights reserved. MSCI Country Classification
  • 28. msci.com©2014. All rights reserved. MSCI Has Captured the Evolution of Markets For 40+ Years 2013
  • 29. msci.com©2014. All rights reserved. Size Segments: Global Investable Market and All Cap Indices All Cap Indices Large Cap Mid Cap Small Cap Micro Cap Total Listed Equity Universe Investable Equity Universe Investable Market Indices Large Cap Mid Cap Small Cap Micro Cap Indices Micro Cap Indices Micro Cap Universe
  • 30. msci.com©2014. All rights reserved. Breadth vs. Coverage: Number and Size Goal: represent the global equity universe, while keeping the number of securities and size of the smallest security at reasonable levels Market Cap (in USD) Largest company 506,035,318,230 5% 9,638,785,576 10% 4,058,595,491 20% 1,562,054,938 30% 792,022,114 40% 474,873,840 50% 302,909,404 60% 192,671,360 70% 122,852,450 80% 74,378,487 90% 40,621,572 Smallest company 1,529 70.2 81.3 90.3 94.4 96.6 97.9 98.8 99.4 99.7 99.9 100.0 65 70 75 80 85 90 95 100 <5% 5 to 10% 10 to 20% 20 to 30% 30 to 40% 40 to 50% 50 to 60% 60 to 70% 70 to 80% 80 to 90% 90 to 100% MarketCoverage(%offullmarketcap) Global Companies (sorted by full market cap, as % of total) Global Market Cap and Coverage Source: MSCI
  • 31. msci.com©2014. All rights reserved. 31msci.com 31msci.com IV. Evolution of Benchmarks
  • 32. msci.com©2014. All rights reserved. Yesterday’s Alpha is Today’s Beta Portfolio Return Sector Beta Beta Alpha Factor Beta Alpha Country Beta 1970s 1980s 2000s Regional Beta
  • 33. msci.com©2014. All rights reserved. What Attracts Investors to Factor Investing? 6.5% 7.5% 8.5% 9.5% 10.5% 11.5% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% 19.0% AnnualizedReturn Annualized Risk PerformanceCharacteristics (June 1988 to June 2013) (Gross Total Return in USD) LOW RISK & LOW RETURN HIGH RISK &LOW RETURN Risk Weighted Quality High Dividend Yield HIGH RISK &HIGH RETURNLOW RISK & HIGH RETURN Minimum Volatility Equal Weighted Momentum MSCI World Value Weighted
  • 34. msci.com©2014. All rights reserved.  Factor investing is the investment process that harvests 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 What is Factor Investing? ValueLow Size QualityMomentum Low VolatilityYield 6 KEY FACTORS
  • 35. msci.com©2014. All rights reserved. 50 100 150 200 250 300 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Risk Weighted/World Value Weighted/World Min Volatility/World Equal Weighted/World Quality/World Momentum/World High Div Yield/World Is This a Free Lunch? Cyclicality is a Key Dimension Relative Performance of Factor Indexes (June 88 – June 2013)
  • 36. msci.com©2014. All rights reserved. The MSCI Family of Factor Indexes 36 MSCI Return-Based Factor Indexes MSCI Risk-Based Factor Indexes MSCI Value Weighted Indexes Weighted according to four fundamental variables (Sales, Earnings, Cash Flow, Book Value) • Semi-annual rebalancing • Launched in 2010, index history from 31 May 1973 (World)/31 May 1991 (EM) MSCI Minimum Volatility Indexes Constructed using minimum variance optimization • Semi-annual rebalancing • Launched in 2008, index history from 31 May 1988 (World) / 31 May 1993 (EM) MSCI Quality Indexes Weights derived from market cap times a quality score based on D/E, ROE, earnings variability • Semi-annual rebalancing • Launched in 2012, index history from 28 Nov 1975 (World)/29 May 1992 (EM) MSCI Risk Weighted Indexes Weights based on the inverse of historical variance • Semi-annual rebalancing • Launched in 2011, index history from 31 May 1973 (World) / 31 May 1991 (EM) MSCI Momentum Indexes Weights derived from market cap times a momentum score based on short- and long-term momentum signals • Semi-annual rebalancing along with conditional rebalancing • Launched in 2013, index history from 31 May 1973 (World) / 31 May 1991 (EM) MSCI Equal Weighted Indexes Equal allocation across parent index constituents • Quarterly rebalancing • Launched in 2008, index history from 31 May 1973 (World) / 31 May 1991 (EM) MSCI Multi-Factor Indexes MSCI High Dividend Yield* Indexes High dividend yield opportunity set within parent index constituents • Semi-annual rebalancing • Launched in 2006, index history from 28 Nov 1975 (World) / 29 May 1992 (EM) MSCI Quality Mix Indexes Combining Quality, Value and Minimum Volatility Strategy Indexes with equal weights • Semi-annual rebalancing • Launched in 2013, index history from 31 May 1988 (World)/ 31 May 1993 (EM) * On June 3, 2013, MSCI launched the enhanced HDY Indexes to incorporate additional screens which exclude stocks based on certain “low quality" characteristics and recent 12-month price performance.
  • 37. msci.com©2014. All rights reserved. 37msci.com 37msci.com V. Appendix
  • 38. msci.com©2014. All rights reserved. MSCI – The Index That Matters 40+ 99.8% Accuracy rate1 150,000 600+ ETFs are based on MSCI indices3 7,500 Clients supported across 83 countries $8.4tn In assets is benchmarked to MSCI indices2 Years of experience in index calculation and maintenance 1 Accuracy calculated based on number of corrections performed over total number of securities or data points covered. 2 As of September 30, 2012, as published by eVestment, Lipper and Bloomberg on January 31, 2013. 3 As of February 2013. Indices calculated daily 9,000+ in real-time
  • 39. msci.com©2014. All rights reserved. How MSCI Does It Over the last four decades MSCI has been recognized as the preferred index provider for global institutional investors based on: 1. Methodology that promotes a global framework, broad coverage, investability and representativeness, while reflecting our clients’ investment process 2. Construction process that supports data quality, index stability and continuity, with low error rates and low index turnover 3. Innovative new products through thought leadership and research that captures the evolution of investment best practices 4. Superior client service focused on responsiveness and adding value 39
  • 40. msci.com©2014. All rights reserved. MSCI Investability MSCI MSCI Rationale Minimum Equity Universe Size Indexed to 99th percentile of DM universe ($100M) Objective and dynamic market-based definition Minimum Equity Universe Size 50% of minimum full market cap size ($50M) Facilitates replication in institutional portfolios Liquidity Minimum Annualized Traded Value Ratio (ATVR) of 20% for DM 15% for EM Allows only inclusion of relevant liquid securities and recognizes liquidity differences between DM & EM Global Minimum Foreign Inclusion Factor 15% in general or (or 1.8 X Standard minimum size) Ensures meaningful access to publicly owned securities Free Float Bands 5% bands, free float rounded up to nearest 5% Captures availability to foreign investors in the most accurate way Seasoning Minimum of 3 months of trading history; 10 business days for larger IPOs Reduces volatility impact around small issuances and includes large IPOs to reflect key market changes 40
  • 41. msci.com©2014. All rights reserved. MSCI : Index Maintenance & Additional Features MSCI MSCI Rationale Reconstitution Semi-annual rebalancing + quarterly index reviews (all synchronized) Frequently and regularly reflects market changes on a timely basis Buffer Zones Yes (Upper band +50%; lower band -33% of size segment cut-off) Reduces turnover and reflects managers’ investment processes Size Indices Yes Offers value and growth segmentation at each size segmentation Index Structure Country Indices (with the exception of Europe being considered as a single country from an index construction and maintenance perspective) Reflects the institutional process Sector Classification Global Industry Classification Standard (GICS®) GICS® is widely adopted by institutional investors 41
  • 42. msci.com©2014. All rights reserved. Assets Benchmarked to MSCI indices  Over $8.4 trillion in assets are benchmarked to MSCI indexes  Over $60 billion in assets are benchmarked to MSCI Factor Indexes Assets Benchmarked to Key MSCI Indexes $ billion Total Mar-13** Sep-13# Δ ACWI 1,364 1,714 26% EAFE 1,496 1,682 12% EM 1,434 1,364 -5% World 2,161 2,388 10% US 190.8 199.6 5% Europe 281.3 336.9 20% APAC 415.4 371.8 -11% Other 363.9 387.1 6% TOTAL 7,707 8,442 10%
  • 43. msci.com©2014. All rights reserved. MSCI Factor Indexes as of 30 September 2013 43 Over USD 60 billion in assets benchmarked to MSCI Factor Indexes Data segregated by index family and region for active and passive funds as of September 30, 2013 and reported as of December 31, 2013 by eVestment, Lipper, Morningstar, Bloomberg and MSCI data (USD bn) Active Passive Total All MSCI Factor Indexes 25.9 37.9 63.8 High Dividend Yield 19.8 4.2 24 Minimum Volatility 3.5 19.7 23.2 Equal Weighted 0 8.3 8.3 GDP Weighted 2.3 0.6 2.9 Value Weighted 0 3.3 3.3 Risk Weighted 0.3 1.3 1.6 Momentum 0 0.2 0.2 Quality 0 0.3 0.3 (USD bn) Active Passive Total Global 25.9 37.9 63.8 Americas 5.5 15.1 20.6 EMEA 20.4 19.1 39.5 Asia 0 3.7 3.7
  • 44. msci.com©2014. All rights reserved. Why Classification Matters: The Korea example  A developed economy does not imply a developed capital market  Korea’s capital market is not yet at the developed level.  Why does this matter to investors?  Difficulties trading the Korean currency outside Korea  Local currency ONLY during local business hours  Inability to transfer shares between different accounts operational difficulties + higher portfolios management costs  Korea has been under review by MSCI for 5 years and will stay in Emerging Markets until accessibility issues are resolved 44
  • 45. msci.com©2014. All rights reserved. Introducing Multi-Factor Indexes  Multi-Factor Indexes blend standardized factor Indexes into a composite index which serves as a benchmark for passive replication  Multi-Factor Indexes may provide investors with a transparent, flexible and cost- effective way to passively seek systematic exposure to premium factors Market Return Rules Based & Transparent Implementation Active Return Passive Investing Factor Investing Active Management Discretionary Implementation
  • 46. msci.com©2014. All rights reserved. Allocating to Multiple Factors 1. State objectives for the allocation: risk reduction, enhance returns at market level risk, increase yield, … 2. Select the desired factor exposures based upon:  investment beliefs (value premium, …)  risk/return characteristics (minimum volatility, …)  investibility constraints (size of allocation, shorting, …) 3. Seek combination benefits:  Diversification through low correlation of active returns  Trading cost reduction through natural crossing Due Diligence Considerations 1. Investment Beliefs 2. Strategic vs. Tactical Allocations 3. Selection of Individual Factors 4. Global vs. Domestic 5. Optimal Allocation 6. Funding of the Factor Allocation 7. Active vs. Passive Implementation 8. Index and Manager Selection (methodology, turnover, transparency, fees, … ) 9. Governance and Operational Risk
  • 47. msci.com©2014. All rights reserved. Considerations for Combining Factor Indexes Factor Risk Correlation Business Cycle Value Comparable to market Low with Momentum and Quality Pro-cyclical Momentum Comparable to market Low with Value, Yield, and Quality Pro-cyclical Low Size Higher than market Low with Min Volatility, Yield, and Quality Pro-cyclical Quality Lower than market Low with Value, Size, Yield and Momentum Defensive Low Volatility Lower than market Low with Value and Momentum Defensive Yield Lower than market Low with Size, Quality and Momentum Defensive
  • 48. msci.com©2014. All rights reserved.  Historically, tracking errors and information ratios for multi-factor Indexes improve substantially compared to standalone factor Indexes  Turnover and cost of replication are reduced due to natural crossing Potential Benefits of Multi-Factor Indexes World Standard Quality Risk Weigthed Value Weighted Momentum Multi Factor Index Total Return* (%) 4.2 5.3 8.6 5.5 6.9 6.7 Total Risk* (%) 16.3 14.3 14.6 17.2 16.7 14.9 Sharpe Ratio 0.18 0.26 0.47 0.25 0.33 0.34 Annualized Active Return (%) 1.1 4.4 1.2 2.7 2.5 Tracking Error* (%) 4.5 5.6 3.6 9.0 3.0 Information Ratio 0.25 0.79 0.35 0.30 0.83 Max Relative Drawdown Period (months) 52 10 9 19 2 Natural Crossing Benefits Turnover** (%) 3.1 23.0 22.0 18.3 89.6 32.0 Turnover if implemented as separate mandates --> 40.8 * Annualized in USD for the 05/31/1999 to 09/30/2013 period ** Annualized one-way index turnover for the 05/31/1999 to 09/30/2013 period
  • 49. msci.com©2014. All rights reserved. 49msci.com 49msci.com MSCI 24 Hour Global Client Service Asia Pacific China North 10800.852.1032 (toll free) China South 10800.152.1032 (toll free) Hong Kong +852.2844.9333 Seoul +798.8521.3392 (toll free) Singapore 800.852.3749 (toll free) Sydney +61.2.9033.9333 Tokyo +81.3.5226.8222 Europe, Middle East & Africa Cape Town +27.21.673.0100 Frankfurt +49.69.133.859.00 Geneva +41.22.817.9777 London +44.20.7618.2222 Milan +39.02.5849.0415 Paris 0800.91.59.17 (toll free) Americas Americas 1.888.588.4567 (toll free) Atlanta +1.404.551.3212 Boston +1.617.532.0920 Chicago +1.312.706.4999 Monterrey +52.81.1253.4020 Montreal +1.514.847.7506 New York +1.212.804.3901 San Francisco +1.415.836.8800 São Paulo +55.11.3706.1360 Stamford +1.203.325.5630 Toronto +1.416.628.1007 clientservice@msci.com | www.msci.com
  • 50. msci.com©2014. All rights reserved. 50msci.com 50msci.com Notice and Disclaimer  This document and all of the information contained in it, including without limitation all text, data, graphs, charts (collectively, the “Information”) is the property of MSCl Inc. or its subsidiaries (collectively, “MSCI”), or MSCI’s licensors, direct or indirect suppliers or any third party involved in making or compiling any Information (collectively, with MSCI, the “Information Providers”) and is provided for informational purposes only. The Information may not be reproduced or redisseminated in whole or in part without prior written permission from MSCI.  The Information may not be used to create derivative works or to verify or correct other data or information. For example (but without limitation), the Information many not be used to create indices, databases, risk models, analytics, software, or in connection with the issuing, offering, sponsoring, managing or marketing of any securities, portfolios, financial products or other investment vehicles utilizing or based on, linked to, tracking or otherwise derived from the Information or any other MSCI data, information, products or services.  The user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. 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