1. Innovative benchmarks for Fixed Income Investors
Stéphane Monier, CIO Fixed Income & Currencies
Lombard Odier Investment Managers
Amsterdam, January 27th 2011
2. What’s broken with traditional indices?
Future LOIM Research: Fundamentally weighted benchmark at a reasonable price
2011
Fundamental Concept in Fundamentally Weighted Sovereign Key Conclusions
2010 Emerging Markets Allocation Approach Fundamental indices make greater
Authors: R. Arnott, S. Shepherd Authors: S. Monier, C. Caillault (LOIM) sense for less efficient markets; produce
superior risk-adjusted returns with lower
drawdowns in sovereign markets
Fundamental Indexing Around The Fundamental indices produce higher
2009 World returns, similar volatilty; lower long-term
Authors: C. Walkshäusl and S. Lobe downside risk; augment exposure to
value stocks
Fundamentally Flawed Indexing Notion of cap-weighting causing
2007 Author: A. Perold performance drag is false. Fundamental
indexing de-facto active through
investing in value stocks
Cap-Weighted Portfolios are Sub- Overweighting/underweighting stocks
2006 Optimal that are priced high/low to their
Author: J. Hsu fundamentals leads to sub-optimal
portfolios
An Examination of Fundamental Fundamental indices significantly
2005 Fundamental Indexation Indexation outperform; have superior risk-reward;
Authors: J. Hsu and C. Campollo Authors: R. Arnott, J. Hsu and P. Moore outperform in bear markets
* All launched by LOIM / positive / negative opinion on fundamental benchmark
Please see important information at the end of the document
LOIM — January 2011 — 2
3. There has to be a better way!
Market Cap Indices 31 Dec 2010
Pros Cons
30'000
• Deep liquidity • Backward looking
20'000
Billions USD
• Standard definition • Overweights overvalued
sectors
• Overweights overvalued 10'000
countries
• Overweights more indebted 0
countries MSCI World Citi Global FTSE RAFI
Equity Govternment All World
• Reliant on lagging Ratings
Agencies
• Higher volatility of returns
• Bigger drawdowns
Please see important information at the end of the document
LOIM — January 2011 — 3
4. Fundamental factor approach to sovereign debt
Fundamental Criteria Weight Metric Relationship to weight in the base portfolio
factors focused on Size 30% GDP (PPP weighted) Larger GDP countries receive a higher relative allocation
macroeconomic Growth 10% GDP Growth (PPP weighted) Countries with a high rate of economic growth will receive a higher
measures, relative allocation
forward-looking Public debt 10% Net Govt. Debt / GDP (PPP When a country increases its debt burden, its weight allocation is
burden adjusted) adjusted downwards
obligations and
Private debt 5% Private Debt / GDP (PPP When a country’s private sector debt burden increases, its weight
socio-economic burden adjusted) allocation is adjusted downwards
issues Foreign debt 5% % Govt. Debt held by When the ownership of a country’s government debt by foreigners
ownership foreigners / Total Govt. Debt increases, its weight allocation is adjusted downwards
Fiscal balance 10% Budget Deficit /GDP When a country’s fiscal balance deteriorates, its weight allocation is
adjusted downwards
External position 10% Current Account (PPP Countries with a high current account surplus will receive a higher
adjusted) relative allocation
Funded pension 10% % of pension fund policy Countries that have a relatively greater component of their future
obligations obligations that are currently pension obligations funded will receive a greater weight under this
funded measure
Demography 5% Old age dependency ratio at Countries with a high dependency ratio will receive a lower relative
a 20 years horizon allocation
Political Risk 5% Misery Index (unemployment Countries with a high misery index will receiver a lower relative
+ inflation) allocation
Please see important information at the end of the document
LOIM — January 2011 — 4
5. We aim to align indices with investor’s objectives
Using the Fundamental weight approach compared market-cap approach
fundamental
approach of debt Market-Cap Weighted Benchmark (Global)
30%
sustainability rather LOIM Fundamentally Weighted Benchmark (Global) (unconstrained)
than indebtedness,
major countries 25%
The US and Japan are
such as the US, substantially lowered
Japan, Italy and the 20% in weight The Nordic countries
UK are excluded & Switzerland are
substantially
15% increased in weight
10%
5%
0%
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Please see important information at the end of the document
LOIM — January 2011 — 5
6. Superior performance using fundamental weights
Global Sovereign Comparison of performance (EUR unhedged) 30.4.2001 – 20.1.2011
Fundamental Bond
200
Index LOIM Fundamentally Weighted Benchmark (Global)
175 Market-Cap Weighted Benchmark (Global)
150
Back-tested using
125
OECD countries
100
75
2001 2003 2005 2007 2009
Comparison of performance (EUR hedged) 30.4.2001 – 20.1.2011
175
LOIM Fundamentally Weighted Benchmark (Global) Hedged
150 Market-Cap Weighted Benchmark (Global) Hedged
125
100
75
2001 2003 2005 2007 2009
Please see important information at the end of the document
LOIM — January 2011 — 6
7. Superior risk-return characteristics as well
Global Sovereign Comparison of risk characteristics (EUR unhedged) 30.4.2001 - 20.1.2011
Fundamental Bond
Index
Annual Ann. Excess Annualised Sharpe Ratio VaR 95% Expected Maximum
unconstrained Return Return Volatility 1 day Shortfall Drawdown
Back-tested using
OECD countries LOIM Fundamental
Approach (unhedged) 5.56% 2.21% 4.59% 1.21 -0..44% -0..64% -6.68%
Market Cap Weighted
Approach 3.36% 5.75% 0.58 -0..54% -0..78% -8.25%
Comparison of risk characteristics (EUR hedged) 30.4.2001 - 20.1.2011
Annual Ann. Excess Annualised Sharpe Ratio VaR 95% Expected Maximum
Return Return Volatility 1 day Shortfall Drawdown
LOIM Fundamental Approach
(Hedged) 4.98% 0.41% 2.09% 2.38 -0.25% -0.29% -3.64%
Market Cap Weighted
Approach 4.56% 2.71% 1.68 -0.27% -0.38% -4.72%
Please see important information at the end of the document
LOIM — January 2011 — 7
8. Fundamental process works for other products
Emerging Local Annual returns (%) 20
Annual volatility (%)
30
Fundamental Index 17.2
25 23
22 15
Back-tested using 20
13.0
18.1
Eurozone countries: 16.9
15.2
14.7 14.2 10 9.1
15 8.6
12.7 12.9 7.7 8.0 7.6
12.1 7.3
Exclusion Criteria 10
5.8
4.9
7.9 4.5 4.8
110% - Net Govt. Debt / 6.3 5 4.1 4.1
GDP 5
200% - Private Debt / GDP 0.4
0 0
-5
-5.2 -5
Fundamentally
-10 Weighted Benchmark
JPM GBI-EM
-15 Global Diversified -10
2003 2004 2005 2006 2007 2008 2009 2003 2004 2005 2006 2007 2008 2009
Fundamentally Weighted Market-Cap Benchmark
Average Annual Returns 10.7% 13.7%
Average Annual Volatility 5.9% 10.4%
Average Sharpe Ratio 1.74 1.26
Max Drawdown -14.5% -27.4%
Please see important information at the end of the document
LOIM — January 2011 — 8
9. Fundamental process works for other products
5B’s – combining Industry weight breakdown (vs. market-cap 5B index)
BBB and BB-rated
40%
issuers
35.0%
35%
Back-tested using 30% 28.0% Fundamentally
Weighted BBB-BB
Eurozone countries: Market Cap Weighted
25% BBB-BB
Exclusion Criteria
110% - Net Govt. Debt / 20% 17.0%
GDP 15.0%
200% - Private Debt / GDP 15%
11.0%
10.0% 10.0%
10% 8.0% 8.0%
7.0% 7.0% 7.0%
6.0% 6.0%
5.0%
4.0% 4.0% 4.0%
5% 3.0% 3.0%
0%
Utilities & Oil
Consumer Products
Chemicals & Health
TMT &Transportation
Capital Goods
Autos & Aerospace
Retail & Services
Basic Industry
Non-Bank Financials
Banking Please see important information at the end of the document
LOIM — January 2011 — 9
10. Key Findings
Wide investment • Fundamental indices produce better results with large investment
universe preferred universe and multiple currencies
Unhedged indices • Fundamental indices have their performance improved by unhedged
outperform currency exposure
Emerging • Global fundamental indices allocate greater weight to emerging
economies
preferred economies due to fundamental economic strength
Eurozone countries • Eurozone fundamental indices exhibit minimal performance differential,
benefit from future but are expected to outperform if Eurozone volatility increases
volatility
Corporates in • Corporate fundamental indices allocate a stable weight to industry sectors
stable sectors overtime, avoiding increasing weight to sectors that are gearing up
preferred
Please see important information at the end of the document
LOIM — January 2011 — 10
11. Current fundamental indexed products
Global Government Bond Fund Emerging Local Currencies and Bonds 5B Bond Fund
Hedged or Unhedged Hedged or Unhedged Hedged or Unhedged
Fund Details Fund Details Fund Details
Benchmark: Benchmark: Benchmark:
LOIM – Fundamental Weight Driven LOIM – Fundamental Weight Driven LOIM – Fundamental Weight Driven
Launch Date: Launch Date: Launch Date:
16th December 2010 12th January, 2010 1st December 2010
Available Currencies: Available Currencies: Available Currencies:
EUR, CHF (unhedged, hedged) USD, EUR, CHF (all unhedged) EUR, CHF (hedged)
Soon available: AuM: Comments:
USD, CHF (dynamically hedged) USD 747m as at the 7th of January 2011 • Active risk budget to take advantage of
Comments: Comments: market opportunities (TE Target: 3%)
• Active risk budget to take advantage of • Active risk budget to take advantage of
market opportunities (TE Target: 2.5%) market opportunities (TE Target: 5%)
S. Croce, Head R. Geiger, CRM H. De Rouw, CRM
(Switzerland, France, Italy) (Switzerland, Germany, Austria) (Belgium, Netherlands, Luxembourg)
Please see important information at the end of the document
LOIM — January 2011 — 11