MSCI Barra Portfolio Management Seminar

Transcription

1 MSCI Barra Portfolio Management Seminar April 28, 2010 Budapest Agenda Page 1 of 1

2 CLIENT SERVICE ASSISTANCE IS AVAILABLE 24 HOURS A DAY Americas (toll free) Amsterdam Atlanta Boston Cape Town China North (toll free) China South (toll free) Chicago Dubai Frankfurt Geneva Hong Kong London Madrid Milan Montreal New York Paris (toll free) San Francisco São Paulo Singapore (toll free) Stamford Sydney Tokyo Toronto Zurich clientservice@mscibarra.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. ( MSCI ), Barra, Inc. ( Barra ), or their affiliates (including without limitation Financial Engineering Associates, Inc.) (alone or with one or more of them, MSCI Barra ), or their direct or indirect suppliers or any third party involved in the making or compiling of the Information (collectively, the MSCI Barra Parties ), as applicable, 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 or Barra, as applicable. The Information may not be used to verify or correct other data, to create indices, risk models or analytics, or in connection with issuing, offering, sponsoring, managing or marketing any securities, portfolios, financial products or other investment vehicles based on, linked to, tracking or otherwise derived from any MSCI or Barra product or data. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), or a promotion or recommendation of, any security, financial product or other investment vehicle or any trading strategy, and none of the MSCI Barra Parties endorses, approves or otherwise expresses any opinion regarding any issuer, securities, financial products or instruments or trading strategies. None of the Information, MSCI Barra indices, models or other products or services is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. NONE OF THE MSCI BARRA PARTIES MAKES ANY EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS WITH RESPECT TO THE INFORMATION (OR THE RESULTS TO BE OBTAINED BY THE USE THEREOF), AND TO THE MAXIMUM EXTENT PERMITTED BY LAW, MSCI AND BARRA, EACH ON THEIR BEHALF AND ON THE BEHALF OF EACH MSCI BARRA PARTY, HEREBY EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF ORIGINALITY, AC- CURACY, TIMELINESS, NON-INFRINGEMENT, COMPLETENESS, MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE) WITH RESPECT TO ANY OF THE INFORMATION. Without limiting any of the foregoing and to the maximum extent permitted by law, in no event shall any of the MSCI Barra Parties have any liability regarding any of the Information for any direct, indirect, special, punitive, consequential (including lost profits) or any other damages even if notified of the possibility of such damages. The foregoing shall not exclude or limit any liability that may not by applicable law be excluded or limited, including without limitation (as applicable), any liability for death or personal injury to the extent that such injury results from the negligence or wilful default of itself, its servants, agents or sub-contractors. Any use of or access to products, services or information of MSCI or Barra or their subsidiaries requires a license from MSCI or Barra, or their subsidiaries, as applicable. MSCI, Barra, MSCI Barra, EAFE, Aegis, Cosmos, BarraOne, and all other MSCI and Barra product names are the trademarks, registered trademarks, or service marks of MSCI, Barra or their affiliates, in the United States and other jurisdictions. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and Standard & Poor s. Global Industry Classification Standard (GICS) is a service mark of MSCI and Standard & Poor s. About MSCI Barra MSCI Barra is a leading provider of investment decision support tools to investment institutions worldwide. MSCI Barra products include indices and portfolio risk and performance analytics for use in managing equity, fixed income and multi-asset class portfolios.the company s flagship products are the MSCI International Equity Indices, which include over 120,000 indices calculated daily across more than 70 countries, and the Barra risk models and portfolio analytics, which cover 56 equity and 46 fixed income markets. MSCI Inc. is headquartered in New York, with research and commercial offices around the world MSCI Barra. All rights reserved. RV0809

3 Strategic Equity Allocation of European Institutional Investors Sebastien Lieblich Introduction The continued evolution of global equity markets challenges the partitioning of the opportunity set into regional or domestic/ international portfolios Several consultants have taken the view that it has become irrelevant to separate domestic and non-domestic equities in asset allocation reviews Risk-return characteristics have become very similar Several large and leading pension plans have adopted a Global Equity approach in asset allocation At the policy level, the role of global equity is to achieve growth. Relative asset allocation to equities is a board responsibility but allocation within equities becomes a staff responsibility 2

4 Introduction Outline Globalization of equity opportunity set & current equity allocation policies Inherent risks of home-biased equity allocation Regional approach to equity allocation faces fundamental challenges Potential merits of an integrated global approach to equity allocation We seek feedback from institutional asset owners on these topics and ask how their approach to equity allocation might evolve in the future 3 Globalization of Equity Opportunity Set & Current Equity Allocation Policies

5 Globalization of Equity Opportunity Set & Current Equity Allocation Policies Over the past few decades, globalization of economic activity and increased integration of capital markets have led to a dramatic expansion of the equity universe for international investors Institutional investors now can access a deeper and broader global equity opportunity set However, most institutional investors have not yet taken a global approach to equity allocation Home bias: Typically, they separate the equity allocation into domestic and international equities at the strategic level, and maintain a significant home bias Regional segmentation: European asset owners commonly further split the international equity policy portfolio into regional allocations, with regional weights determined at the strategic asset allocation level 5 Economic and Financial Integration Global Trade and Capital Flows World exports as a percentage of GDP have more than doubled in the last 50 years Declining trade barriers: Average applied tariffs in the world (169 countries) have declined from 26.3% in 1986 to 8.8% in 2007 (World Bank) Increasing capital flows to emerging and developing economies Exports as % of GDP Exports as Percentage of GDP Average Applied Tarriff (Right Axis) plied Tarriffs (%) Average App US Dollars at current prices in billions 1, FDI Flow into Developing and Transition Economies Total FDI Flow Source: World Bank 6

6 Economic and Financial Integration GDP Growth is Global 100.0% 90.0% 80.0% 0% 70.0% Developed GDP (Wt%) 60.0% 50.0% 40.0% 30.0% Emerging 20.0% 10.0% 0.0% * Rank Country GDP Wt Country GDP Wt Country GDP Wt 1 United States 30.1% United States 26.7% United States 22.8% 2 Japan 16.2% Japan 9.1% China 15.5% 3 Germany 6.6% China 6.3% Japan 5.2% 4 United Kingdom 4.9% Germany 6.1% Germany 4.3% 5 France 4.5% United Kingdom 4.8% India 4.2% 6 Italy 3.9% France 4.6% United Kingdom 3.7% 7 Canada 2.3% Italy 3.6% France 3.3% 8 Brazil 2.1% Canada 2.6% Brazil 2.6% 9 Spain 1.8% Spain 2.5% Russia 2.4% 10 Russia 1.7% Brazil 2.3% Italy 2.3% Source: World Bank, USDA. Note:* Projected Source: World Bank World Development Indicators, International Financial Statistics of the IMF, Global Insight, and Oxford Economic Forecasting, as well as estimated and projected values developed by the Economic Research Service all converted to a 2005 base year. As compiled by USDA0 7 Economic and Financial Integration Companies Go Global Companies have significant international exposure, as measured by the proportion of foreign sales and foreign assets Today more than 100 countries require or permit International Financial i Reporting Standards (IFRS) in varying degrees Country Foreign Sales as Percent of Foreign Assets as a Percent Total Sales of Total Assets Australia 33.1% 14.1% Austria 57.9% 21.4% Belgium 22.9% 32.0% Canada 36.7% 34.1% Denmark 43.9% 7.8% Finland 71.5% 31.7% France 48.1% 27.8% Germany 57.4% 9.3% Greece 15.4% 17.0% Hong Kong 52.9% 23.3% Ireland 79.2% 62.3% Italy 36.0% 18.9% Japan 27.7% 15.9% Netherlands 56.4% 36.0% New Zealand 33.2% 26.9% Norway 41.1% 30.1% Portugal 34.9% 24.9% Singapore 60.6% 6% 34.6% Spain 35.9% 30.7% Sweden 67.9% 60.2% Switzerland 52.2% 70.6% United Kingdom 55.9% 33.5% United States 32.2% 9.8% Source: MSCI Barra, Worldscope. Data as of May 31,

7 Current Equity Allocation Policies Home Bias Despite greater economic and financial integration and the globalization of the equity opportunity set, most institutional investors have not yet taken a global approach to equity allocation Typically, they continue to separate equity policy portfolios into domestic and international equities at the strategic level, with a significant home bias that overweights domestic equities Equity Home Bias Based on IMF (CPIS) Surveys Average Equity Home Bias Country Denmark 79.7% 7% 56.1% 51.4% 48.5% Finland 94.1% 74.4% 51.3% 48.8% France 83.5% 69.4% 59.5% 62.7% Germany NA 49.9% 43.3% 42.3% Netherlands 70.2% 35.4% 20.1% 12.2% Norway 84.6% 50.4% 46.1% 46.8% Sweden 79.2% 51.1% 50.8% 49.7% Switzerland NA 57.3% 52.6% 51.1% United Kingdom 75.9% 64.0% 56.1% 52.2% USA 79.0% 69.6% 59.1% 52.3% Japan 92.1% 86.1% 84.7% 83.7% Source: IMF (CPIS), MSCI Barra. Home bias is defined as 1 (actual international equity allocation / market cap based international equity allocation). 9 Current Equity Allocation Policies Regional Approach Many European institutional investors further split the international equity policy portfolio into regional allocations, such as Europe, North America, Japan, Pacific ex Japan, and Emerging Markets, with regional weights determined at the strategic asset allocation level The partitioned regional approach may create market-timing risk linked to the regular review of the regional allocations at the strategic level Changing Market-cap Regional Weights in a Global Equity Portfolio (1970 to 2009) 100% 90% 80% 70% 60% 50% 40% 30% Emerging Markets Pacific ex Japan Japan North America Europe 20% 10% 0%

8 Inherent Risks of Home- Biased Equity Allocation Inherent Risks of Home-Biased Equity Allocation Home bias in equity policy portfolios can result in significant concentration risks and opportunity costs This section analyzes the inherent risks and potential costs of a home-biased equity allocation and discusses the traditional arguments for home bias Often Cited Reasons for Home-bias International markets are hard to access Domestic equities are a better match for domestic liabilities International equities are more risky due to currency risk Informational asymmetry: There is an informational advantage to investing in the domestic market 12

9 Portfolio Concentration Risks Home-biased equity allocation can lead to portfolio concentration in a few large domestic companies As the opportunity set broadens from domestic markets to the broad global equity market, the level of concentration and specific risk coming from security selection significantly decrease Risk Characteristics of Indices Using Barra Global Equity Model (GEM2L) Number of Securities Weight of Top 10 Companies (%) Asset Selection Risk (% Std Dev) Total risk (% Std Dev) Asset selection Risk Contribution (% Total Risk) MSCI Denmark IMI MSCI Switzerland IMI MSCI Finland IMI MSCI Netherlands IMI MSCI Norway IMI MSCI Germany IMI MSCI Sweden IMI MSCI France IMI MSCI UK IMI MSCI Europe MSCI Europe IMI MSCI World MSCI ACWI MSCI ACWI IMI Source: MSCI Barra. Data as of September This risk analysis uses Barra Global Equity Model (GEM2L), from local currency perspective for country indices and Euro perspective for regional and global indices. 13 Unintended Sector Bets Home-biased equity allocations may experience significant sector concentration, especially for European investors whose domestic markets are dominated d by certain sectors For instance, a 50/50 home-biased allocation would lead to a significant bet on the Energy sector (18.2% overweight) for a Norwegian investor and a significant underweight in the same sector for German and Finnish investors GICS Sector Active Sector Exposures of Home-biased Policy Benchmark vs. MSCI ACWI IMI 50% Germany IMI + 50% Finland IMI + 50% Norway IMI + 50% ACWI IMI 50% ACWI IMI 50% ACWI IMI Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication Services Utilities Source: MSCI Barra. Data as of October 1,

10 Higher Risk associated with Home-Biased Equity Allocation The concentration of certain home-biased allocations in a small number of companies and industries i can have a significant ifi impact on the risk of such equity portfolios The below Exhibit shows that the three 50/50 home-biased allocations historically experienced higher volatility and higher exposure to tail risk and extreme events, compared with the market-cap-weighted global equity portfolio Historical Risk Profile of Home-biased Policy Benchmarks vs. MSCI ACWI IMI Annualized risk VAR Expected Maximum shortfall drawdown 50% Germany IMI + 50% ACWI IMI 20.58% 2.10% 3.12% 63.29% 50% Finland IMI + 50% ACWI IMI 26.00% 2.65% 3.85% 67.31% 50% Norway IMI + 50% ACWI IMI 23.12% 2.23% 23% 379% 3.79% 62.81% MSCI ACWI IMI 18.86% 1.95% 2.86% 56.23% Source: MSCI Barra. The horizon for VAR and expected shortfall is 1 day. Based on gross total return index levels in Euro, for the 10 years to September 30, Potential Opportunity Cost of Home Bias Home-biased equity allocation may come at a significant opportunity cost resulting from the under-representation representation of the investment opportunities outside the domestic market For example, for European investors, the vast majority of investment opportunities in the global manufacturing industries and technology industries are outside Europe, and they can be captured fully only by adopting a global equity opportunity set Selected Manufacturing Industries Dominated by Asian Companies Selected Global Industries Dominated by Asian and U.S. Companies Weight of Asian Companies in MSCI Industry Selected Technology Industries Dominated by U.S. Companies Weight of U.S. Companies in MSCI Industry Auto Components 55.8% Biotechnology 84.6% Automobiles 62.8% Communications Equipment 66.0% Electronic Equipment & Instruments 65.6% Computers & Peripherals 83.1% Household Durables 50.8% Internet Software & Services 82.9% Leisure Equipment & Products 56.9% IT Services 67.1% Office Electronics 84.2% Software 78.0% Source: MSCI Barra. Data as of October 1,

11 Potential Opportunity Cost of Home Bias A notable example is that t Emerging Markets have expanded from less than 1% of the global equity opportunity set in 1988 to more than 12% in 2009 European investors with home-biased equity allocation might have at least partially missed the new investment opportunities in the Emerging Markets which now represent more than 27% of the World s GDP Expansion of Emerging Markets Equity Opportunity Set Accompanied Their Growing Economic Importance Note: Global equity market is proxied by MSCI ACWI IMI 17 Often Cited Reasons for Home-bias International markets are hard to access Domestic equities are a better match for domestic liabilities International equities are more risky Currency risk Other risks Informational asymmetry There is an informational advantage to investing in the domestic market 18

12 Market Accessibility Has Improved Due to further opening to foreign investors and investments in market infrastructure around the world, access to many international markets has become more cost effective and operationally easier While bid-ask spreads remain higher in Emerging Markets (28 bps in EM, versus 9 bps in Europe and 8 bps in DM ex Europe), the ATVR - a measure of relative liquidity - highlights g how both developed and certain emerging g markets have become increasingly investable Annualized Traded Value Ratio (ATVR) for Top Developed and Emerging Markets 19 Are Domestic Equities a Better Match for Domestic Liabilities? Both domestic and international equity returns have low correlations with pension liabilities, making them less suitable as a straight hedge for pension liability growth Domestic liability hedging and matching may be better served with a fixed income allocation The role of equities at the plan level is generally to provide long term growth rather than short term cash-flow liability matching If growth is the main argument for equity allocation, then constraining it to only domestic growth may come with a significant opportunity cost MSCI ACWI ex USA MSCI ACWI MSCI US Bond IMI Index IMI Index USA IMI Index Correlation with Pension Liability Index Source: MSCI Barra, Citigroup. Note: The pension liability index is represented by Citigroup Pension Liability Index. 20

13 Currency Risk: Are International Equities More Risky? From a long term historical perspective, currency exposure has not significantly ifi changed the risk and return profile of global l equity portfolios, from the perspective of investors in large equity markets, such as the US, UK, France, and Germany Historical Long-term Risk and Return Characteristics of Domestic and Global Portfolios Domestic Reporting Domestic Portfolio (1) MSCI ACWI, unhedged (2) MSCI ACWI, hedged (2) Country Currency Return Volatility Return Volatility Return Volatility Denmark DKK 12.2% 18.2% 8.5% 16.1% 10.7% 14.4% France EUR/FRF 10.2% 20.6% 9.0% 16.1% 1% 9.7% 14.3% Germany EUR/DEM 7.5% 19.9% 6.8% 16.3% 7.9% 14.3% Netherlands EUR/NLG 10.2% 18.3% 7.2% 16.2% 7.7% 14.4% Norway NOK 10.9% 25.6% 9.0% 15.5% 10.0% 14.4% Sweden SEK 14.8% 23.1% 10.4% 15.5% 9.8% 14.4% Switzerland CHF 7.8% 16.9% 5.7% 17.5% 6.0% 14.3% UK GBP 11.5% 20.3% 10.6% 15.9% 10.7% 14.3% USA USD 9.3% 15.6% 9.5% 15.1% 8.9% 14.3% Japan JPY 6.2% 18.6% 5.8% 16.5% 6.4% 14.2% 1) Proxied by the respective MSCI Standard Country Indices. 2) Annualized return and volatility for period from December 1969 to August MSCI World Index until Dec Informational Asymmetry: Value for Active Managers? More return dispersion across the larger global universe translates into more alpha opportunities. Fundamental global managers can take full advantage of bottom-up research by sharing the best ideas across a global analyst team Quant managers may benefit from the increased breadth** of the larger universe potentially leading to higher risk-adjusted returns A recent study by MFS* shows that t on average global l equity managers have earned higher risk-adjusted excess returns than U.S. large cap and international (non-u.s.) equity managers over the 3-, 5-, and 10-year periods ended December 31, * MFS White Paper Series, Why Global? ** Breadth: Number of independent forecasts (see Fundamental Law of Active Management ) 22

14 Regional Approach to Equity Allocation Faces Fundamental Challenges Regional Approach to Equity Allocation Faces Fundamental Challenges This section discusses the evidence that challenges the separation of equity policy portfolios into regional allocations at the strategic level Increased integration of equity markets Growing importance of global industry effects Global comparison of companies challenges the regional divides Global equities as a single asset class 24

15 Increased Integration of Equity Markets The regional approach may reflect the perception that regional/country factors are of foremost importance to equity allocation, and therefore regional weights should be determined at the strategic level However, there is growing evidence that regional equity markets are converging, and that country factors are becoming relatively less important in driving i the variations in global l security returns Rising Correlation between European Equities and Other Regional Equities Average Pairwise Pi i Correlation of European Equities vs Other Regional Equities 1970s 1980s 1990s 2000s North America Japan Pacific ex Japan Emerging Markets Dec 9 92 Nov 9 93 Oct 9 94 Sep 9 95 Aug 9 96 Jul 9 97 Jun 9 98 May 9 99 Apr 0 00 Mar 0 01 Feb 0 02 Jan 0 03 Dec 0 03 Nov 0 04 Oct 0 05 Sep 0 06 Aug 0 07 Jul 0 08 Jun Growing Importance of Global Industry Effects Global industry factors have become increasingly important determinants of global security returns The IT bubble in , the energy and commodities bull market over the recent years, and the financial crisis in all illustrate that individual global sectors/industries can perform very differently from the broad market and even drive the market over certain periods The dramatically different performance of global sectors relative to global equity over the last ten years highlights that the global sector allocation decisions would have had a major impact on the risk and return of global equity portfolios over the last decade Performance of Selected Global Sectors Relative to Global Equity 26

16 Global Comparison of Companies Challenges the Regional Divides The global nature of businesses and the geographical diversity of the leading companies within global industries are making the global comparison of companies an increasingly essential element of a global equity investment process For the industries that are increasingly global in nature, it is difficult to identify the best investment opportunities without comparing the leading companies within the industry globally Largest Metals & Mining Companies and Semiconductor Companies in MSCI ACWI Top Metals & Mining Companies Top Semiconductor Companies Name Country Name Country BHP Billiton Ltd Australia Intel Corp USA Vale Brazil Samsung Electronics Co Korea Rio Tinto Plc United Kingdom Taiwan Semiconductor Mfg Taiwan Anglo American United Kingdom Texas Instruments USA Barrick Gold Corp Canada Applied Materials USA Arcelormittal France Mediatek Inc Taiwan Goldcorp Canada ASML Hldg Netherlands POSCO Korea Broadcom Corp A USA Freeport Mcmoran USA Tk Tokyo Electron Japan Xstrata United Kingdom Hynix Semiconductor Korea 27 Global Equities as a Single Asset Class The increased integration of regional equity markets and the growing importance of global l sectors have significant ifi implication for equity asset allocation The approach of separating the equity policy portfolio into regional allocations at the strategic level faces fundamental challenges, as the regional dimension alone cannot fully capture the dynamics of global equities By removing the regional boundaries or the domestic/international divide at a strategic level, a global approach defines global equity as a single strategic asset class and leaves the determination of regional and global sector allocations as investment decisions at the tactical level It would enable the asset owner equity team to organize the management of a global equity portfolio along both important dimensions to capitalize on the additional flexibility 28

17 Potential Merits of an Integrated Global Equity Investment Process Potential Merits of an Integrated Global Equity Investment Process Structural changes in the global economy and capital markets have prompted some institutional investors to rethink or review their equity allocation approach and investment process By removing the domestic/international t divide, id several large and leading pension plans recently have adopted a global equity approach in asset allocation This section discusses the potential investment and operational benefits of a global equity approach to asset allocation 30

18 Potential Investment Benefits of a Global Equity Approach A global approach places the entire global equity universe as the natural starting ti point for equity allocation It contemplates the entire global equity opportunity set and considers exposures to different geographical regions, countries, industries, and currency movements It recognizes that deviations from market-cap weights represent active investment decisions It views both regional allocation and global sector allocation as important tactical decisions, rather than strategic asset allocation decisions For active investors, operating from a broader universe potentially increases the opportunity for delivering alpha For passive investors, the market-cap-based global equity portfolio is a very diversified and comprehensive representation of the global equity beta 31 Potential Operational Benefits of a Global Equity Approach Defining global equities as a single asset class removes the need for periodic reviews at the strategic t level l of the regional allocation or domestic / international equity allocation It facilitates a focus on the important strategic allocation issues It eliminates market-timing risk linked to the regular reversal of the domestic/international allocation movements From an organizational perspective, an integrated global equity structure potentially allows for a more efficient use of valuable investment resources and streamlines the investment process Having one global equity investment process may reduce potential conflicts and unintended bets arising from independent investment processes It may harmonize the overall investment decision making process and ease the implementation and oversight of the equity allocations 32

19 Additional Considerations An integrated global equity investment process is not an assurance for better portfolios and better returns Pure global mandates are neither the only nor necessarily the best solution For example, regional mandates may be preferred due to the availability of manager skills, or lack thereof, or due to other factors beyond the scope of this paper 33 Conclusions Thought leaders are increasingly looking at their equity allocation as one integrated global segment Some institutional investors believe that it is time to break the regional and domestic/international divide in equity allocation that is already blurred today Several large and leading pension plans recently have adopted a global equity approach in asset allocation, defining global equities as a single, strategic asset class A more integrated global approach to equity investing may be the next stage in the evolution of investment processes A broad and investable global equity benchmark defines the natural starting point for equity allocation and is an essential part of such a process 34

20 Appendix Emerging Markets and International Small Caps Emerging markets and international ti small caps are both important components of the global equity opportunity set The MSCI Emerging g Markets (EM) Index was launched in Over the last twenty years, the MSCI EM Index has outperformed the MSCI World Index with higher volatility, indicating that risk has been compensated historically Over the last 15 years, international small cap has outperformed the large/mid cap segment with slightly higher volatility Sterling Euro/Deutschmark MSCI World MSCI EM MSCI World MSCI EM Annualized Returns 10 Year 0.8% 10.2% 2.1% 7.0% 20 Year 5.7% 10.6% 4.0% 8.8% Annualized Volatility 10 Year 16.6% 24.0% 16.5% 23.9% 20 Year 16.0% 25.4% 16.7% 25.8% Source: MSCI Barra. As of 31 August 2009 MSCI ACWI Sterling Euro/Deutschmark MSCI ACWI Small Cap MSCI ACWI MSCI ACWI Small Cap Annualized Returns 5 Year 6.7% 9.1% 1.2% 3.4% 10 Year 1.3% 6.1% 1.6% 3.0% 15 Year 5.3% 5.7% 4.7% 5.1% Annualized Volatility 5 Year 16.2% 19.3% 15.4% 18.4% 10 Year 16.9% 18.9% 16.8% 18.6% 15 Year 16.4% 17.8% 17.0% 18.0% Source: MSCI Barra. As of 31 August

21 Quantifying the Cost of Home Bias in the UK Based on recent data, a UK biased equity allocation would have led to lower return, higher volatility, and higher exposure to tail risk. In comparison, a global equity policy benchmark lies very close to the ex-post efficient frontier Risk and Return of Different Policy Benchmarks over Recent Time Periods (in GBP, as of July ) Annualised return 1 year 3 years 5 years 10 years Annualised risk Annualised return Annualised risk Annualised return Annualised risk Annualised return Annualised risk Domestic: MSCI UK 10.97% 38.84% 4.41% 26.80% 4.38% 21.81% 0.41% 20.92% Home biased: 65% UK + 35% ACWI 8.65% 33.70% 2.86% 23.24% 4.97% 19.06% 0.80% 18.27% Global: MSCI ACWI 4.66% 466% 31.17% 17% 0.11% % 18% 600% 6.00% 17.79% 79% 1.49% 17.84% Extreme Risk Measures ( ) Ex-Post Efficient Frontier ( ) Expected Maximum VAR shortfall drawdown MSCI EM Domestic: MSCI UK Index 1.87% 3.17% 41.56% Home biased: 65% UK + 35% ACWI 1.70% 2.80% 39.26% Global: MSCI ACWI 1.58% 2.56% 36.74% Return MSCI ACWI IMI MSCI UK 70% UK, 30% EM 65% UK, 35% ACWI IMI Risk Feedback Asset Allocation What is your current target asset allocation? How often do you review your asset class mix and strategic asset allocation? Do you make allocations to micro caps and frontier markets? Home Bias and Regional Allocation In your current target allocation for equities do you have a home biased allocation to domestic equities? What drives that decision? Do you think home bias is an issue? In your current target allocation for equities do you fix weights of different regions (e.g., Europe, North America, Asia Pacific, Emerging Markets)? If yes how often do you review these regional weights? Do you consider currencies as a major issue for international investors? How do you handle currency risk? Un-hedged, partially or fully hedge the currency exposures? 38

22 Feedback An Integrated View of Equities Do you consider domestic and foreign equities as two separate asset classes? What is the rationale for your decision? Is there an attempt to adopt an integrated equity asset class view? What are the major road blocks? Do you have or intend to make specific allocation to global mandates? How do you implement them? Benchmark What factors do you consider in selecting the policy benchmarks for the various asset classes? Who guides the decision process? Why would you adopt MSCI ACWI IMI as your policy benchmark for equities? If not, what are the major concerns? What should be the role of benchmark providers like MSCI in facilitating the plans to adopt a global approach towards policy allocation? 39 MSCI Barra 24 Hour Global Client Service Americas Europe, Middle East & Africa Asia Pacific Americas (toll free) Amsterdam China North (toll free) Atlanta Cape Town China South (toll free) Boston Frankfurt Hong Kong Chicago Geneva Seoul Montreal London Singapore (toll free) Monterrey Madrid Sydney New York Milan Tokyo San Francisco Paris (toll free) São Paulo Zurich Stamford Toronto clientservice@mscibarra.com Barra Knowledge Base Online Answers to Barra Questions: RV

23 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 MSCI Inc., Barra, Inc. ( Barra ), or their affiliates (including without limitation Financial Engineering Associates, Inc.) (alone or with one or more of them, MSCI Barra ), or their direct or indirect suppliers or any third party involved in the making or compiling of the Information (collectively, the MSCI Barra Parties ) ), as applicable, 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 or Barra, as applicable. The Information may not be used to verify or correct other data, to create indices, risk models or analytics, or in connection with issuing, offering, sponsoring, managing or marketing any securities, portfolios, financial products or other investment vehicles based on, linked to, tracking or otherwise derived from any MSCI or Barra product or data. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), or a promotion or recommendation of, any security, financial product or other investment vehicle or any trading strategy, and none of the MSCI Barra Parties endorses, approves or otherwise expresses any opinion regarding any issuer, securities, financial products or instruments or trading strategies. None of the Information, MSCI Barra indices, models or other products or services is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. NONE OF THE MSCI BARRA PARTIES MAKES ANY EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS WITH RESPECT TO THE INFORMATION (OR THE RESULTS TO BE OBTAINED BY THE USE THEREOF), AND TO THE MAXIMUM EXTENT PERMITTED BY LAW, MSCI AND BARRA, EACH ON THEIR BEHALF AND ON THE BEHALF OF EACH MSCI BARRA PARTY, HEREBY EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF ORIGINALITY, ACCURACY, TIMELINESS, NON- INFRINGEMENT, COMPLETENESS, MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE) WITH RESPECT TO ANY OF THE INFORMATION. Without limiting any of the foregoing and to the maximum extent permitted by law, in no event shall any of the MSCI Barra Parties have any liability regarding any of the Information for any direct, indirect, special, punitive, consequential (including lost profits) or any other damages even if notified of the possibility of such damages. The foregoing shall not exclude or limit any liability that may not by applicable law be excluded or limited, including without limitation (as applicable), any liability for death or personal injury to the extent that such injury results from the negligence or wilful default of itself, its servants, agents or sub-contractors. Any use of or access to products, services or information of MSCI or Barra or their subsidiaries requires a license from MSCI or Barra, or their subsidiaries, i as applicable. MSCI, Barra, MSCI Barra, EAFE, Aegis, Cosmos, BarraOne, and all other MSCI and Barra product names are the trademarks, registered trademarks, or service marks of MSCI, Barra or their affiliates, in the United States and other jurisdictions. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and Standard & Poor s. Global Industry Classification Standard (GICS) is a service mark of MSCI and Standard & Poor s MSCI Barra. All rights reserved. RV

24 Barra Europe Equity Model (EUE3): Eastern Europe Focus Andrew Wilson Agenda Barra Modelling Approach Barra Europe Equity Model (EUE3) Eastern Europe Derived Model Case Study 2

25 Barra Multi-factor Equity Risk Models For over 30 years, MSCI Barra has been a pioneer in the field of multi-factor model research Today, the ongoing development of the Barra fundamental equity multi-factor t models continues to reflect MSCI Barra s commitment to innovative research across: financial markets regions time horizons Barra equity multi-factor models can now be licensed through Models Direct, the Barra Aegis System, BarraOne, and thirdparty platforms such as Factset and Market QA 3 Barra Multi-factor Equity Risk Models: Motivations Provide a consistent framework for portfolio construction, risk forecasting and hedging Enable the identification of common, fundamental drivers of asset returns Slice-and-dice returns and risk along the systematic factors, and idiosyncratic dosy atc components Define pre-specified exposures to factors, which quickly respond to changes in company fundamentals and market evolution 4

26 From Asset Returns to Factor Returns Companies possessing similar characteristics may, in a given month, show returns that are different from the other companies. The pattern of differing shows up as the factor relation. Barr Rosenberg, founder of Barra Source: Barra EUE3 Equity Model, Aegis Performance Attribution 5 From Asset Returns to Factor Returns Asset excess returns can be written as a linear combination of asset exposures and common factor returns plus a residual component For example, Vodafone s excess return of 1.962% for a sample random date can be written as 1.962% = Europe + Risk Indices + Industry + Country + Currency + Asset Specific 1.962% = 1*Europe *Size *Telecom + 1*UK + 1*GBP + Asset Specific Common Factor Return Component Asset Specific Return Component Given the estimation universe s asset excess returns and their factor exposures we can now estimate the factor returns through a cross-sectional regression This robust multi-step regression scheme curtails the influence of asset return outliers on the factor return estimates by detecting and trimming outlier asset returns 6

27 Europe Equity Model (EUE3): Eastern Europe Derived Model What is EUE3? EUE3 is the latest version of the Barra Europe Equity Model It is an innovative fundamental multi-factor model, designed to help portfolio managers construct and maintain better risk- adjusted d portfolios The intuitive model structure can accommodate multiple investment e t processes in both developed e and emerging e g markets, with variants directed at the Europe-wide investors as well as those tilted towards UK-centric and Eastern Europe-centric investors 8

28 Model Structure Overview EUE3 is composed of 102 individual factors (132 for the derived models), grouped as follows: Market factor(s), that reflect the movements of the European Equity Markets 9 risk indices or style factors: Momentum, Volatility, Value, Growth, Leverage, Size, Liquidity, Earnings Yield and Dividend Yield 29(58) industries, based on the Global Industry Classification Standard (GICS ) classification scheme 29 countries 34 currencies Multiple Horizons (Long and Short) These factors are chosen for their market relevance, and ability to explain the common drivers of asset excess returns over time The estimation universe of EUE3 comprises circa 2,400 stocks. Results are projected onto a coverage universe of circa 9,400 stocks 9 Factor Overview Market Factor Every asset has a unit exposure to this factor. This factor can be generically considered d to replicate the returns of a cap weighted broad market index Style Factors Asset level exposures to these factors are determined from a set of descriptors Raw descriptors are calculated l from a mix of Fundamental and Technical data The raw descriptors are then standardized and combined to form a factor exposure e.g. an asset s exposure to the Value Factor can be though of as a standardized combination of Book-to-Price (62%) and Sales-to-Price (38%) ratios Industry, Country and Currency Factors Every asset has a unit exposure to an Industry. The Industry factors are based on the GICS Every asset has a unit exposure to a Country Every asset has a unit exposure to the currency of quotation Depositary receipts and cross listings In these cases, the assets Country and Currency exposures match those of the respective parent asset. For example, the US-listed ADR of Vodafone has UK and GBP as country and currency of exposure. 10

29 EUE3 Factor Covariance Matrices Estimated from daily factor returns data Currency and equity factors are treated equally Exponentially weighted moving average with split half-lives: Model Variance Half-life Correlation Half-life Sample Size EUE3S 90 d 180 d 540 d EUE3L 250 d 500 d 1500 d Serial correlation correction with up to 15 days lag to calculate covariance matrices with monthly forecasting horizon 11 Eastern Europe Derived Model - Highlights 11 Eastern European countries are covered History back to 1997 for Czech Republic, Poland, Hungary, Russia & Turkey History back to 2005 Croatia, Estonia, Latvia, Lithuania, Romania & Slovenia Asset Coverage for over 1,500 securities 9 Style Factors 29 Specific Eastern Europe Industry Factors 12

30 Example: Emerging Market Factors EUE3S factor volatilities reflecting crisis events in Russia, Turkey, and Iceland Fac ctor Volatil ity (ann.) 100% 80% 60% 40% 20% Russia Iceland Turkey Aug 1998 Oct 2008 credit crisis Feb Apr 2001 TRL devaluation 0% Example: Risk Decomposition Comparison Take a concentrated portfolio of Eastern European utility and energy stocks (137 stocks) and compare the x-sigma-rho risk forecasts in EUE3S base and EUE3S EE (in standard deviations): Styles Industries Countries Currencies Market Factor Asset Selection Total Risk The base model over-predicts the risk compared to the Eastern European derived model The style, currency and asset selection risks are roughly identical in both models but the industry and country risks change Only EUE3 EE captures that utilities are a diversifier Market risk dominates in EUE3S EE model EUE3S base EUE3S EE 14

31 Portfolio Case Study Appendix

32 Europe Model Factor Structure Market Factors* Europe UK / Europe ex-uk Eastern Europe / Western Europe Base Model UK Derived Model Eastern Europe Derived Model Style Factors (9) Industry Factors** (29/58) Size Momentum Volatility Liquidity* Value Growth Financial Leverage Earnings Yield* Dividend Yield Energy Equipment & Services Autos & Components Banks Oil Gas & Consumable Fuels Consumer Durables & Apparel Diversified Financials Other Materials Consumer Services Insurance Metals & Mining Media Real Estate Other Capital Goods Retailing Software & Services Construction & Engineering Food & Staples Retailing Technology Hardware & Equipment Machinery Food Beverages & Tobacco Semiconductors Commercial Services Household & Personal Products Telecommunication Services Other Transport Healthcare Equipment & Services Utilities Airlines Pharmaceuticals * New in EUE3 ** Derived models have the same industries but split into Home and ex-home For example EE Derived model will have Eastern Europe Banks and Western Europe Banks 17 Europe Model Factor Structure Country Factors Austria France Netherlands Belgium United Kingdom Norway Switzerland Greece Poland* Cyprus* Croatia* Portugal Czech Republic* Hungary* Romania* Germany Ireland Russia* Denmark Iceland* Slovenia* Spain Italy Sweden Estonia* Lithuania* Turkey* Finland Latvia* Currency Factors Croatia* Cyprus* Czech* Denmark Estonia* Euro Hungary* Iceland* Latvia* Lithuania* Norway Poland* Romania* Russia* Slovenia* Sweden Switzerland Turkey* United Kingdom United States * New in EUE3 18

33 EUE3 Style Factors SIZE Combines log of market cap and log of total assets MOMENTUM Systematic ti return and risk associated with trending behaviour over a horizon of about one year. Combines 1-month lagged relative strength over 6 and 12 months with a 2-year weekly alpha LIQUIDITY Indicates return and risk differences associated with infrequent trading. Combines monthly, quarterly, and annual relative turnover descriptors 19 EUE3 Style Factors VOLATILITY Return and risk differences between high-beta and low-beta stocks. Complements the regional market factor which uses uniform betas of one. Contains a 2-year weekly historical beta, the 12-month cumulative range, and a 3-month daily volatility LEVERAGE Indicates relationship between indebtedness of a firm and its asset returns. Combines book leverage and market leverage descriptors GROWTH Return and risk differences associated with fundamental firm growth. Combines five descriptors of asset, sales, and earnings growth, and includes forward-looking estimated earnings growth 20

34 EUE3 Style Factors VALUE Return and risk associated with valuation differences. Uses book-to-price and sales-to-price descriptors EARNINGS YIELD Relationship between systematic risk and the ability of a company to generate positive cash flows and earnings. Uses earnings-to-price, cash earnings-to-price, return on equity, and forward earnings-to-price DIVIDEND YIELD Indicator for systematic return and risk differences between firms that pay dividends and firms that reinvest their earnings or don t generate positive cash flows 21 MSCI Barra 24 Hour Global Client Service Americas Europe, Middle East & Africa Asia Pacific Americas (toll free) Amsterdam China North (toll free) Atlanta Cape Town China South (toll free) Boston Frankfurt Hong Kong Chicago Geneva Seoul Montreal London Singapore (toll free) Monterrey Madrid Sydney New York Milan Tokyo San Francisco Paris (toll free) São Paulo Zurich Stamford Toronto clientservice@mscibarra.com Barra Knowledge Base Online Answers to Barra Questions: RV

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