INTEGRATING ALL SOURCES OF PERFORMANCE TO CREATE MORE EFFECTIVE PORTFOLIOS So Sources ces of of Per Perfor orman mance ce an and d the he Val alue e of of Fo Forecas asts ts Jacques Lussier , Chief Investment Officer October 2015
TABLE OF CONTENTS We Can do Better er Sources ces of Excess xcess Perfor orma manc nce e Changes ges in Po Portfol folio io Design sign Beta, a, Alph pha a & Luck How w to St Structu ucture e a Prod oduc uct When n Perfor orma mance nce is Not Ther ere An Analy alysis is using g the Multi-Fact actor or App pproac oach An Example ample of a C Comp mplete e Produc oduct Concl clus usion ion and d Recom ommen mendat ation ion 2
WE CAN DO BETTER, BUT HOW? An asset reaches its maximum weight when it is most highly overvalued. 3
STRUCTURE OF MANAGERS‟ PERFORMANCES Management approaches Skill: Portfolio Structuring Market structure Indexing Active Diversification – pricing Diversification – effective statistics errors Underperforms Outperforms Balance of risk premiums Nature of performance Skill: Forecasting Unique skill - forecasting Luck Expertise It is the philosophy, not the methodology, that determines the capacity to perform. 4
UNDERSTANDING SOURCES OF PERFORMANCE Return = Beta + Alpha + Luck Unique expertise tise Exposu sure re to Exposu sure re to risk premiums ums Forecasting returns uncomp mpen ensat sated d risk Market Better integration of risk + Good luck – Announcement of premiums Size better profit than anticipated Exposure to unknown risk Value premium Trends Bad luck – Report indicating a Quality particular drug increases Diver ersi sificat ation on of pricing ng etc. cancer risk error Identifying and Identifying and/or Diversifying uncompensated 𝑁𝑏𝑦. 𝑆𝑓𝑢𝑣𝑠𝑜 risks effectively 𝑆𝑗𝑡𝑙 = diversifying risk factors + (Factor-based approach) + diversifying pricing error (Volatility management (Naive approach) approach) 5
DIFFERENT APPROACHES TO PORTFOLIO STRUCTURING Volatility management Factor-based approach Naive approach approach Low-Beta market Equal-weight Low volatility Small cap Weight based on historical Maximum Diversification (TOBAM) moving average Value style Sampling on risk measures Weight based on accounting Trend/momentum style variables (RAFI) Equal weighting Multi-factor approach (AQR) 6
BETA – IDENTIFYING AND DIVERSIFYING FACTORS Performance of key factors – U.S. equities Period Market + Size Value Momentum 72-75 -5.8% -6.6% 11.0% 11.3% 76-79 6.8% 16.6% 6.3% 14.4% 80-83 6.9% 7.9% 7.0% 10.7% 84-87 7.2% -6.4% 5.6% 7.2% 88-91 10.7% -2.0% -3.6% 12.2% 92-95 9.2% 1.3% 9.3% 10.3% 96-99 19.3% -3.2% -7.1% 15.9% 00-03 -6.5% 11.2% 16.8% 6.5% 04-07 6.3% -0.8% 4.3% 7.3% 08-11 0.7% 5.7% -1.6% -7.7% 12-15 (June) 17.2% 1.0% -0.9% 3.8% 72-15 (June) 8.2% 3.4% 3.8% 7.5% Source: IPSOL T raditional indexes are fully exposed to market risk (β market = 1) and have no exposure to the other factors (βs of other factors = 0). 7
LUCK – DIVERSIFYING UNCOMPENSATED RISKS Firm Date β S&P500 ret. Firm ret. Explanation Microsoft 24/04/2015 0.78 0.22% 10.45% Profits better than anticipated ResMed 24/04/2015 0.48 0.22% -10.47% Sales lower than anticipated Uncompensated risks cannot be forecasted but they can be diversified. This explains why a portfolio‟s risk is lower than the average risk of its components. Lower volatility = Higher compounded return The objective is to manage volatility more efficiently Market portfolios are not necessarily the most efficient at diversifying uncompensated risk. The objective is to reduce the volatility attributed to uncompensated risks per unit of periodic return. 8
ALPHA – IDENTIFYING / DIVERSIFYING PRICING ERRORS Traditional indexes assign too much weight to overvalued securities and too little to undervalued securities. Initial index Firm Period Initial price Final price Return Comment weight 3/27/2000 to Nortel 35% 143.06 9.86 -93% Large loss on large position 6/15/2001 3/9/2009 to Large gain on small Ford 0.12% 1.74 12.80 635% 3/9/2010 position Alpha is also related to diversification The objective is either to forecast returns (which is difficult) or to diversify pricing error more efficiently than an index based on market capitalization. This can be achieved using an allocation method that is not correlated with pricing error. 9
PUTTING TOGETHER A PORTFOLIO – EXAMPLE OF U.S. EQUITIES A combination of 3 processes: A sampling process – which securities are authorized in the portfolio S&P500, equal-weight: Authorized securities in the S&P500 market capitalization RAFI US 1000: 1000 securities with the highest score based on the Fundamental Index measure on the NYSE, the AMEX and the NASDAQ. The score is based on a combination of 5-year averages for the sales, accounting value, cash flow and dividend variables. An allocation process – weights allocated to the securities S&P500, equal-weight: 1/N RAFI US 1000: weight based on score A rebalancing process S&P500 – equal-weight: quarterly RAFI US 1000: annual An allocation process necessarily creates factor bias, whether intentional or not. 10
WHEN DO FACTOR-BASED PRODUCTS UNDERPERFORM? When risks other than market risk are not compensated When the impact of uncompensated risks dominates in the short term. E.g. positive surprises regarding the profits of large growth companies such as Apple in 2014 and Google in July 2015 and/or when large countries dominate performance, as in the case of China in 2014 and early 2015. 11
A FEW STRATEGIES AND PRODUCTS EXPLAINED USING THE FACTOR-BASED APPROACH Equal Fundamental Maximum Fidelity Large Cap Fidelity Blue Chip One-factor model weighting Index Diversification Value Enhanced* Growth* Alpha „ 1.59% „ 2.14% „ 2.50% - 1.44% 1.16% Beta market 1.04 0.94 0.82 0.88 1.03 Five-factor model Alpha 0.70% - 0.23% - 0.51% - 0.99% 2.34% Market 1.01 0.99 0.82 0.92 1.02 Size 0.01 - 0.08 0.20 - 0.22 - 0.07 Value 0.27 0.32 0.15 0.33 - 0.15 Momentum - 0.03 0.03 - 0.08 „ 0.16 - 0.04 Low Beta 0.07 0.07 0.26 0.03 - 0.05 * Five-star Morningstar rating. 0.46% and 0.80% management fees respectively have been added to returns from both Fidelity Funds to ensure that all portfolios are comparable. 12
IMAGINE A GLOBAL PORTFOLIO THAT INTEGRATES ALL OF THESE MANAGEMENT APPROACHES Highly diversified: • U.S. and international equities – Approximately 200 positions each • Emerging markets – Exposure to 20 countries • Resources – Exposure to 24 contracts • Balanced exposure to all risk premiums: • Equities - Value, trend/momentum, size, current yield, asymmetry, etc. • Resources, currency – Value, trend/momentum • Managing uncompensated risks to improve geometric return • 13
PERFORMANCE (CAD) Absolute return – Annualized Relative return (60/40) – Annualized Scatter plot – Portfolio vs 60/40 You cannot win all of the time, but you can do much better in the long term. 14
CONCLUSION AND RECOMMENDATIONS 15
KEY MESSAGES • The best managers do not outperform systematically. • Only 20% to 30% of active managers beat their targets after fees. This percentage is structural and is not affected by participant quality but instead by fees. • Luck is always a significant factor in performance. • Forecasting returns is not the main source of performance. Three forms of diversification explain much of the long term performance. 16
WHICH APPROACH IS PREFERABLE – FUNDAMENTAL OR QUANTITATIVE? It doesn‟t matter! What does matter: The process (not necessarily the methodology) and total fees AVOID ACTIVE MANAGEMENT IN THE FOLLOWING SCENARIOS: • You cannot tolerate underperformance over 3 to 5 years. • Sources of creation of enigmatic value • “Closet Indexing” • If fees are unreasonable The best managers share a similar philosophy even if the implementation methodology is different. 17
J ACQUES L USSIER , President & Chief Investment Officer G UY D ESROCHERS , VP & Chief Compliance Officer 514-842-2224 , jacques.lussier@ipsolcapital.com 514-842-2225, guy.desrochers@ipsolcapital.com H UGUES L ANGLOIS , Director of Research L UC G OSSELIN , Director of Operations 646-583-2092, hugues.langlois@ipsolcapital.com 514-842-2022, luc.gosselin@ipsolcapital.com 368 Notre-Dame West, Suite 301, Montreal, Québec, H2Y 1T9, www.IPSOLCAPITAL.com This document has been prepared for information purpose only, and does not constitute an offer or solicitation to buy or sell any securities, products or services and should not be construed as specific investment advice. The content of this presentation is proprietary and should not be further distributed without prior consent of IPSOL Capital Inc. Les informations et les opinions exprimées dans ce document sont offertes à titre informatif seulement et ne doivent pas être considérées comme une offre ou une sollicitation visant l‟achat ou la vente d‟un titre, d‟un produit ou d‟un service quelconque, ni interprétées comme un conseil de placement précis. Le contenu du présent document est la propriété exclusive d‟IPSOL Capital Inc. et ne doit pas être distribué sans son consentement préalable. 18
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