Post on 14-Aug-2015
CIBC Global Asset Management Inc.CIBC Global Asset Management Inc.
Building Better Benchmarks: A top-down approach
Presented by Maxime TessierVice President, Currency ManagementGlobal Asset Allocation
12/05/05 | Page 2
The problem with capitalization-weighted benchmarks
If not capitalization-weighted, then what?
Some insights
AGENDA
12/05/05 | Page 3
The problem with capitalization-weighted benchmarks
12/05/05 | Page 4
Evolution of the Equity Benchmark
1952Harry Markowitz proposes
Mean-Variance Optimization inPortfolio Construction
1964Sharpe, Lintner, Mossin
identify ‘Market Portfolio’ - CAPM
1974Barr Rosenberg (Barra) presents a
Factor Model to provide Betaestimates for individual securities
Birth of MPT
70s and 80sRapid Growth in usage of
CAPM statisticsand optimization concepts by
Investment Managers
80s and 90sSecular Bull Market in Equities
culminates in P/E ratiosnobody has ever seen before
Rapid Growth ofIndex Funds
Improved Technology
2005FTSE, Bob Arnott and Research
Affiliates begin launching RAFI fundamental-based Index funds
12/05/05 | Page 5
Global Equity Returns vs. Capitalization
Returns vs. Market Cap - Equities
US
SG
SW
NO
NL
JP
IT
HK
UK
FR
ES
DK
BD
SD
BG
AU
AT
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
10,000 100,000 1,000,000 10,000,000 100,000,000Market Cap (in Millions - Log Scale)
An
nu
aliz
ed R
etu
rns
(30
Yea
rs -
'76
- '0
5)
12/05/05 | Page 6
Global Bond Returns vs. Capitalization
Returns vs. Market Cap - Bonds
US
UK
SW
ES
NL
JP
IT
BD
FR
DK
BG
AU
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
10000 100000 1000000 10000000Market Cap (in Millions - Log Scale)
An
nu
aliz
ed
Re
turn
s (1
8 Y
ears
- '8
8 -
'05
)
12/05/05 | Page 7
Currency Returns vs. Capitalization
FX Returns vs. Market Cap (Equity or Bond) - Currencies
AU
DKJP
UK
US
EUAU
DKJP
UK
US
EU
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
10000 100000 1000000 10000000 100000000Market Cap (in Millions - Log Scale)
An
nu
aliz
ed
Re
turn
s (3
0 Y
ea
rs -
'76
- '0
5)
EQUITY CAPBOND CAP
12/05/05 | Page 8
Global Equity Risk vs. Market Capitalization
Standard Deviation vs. Market Cap - Equities
US
SG
SW
NO
NL
JP
IT
HK
UK
FRES
DK
BD
SD
BG
AUAT
10%
15%
20%
25%
30%
35%
10,000 100,000 1,000,000 10,000,000 100,000,000Market Cap (in Millions - Log Scale)
An
nu
aliz
ed S
tDev
(3
0 Y
ears
- '7
6 -
'05)
12/05/05 | Page 9
Global Bond Risk vs. Market Capitalization
Standard Deviation vs. Market Cap - Bonds
AU
BGDK
FR
BD
IT
JP
NLESSW
UK
US
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
10000 100000 1000000 10000000Market Cap (in Millions - Log Scale)
An
nu
aliz
ed
StD
ev
(18
Yea
rs -
'88
- '0
5)
12/05/05 | Page 10
Currency Risk vs. Market Capitalization
Standard Deviation vs. Market Cap (Using Equity Cap) - Currencies
AU
DK
JP
UK
US
EU
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
10,000 100,000 1,000,000 10,000,000 100,000,000Market Cap (in Millions - Log Scale)
An
nu
aliz
ed
ST
de
v(3
0 Y
ea
rs -
'76
- '0
5)
12/05/05 | Page 11
Sharpe Ratio vs. Market Cap
Sharpe Ratio vs. Market Cap - Equities
US
SG
SW
NO
NL
JPIT
HK
UK
FR
ES
DK
BD
SD
BG
AU
AT
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
10,000 100,000 1,000,000 10,000,000 100,000,000Market Cap (in Millions - Log Scale)
Sh
arp
e R
atio
(30
Yea
rs -
'76
- '0
5)
12/05/05 | Page 12
Sharpe Ratio vs. Market Cap
Sharpe Ratio vs. Market Cap - Bonds
AU
BG
DK
FR
BD
IT
JP
NL
ES
SWUK
US
0.25
0.35
0.45
0.55
0.65
0.75
0.85
0.95
1.05
10000 100000 1000000 10000000Market Cap (in Millions - Log Scale)
Sh
arp
e R
ati
o(1
8 Y
ea
rs -
'88
- '0
5)
12/05/05 | Page 13
Sharpe Ratio vs. Market Cap
Sharpe Ratio vs. Market Cap (Using Equity Cap) - Currencies
EU
US
UK
JP
DK
AU
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
0.40
0.50
0.60
10,000 100,000 1,000,000 10,000,000 100,000,000Market Cap (in Millions - Log Scale)
Sh
arp
e R
atio
(30
Yea
rs -
'76
- '0
5)
12/05/05 | Page 14
Summary of Observations
• Empirically, larger markets have not necessarily delivered higher risk-adjusted returns.
• Large markets are sometimes the riskiest markets (Japanese govt. bonds over the past 18 years…)
12/05/05 | Page 15
If not capitalization-weighted,then what?
12/05/05 | Page 16
Building a better benchmark
OBJECTIVE
• Choose an intuitive approach to setting weights: technical movements, fundamental values, etc…
• Starting from a common index, adjust the cap-weighted benchmark so that it captures higher risk-adjusted returns based on simple, replicable rules.
• Keep weight adjustments relatively small so as to not incur high transaction costs or liquidity issues.
12/05/05 | Page 17
Set a 2% minimum weight in each country in the MSCI World and reduce the weights of the other countries on a pro-rated basis.
Back tested results, 1976 – 2005. Weights are set at each year-end. Rebalanced Annually.
Benchmark change #1: Global Equity
MSCI WORLD MIN WEIGHT BENCHAnnualized Return 13.12%Annualized Standard Deviation 15.84%MSCI WORLDAnnualized Return 12.46%Annualized Standard Deviation 15.72%
Return +66bps
Risk +12bps
12/05/05 | Page 18
Ranking countries based on their normalized values versus their 5-Year moving averages. Starting from a 2% minimum weight, adjust weights either up by 1%, down by 1%.
Benchmark change #2: Global Equity
MSCI WORLD CUSTOM BENCHAnnualized Return 12.23%Annualized Standard Deviation 13.40%MSCI WORLDAnnualized Return 11.94%Annualized Standard Deviation 13.55%
Back tested results, 1979 – 2005. Weights are set at each year-end, portfolio rebalanced monthly. Transaction costs of 15bps per trade are assumed.
Return +29bps
Risk -15bps
12/05/05 | Page 19
Set a 2% minimum weight in each currency in the MSCI World and reduce the weights of the other countries on a pro-rated basis.
Back tested results, 1976 – 2005. Weights set annually.
Benchmark change #1: Currencies
MSCI WORLD MIN WEIGHT FX BENCHAnnualized Return 0.13%Annualized Standard Deviation 7.58%MSCI WORLDAnnualized Return -0.09%Annualized Standard Deviation 7.31%
Return +22bps
Risk +27bps
12/05/05 | Page 20
Ranking currencies based on their values versus their 5-Year moving averages. Starting from a 2% minimum weight, adjust weights either up by 1%, down by 1% based on mean reversion principle.
Benchmark change #2: Currencies
Back tested results, 1979 – 2005. Weights are set at each year-end, portfolio rebalanced monthly. Transaction costs of 15bps per trade are assumed.
Return +94bps
Risk -37bps
MSCI WORLD CUSTOM FX BENCHAnnualized Return 0.27%Annualized Standard Deviation 6.15%MSCI WORLD FX RETURNSAnnualized Return -0.67%Annualized Standard Deviation 6.52%
12/05/05 | Page 21
If the two benchmarks are combined to form a Global Equity and FX Benchmark
Putting it all together
Back tested results, 1979 – 2005. Weights are set at each year-end, portfolio rebalanced monthly. Transaction costs of 3bps for FX, 15bps for Equity.
Return +99bps
Risk -37bps
MSCI WORLD CUSTOM FX & EQ BENCHAnnualized Return 12.93%Annualized Standard Deviation 13.18%MSCI WORLD RETURNSAnnualized Return 11.94%Annualized Standard Deviation 13.55%
12/05/05 | Page 22
Custom Benchmark vs. MSWorld Cumulative Performance
100
350
600
850
1100
1350
1600
1850
2100
2350
2600
2850
3100
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Custom BenchMSWORLD
Some Performance Statistics
COMBINED CUSTOM BENCH VS. MSCI WORLD
# Up Months 175# Down Months 149
Max # Consecutive Up Months 9Max # Consecutive Down Months 7
Worst 1M Underperformance -2.00%Worst 12M Underperformance -7.38%
Annual tracking error vs. MSWorld 2.75%
12/05/05 | Page 23
Some Insights
12/05/05 | Page 24
Establishing why this works
EQUITIES• Smaller-Cap Bias• Diversification of exposure• Sector Bias?
Currencies• Carry earned by holding smaller cap currencies adds performance over most periods. (liquidity premium)• Diversification of exposure
12/05/05 | Page 25
Benefits and further research
• Enhanced return from a cap-only approach to benchmarking.
• Risk-reduction through greater diversification.
• Increased breadth by allowing managers more room to express over/under weight strategies.
• More research: New ways to assign benchmark weights (valuation, valuation-indifferent); Dynamic
weight processes (technical or fundamental)