Minimum volatility is a risk based approach which has been an active research area since the 1970s when it was first documented that low risk stocks tend to outperform high risk stocks over time and across markets. This identification has been one of the biggest challenges to CAPM and the results are corroborated in recent studies. The MSCI World Minimum Volatility Index targets the performance characteristics of a minimum variance strategy by adding a set of volatility constraints onto an existing parent cap weighted index, such as the MSCI World Index. The result is an index that has exhibited lower realized volatility (around 30% less) compared to the parent index but with similar historical total returns. Historically the MSCI World Minimum Volatility Index has shown a bias towards more defensive securities with lower idiosyncratic risks compared to the parent index.
Global REI portfolios closely approximate the risk characteristics of the benchmark with the focus on adding value through stock selection by exploiting stock specific ideas. Our investment process for the Global REI Minimum Volatility strategy combines fundamental research with disciplined portfolio management and implementation whilst the goal of the portfolio is to deliver 0.75% to 1% of annualised excess returns (gross) at a tracking error of 0.75% to 1.25% versus its benchmark.
Our strategy displays the same characteristics as the benchmark. Uncompensated risk is minimised using a portfolio construction framework which limits stock specific, sector, region, style and country risks as well as trading costs. Regional and sector weights are neutral to the regional benchmark sector weightings. Stock positions are constrained to within a range of +/-0.5% relative to the benchmark for the Global REI. The outcome is a portfolio where approximately 75% of the active risk is stock specific.
We monitor portfolio factor exposures daily using BARRA’s risk model to ensure that any style or theme positions are controlled, as well as to ensure that an acceptable level of tracking error is maintained. Daily supervision and monitoring across all portfolios ensures that each portfolio is consistent with the chosen target. We rebalance the portfolio monthly to ensure that the fundamental and risk factors and sector weights are consistent with the benchmark. Portfolio managers also make use of other risk models which serve to provide a deeper insight into the sources of risk. These systems allow analysis on a style bias, size bias and a number of other measures, giving our portfolio managers a deep understanding of the breakdown and contribution of risk within the portfolio. While BARRA and other risk models are an important part of our investment process, the stock specific research of our fundamental analysts and their in-depth knowledge of the factors that drive the profitability of each company in their universe is not only key to adding value via outperformance, but is equally important as fundamental risk controls to steer away from investing in those companies with very high unrewarded risk. Our portfolio construction process uses a proprietary transaction cost model, ensuring that only cost-efficient trades are presented to the traders for execution. The model estimates the cost of a trade in terms of its size, traded exchange, and general market tone. This ensures that the resulting portfolio is liquidity sensitive; increasing our confidence that expected value added can be captured. We rebalance the portfolio monthly, with the exception of some ad hoc trading that count for a minimal part of our turnover. The annual turnover is around 40% each way.
Exploiting Stock Specific Ideas
The most distinctive element in our stock selection process is our commitment to proprietary fundamental research, the primary driving force behind the value we add. Our in-house equity analysts follow around 2000 securities in global equity markets. They conduct fundamental research within their sectors making site visits to companies, speaking with company management, gathering information on competitors, and engaging in discussions with a wide range of industry participants and experts in order to arrive at their estimates of future cash flow, earnings, and dividends. These estimates are systematically captured through our uniform valuation model.
Our network of approximately 70 in-house fundamental research analysts have, on average, 17 years industry experience and 12 years with the firm. Each analyst provides proprietary company forecasts to identify the most likely out/underperforming stocks in his/her sector and region. Their in-house experience adds integrity to the successful REI track record. Our research analysts research more than 1,750 companies within the developed World equity markets. Their extensive coverage allows us to manage diversified regional equity portfolios required to focus risk budget on the stock specific research of our analyst team. As the analysts conduct proprietary research, we are able to create a genuine information advantage that gives us the potential to deliver strong investment returns to our clients.
Regardless of which sector or region of the world they cover, all our analysts utilize the same analytic framework, J.P. Morgan’s Dividend Discount Model (DDM).
Based upon their research (analysis of corporate financial statements, meetings with company management, knowledge of the sector, etc.), analysts generate earnings and cash flow estimates with an emphasis on forecasting each company’s normalized, i.e. mid-cycle or sustainable, level of earnings and the rate at which those normalized earnings are expected to grow over the intermediate term. This focus on intermediate, “normalized” earnings ensures: (a) that we value companies based on their sustainable level of earnings rather than on peak or trough earnings and (b) allows us to identify attractively valued companies sooner than other firms that focus on just short-term estimates one to two years out.