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A Better Way to Assess Global Risk & Return Ronnee Ades Senior Director, Institutional Markets
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A Better Way to Assess Risk & Return AGENDA Risk Management Index Methodology Market Representation Market Segmentation Conclusions
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A Better Way to Assess Risk & Return Risk Management Trustees Money Managers Consultants Investment Strategy Decision Making
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A Better Way to Assess Risk & Return Risk Management Pension Plan’s #1 Objective: Meet Funding Obligations Pension Plan’s #1 Problem: Projected Payments Out > Projected Payments In
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A Better Way to Assess Risk & Return Risk Management The Plan Sponsor’s Responsibility to Meet Funding Obligations involves the process of Risk Management. The overall goal of the risk management process should be an investment fund having well understood and desirable risk and return characteristics.
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A Better Way to Assess Risk & Return Risk Management BUT what is risk? The definition of risk is variability of return. For the Pension Plan it is commonly the percentage change in assets over 1 Qtr., 1 year.
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A Better Way to Assess Risk & Return Risk Management—Developing an Investment Strategy Investment strategies behave differently relative to the chosen definitions of risk and return. The First step in the process requires assumptions about asset class behavior. Then you choose your Plan’s investment strategy (policy portfolio) having what you judge to be the optimal risk versus return trade off. Then you choose managers to implement the strategy. You may use passively managed index funds and/or add what may be termed implementation risk and hire active managers.
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A Better Way to Assess Risk & Return Risk Management Benchmarks are used in the process as: Proxies for Asset Class behavior Targets for Investment Return in passive portfolios Performance benchmarks for the active managers and also, their universe for stock selection
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A Better Way to Assess Risk & Return Index Methodology Knowing the construction parameters (methodology) of the popular benchmarks is critical to assessing the best choice for your Plan. Criteria for a good benchmark: Rules-based & transparent Market representation Market segmentation
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A Better Way to Assess Risk & Return Index Methodology—Market Representation Typical Investment Strategy Starts With a 60/40 Asset Allocation Equities 60% Fixed Income 40%
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A Better Way to Assess Risk & Return Index Methodology—Market Representation Actual Investing is Typically in Market Segments Large Cap 35% Fixed Income 40% International Equity 10% Small Cap 10% Alternative Investments 5%
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A Better Way to Assess Risk & Return Index Methodology—Rules Based Committee-based indexes Subjective selection Review frequency is usually as needed Examples – Dow Jones Industrial Average, S&P 500 Rules-based indexes Objective selection Review frequency are usually scheduled Examples – Dow Jones Wilshire 5000, Russell 2000
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A Better Way to Assess Risk & Return Index Methodology—Rules Based Rules–based and Representative David Blitzer from S&P on CNBC’s “Squawk on the Street”: “we were slightly underweight technology throughout most of the tech boom specifically because we look for companies that have at least a year of solid profit.” “…stood us in very good stead” Good stead versus what? – the market? Underweight versus what? – the market?
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A Better Way to Assess Risk & Return Wilshire 5000 Today Index Methodology—Market Representation Evolution of US Stock Market Benchmarks In the 1970s there was the S&P 500 Then in the 1990s there was the Russell 3000 And now there is the Dow Jones Wilshire 5000 1990s1970s DJW 5000 Russell 3000 S&P 500
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A Better Way to Assess Risk & Return Index Methodology—Market Representation The S&P 500 components are selected by committee, in private. The DJW 5000 is rules based and those rules are transparent. The S&P 500 components are not the 500 biggest stocks. In fact, after the top 350, they scatter down to nearly the 2000 rank within the DJW 5000. DJ Wilshire 5000S&P 500 Rank #1788
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A Better Way to Assess Risk & Return Index Methodology—Market Representation Evolution of Global Stock Market Benchmarks DJWG ~12000 FTSE ~7900 EAFE ~1140 ACWI ~2600 In 1969 there was the MSCI EAFE Then in 1987 there was the MSCI All-Country World Index Then in 1993 the FTSE World Index started And now there is the Dow Jones Global Total Market Index Today 1993 1987 1969
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A Better Way to Assess Risk & Return Depth of Coverage within the Counties Investable Universe Number of Countries Covered World INDEX B 50 Countries World INDEX A Investable Universe Investable Universe 40 Countries
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A Better Way to Assess Risk & Return Index Methodology—Market Segmentation Segmentation is a extension of Representation: How is the broad market sliced?: Industry Groups/Sectors Size Segments Style Segments
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A Better Way to Assess Risk & Return DOW JONES GLOBAL TOTAL MARKET INDEX Index Methodology—Market Segmentation Market Size Distinctions RUSSELL DOW JONES WILSHIRE S&P Small-Cap 1,750 Stocks Micro-Cap 2,500+ Stocks Large-Cap 750 Stocks Small-Cap 2,000 Stocks Large-Cap 1,000 Stocks Micro-Cap 2,000 Stocks Large-Cap 500 Stocks Small-Cap 600 Stocks Mid-Cap 400 Stocks Micro-Cap 0 Stocks US ~5000 World ExUS ~7000
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A Better Way to Assess Risk & Return Index Methodology—Market Segmentation YEARLY TOTAL RETURN PERFORMANCE Index 20052004200320022001200019991998199719961995 DJ Wilshire 5000 6.3412.6231.64-20.86-10.97-10.8923.5623.4331.2921.2136.45 DJ Wilshire U.S. Large-Cap Index 6.3811.6528.89-21.07-12.96-10.5021.9328.5932.9722.5237.61 DJ Wilshire U.S. Small-Cap Index 7.3719.46 49.02-18.983.13-9.0829.251.3524.8717.3831.07 DJ Wilshire U.S. Micro-Cap Index 1.2117.1883.20-8.7124.31-18.2940.995.9522.0217.8136.42 Shaded values indicate top-performing segments. 7.3719.46 83.20-8.7124.31 -9.08 40.99 28.5932.9722.5237.61
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A Better Way to Assess Risk & Return Index Methodology—Market Segmentation YEARLY TOTAL RETURN PERFORMANCE Index 20062007 DJ Wilshire Global DJ Wilshire Global Large-Cap Index DJ Wilshire Global Small-Cap Index ? ? 20082009201020112012201320142015 ? ?? ? ? ?? ?
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A Better Way to Assess Risk & Return Market Segmentation—Style Methodology Distinctions Factors used for Mapping Stocks into Growth and Value Segments Historical Trailing Revenue Growth Trailing Earnings Growth Current Price-to-Book Ratio Dividend Yield Projected Projected Earnings Growth Projected Price-to-Earnings Ratio DOW JONES WILSHIRERUSSELLS&P citi
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A Better Way to Assess Risk & Return Index Methodology—Market Segmentation Style Distinctions RUSSELL DOW JONES WILSHIRE Micro-caps Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value Micro-caps Large Cap Growth Large Cap Value Small Cap Growth Small Cap Value
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A Better Way to Assess Risk & Return Index Methodology We know that the Benchmarks are different – S&P 500 vs. DJW 5000 Over a 10 year period we can reasonably expect the returns will be significantly different 55% probability the 1 year return difference exceeds 1.5% 55% probability the 3 year return difference exceeds 1.0% 40% probability the 5 year return difference exceeds 1.0% 20% probability the 10 year return difference exceeds 1.0% Impact on $50 million @ 1% (100bps) = $500,000 It does matter in the long run – it does make a difference!
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A Better Way to Assess Risk & Return Compare Broad Market Managers to the Broad Market Benchmarks Should your Plan pay for BETA? Should a manager who had 5.75% return be given a performance bonus or potentially fired? ReturnsS&P 500Russell 1000DJW 750 6.34%6.27%4.91%1 Year 4.91%6.27%6.34% Comparative Index Returns, Major US Index Families As of December 31,2005 Large GROWTHVALUE S&PRussellDJWS&PRussellDJW 0.02%-0.31%-0.05%0.05%0.61%0.29% 1.27%2.98%3.12%2.94%1.27%1.61% 1.14%5.26%7.13%8.71%7.05%5.72% 11.20%13.23%14.36%17.69%17.49%16.16% -3.68%-3.58%-2.74%4.54%5.28%4.8% 8.47%6.85%7.61%9.60%11.24%10.29% ReturnsS&P 500Russell 1000DJW 750 1 Month0.03%0.14%0.13% 3 Months2.09%2.12%2.32% 1 Year4.91%6.27%6.34% 3 Years (% pa) 14.39%15.42%15.24% 5 Years (% pa) 0.54%1.07%1.01% 10 Years (% pa) 9.07%9.29%9.17%
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A Better Way to Assess Risk & Return 1 Year7.68%4.55%7.37% Compare Small-Cap Market Managers to the Small-Cap Benchmarks Should your Plan pay for BETA? Should a manager who had 5.75% return be given a performance bonus or potentially fired? ReturnsS&P 600Russell 2000DJW 1750 7.37%4.55%7.68%1 Year Comparative Index Returns, Major US Index Families As of December 31,2005 Small GROWTHVALUE S&PRussellDJWS&PRussellDJW -1.04%-0.15%0.54%-0.81%-0.77%-0.32% -0.48%1.61%2.49%1.24%0.66%0.85% 7.27%4.15%9.68%8.47%4.71%5.3% 22.69%20.93%25.4%22.28%23.18%22.75% 9.68%2.28%5.32%11.76%13.55%13.74% 10.69%4.46%7.13%14.25%13.31%13.73% ReturnsS&P 600Russell 2000DJW 1750 1 Month0.92%-0.46%0.10% 3 Months0.39%1.13%1.65% 1 Year7.68%4.55%7.37% 3 Years (% pa) 22.38%22.13%24.10% 5 Years (% pa) 10.76%8.22%9.82% 10 Years (% pa) 11.17%8.88%10.80%
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A Better Way to Assess Risk & Return Index Methodology Using indexes from multiple providers has serious implications for your investment strategy. What happens when you don’t use one consistent index methodology?
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A Better Way to Assess Risk & Return Methodology—Multiple Vendor Dilemma—An Example S&P 500 + S&P Mid Cap 400 + Russell 2000 Missing 250 names from the universe of 3000 Over 130 of top 750 stocks missing Double count 140 stocks with median market cap over $1 Billion Missing micro cap
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A Better Way to Assess Risk & Return Methodology—Multiple Vendor Dilemma—An Example Some Missing Companies Amazon.com Directv Group Fox Entertainment Group Genentech Kraft Foods
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A Better Way to Assess Risk & Return Methodology—Multiple Vendor Dilemma—An Example Double Counted Companies Callaway Golf Calpine Cooper Tire & Rubber Delta Air Line Goodyear Tire & Rubber
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A Better Way to Assess Risk & Return Methodology—Multiple Vendor Dilemma—The Point (on a global scale) S&P 500 + Russell 2000 + MSCI EAFE Gaps Overlaps
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A Better Way to Assess Risk & Return Trustees TRUSTEES Conclusions —The Process Begins and Ends with the Investors ConsultantsMoney Managers
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A Better Way to Assess Risk & Return Conclusions—What Every Trustee Should Know Benchmarks should be rules-based and transparent Objective Selection Scheduled Reviews
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A Better Way to Assess Risk & Return Today Conclusions—What Every Trustee Should Know The benchmark selected should provide the relevant opportunity set of stock market returns. 1990s 1970s DJW 5000 Russell 3000 S&P 500
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A Better Way to Assess Risk & Return Conclusions—What Every Trustee Should Know Discrete market size segments that add up to the total market Large Cap Fixed Income International Equity (Ex-US) Small Cap Alternative Investments Micro Cap Exclusive style segments with an emphasis on purity Growth Value Growth Value Greater explanatory power (of Benchmark Mismatch, Asset Class Misfit, Alpha) can be obtained by using an index family with: Risk management in the global space requires: Rules Based Indexes Consistent Methodology Size and Style (growth/value) segmentation matters.
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A Better Way to Assess Risk & Return Conclusions Not all Benchmarks are the same Don’t make the Benchmark decision lightly Seek information from the index provider Dow Jones Wilshire: A Better Way to Assess Risk & Return
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