Maxime Tessier

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

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- '0

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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

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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

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ST

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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

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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)