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For Professional Investors Only Beyond Traditional Beta
Deutsche Bank AG 1. Introduction
Deutsche Asset
& Wealth Management
db X-trackers ETF Team As a growing number of financial indices are developed to offer
Winchester House exposure to investment strategies in a systematic way, investors
1 Great Winchester Street are confronted with new challenges.
London EC2N 2DB
United Kingdom How should they evaluate these non-traditional indices? What
distinguishes a valid strategy index from one based on a random
Hotline: +44 (20) 7547 1747 back-test? Where does the dividing line between index-based and
etf@db.com discretionary fund management now lie? Does an asset-based or
www.etf.deutscheawm.com factor-based approach to portfolio allocation make more sense?
1
On p.18 we outline Deutsche AWMs experience in managing passive investment mandates and the role of Deutsche Banks quantitative equity research team.
Fama-French/Carhart
publish studies of size,
1990s value/momentum equity
market factors
First ETFs launched
2000s extended
Rapidly increasing
usage of ETFs, index
funds
Popularisation of factor-
based investment
2010s strategies
Indexing overlaps with
quantitative investment
management
The first step in the traditional process is to set target portfolio weightings
(or weighting ranges) for individual asset classes, such as bonds, equities
and alternatives. The key inputs in determining these target weightings are
long-term estimates of individual asset classes returns and volatility,
together with estimates of intra-asset class correlations. Allocations to
individual equity and bond markets (or market regions) are typically also
made at this first stage.
A traditional asset allocation process usually starts with the most important
decision, i.e., the strategic asset class targets. Overall, the equity/bond
split can be seen as the key decision from a return perspective: given
equities greater historical volatility and long-term return premium over
bonds, portfolios with greater risk appetite and higher return expectations
target a higher equity weighting, while those with more conservative risk
appetite target higher bond weightings.
A 60/40 target equity/bond weighting split has been called the classic
asset allocation recipe (Mesomeris, Wang, Salvini, Assetand-Fenoel,
2012). According to Christopher Brightman of Research Affiliates, a 60/40
portfolio of US equities and US bonds generated a nominal return of 7.6%
per annum and a real (post-inflation) return of 5.4% per annum over a
period of more than a century (1871-2010: Brightman, 2012).
Many US pension funds currently have long-term return targets that are
consistent with a 60/40 target asset allocation and with the expected
continuation of its historical returns: according to Boston Colleges Centre
for Retirement Research, the mean long-term nominal return assumption
2
of US pension funds in 2012 was 7.75% (Munnell, Aubry, Hurwitz, 2013).
2
In Europe pension funds return targets are somewhat lower. According to a survey of 190 European
pension funds with combined assets of 1.9 trillion, published in November 2014 by Create Research, the
median long-term nominal return expectation (net of fees) is 5% a year (Rajan, 2014).
7%
93%
Figure 3 (see previous page) shows that equity risk dominates the overall
risk of a 60/40 portfolio consisting of US equities and 10-year US
government bonds (equity risk contributed 93% of the portfolio risk during
1992-2014). And, based on a five-year rolling view of risk contribution,
equities contributed 90% or more of risk at certain points during this
historical window.
80%
60%
40%
20%
0%
Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14
Average Pairwise Correlation
Source: Source: Deutsche Bank AG, Bloomberg Financial LP, 01/01/1991-31/12/2014, based on three-year rolling returns
and first three-year period ending 01/01/1994.
3. Factors Explored
As outlined in the previous section, a shift has taken place amongst both
academics and practitioners regarding the sources of equity portfolio
returns.
Fama and French found that, based on 50 years of equity market data,
there was only a weak relation between beta (as understood in the CAPM
framework) and average stock returns. Instead, they found that a multi-
factor model using market beta plus two additional factors (size and value)
had much better explanatory power.
where:
Screening Factors
Below we explore in further detail the risk/return characteristics of these
factors. However, since all factors are identified by means of the study of
empirical data on securities returns, a question immediately arises: what
distinguishes a true factor from one that may be the coincidental result of
the data and period used for the analysis? In other words, how confident
can investors be that the factor characteristics identified in sample will
persist out of sample?
Explainable
Accessible Established
Equity
Factors
Persistent Attactive
For example, in the 1930s Graham and Dodd described their preferred
approach as the discovery of undervalued individual common stocks,
which presumably are available even when the general market is not
particularly low, and whose margin of safety resides in the discount at
which the stock is selling below its minimum intrinsic value.
Six decades later Fama and French described value (and size) as two of
the three factors (together with market risk) with significant ability to
explain stocks long-term returns.
Value can be measured in different ways, for example via stocks price-to-
book value ratios (the method used by Fama and French in their 1992
paper), their price-to-earnings ratios, their dividend yield or by a ratio of
standardised earnings to enterprise value.
In the DB Equity Value Factor Index, companies yield and earnings power
are compared to their sector averages and weightings are then neutralised
across sectors. This is done with the aim of ensuring that structural
differences in value scores between different types of company do not
result in imbalanced sector weightings at the index level.
Explanations for the existence of factor risk premia commonly fall into two
categories: risk-based and behavioural. The risk-based (or economic)
explanation is more consistent with concepts of market efficiency, since
the return associated with a factor risk premium is seen as compensation
to an investor for bearing a type of systematic risk. Behavioural
explanations for factor risk premia tend to focus more on investor
irrationality or on market inefficiencies.
Risk-based explanations for the value factor premium include: the higher
potential exposure of value stocks (given their low valuation) to financial
distress or default; higher cash flow risk; and value stocks greater
sensitivity (by comparison with growth stocks) to economic downturns.
In the DB Equity Quality Factor index, ROIC and change in accruals are
compared to their sector averages and weightings are then neutralised
across sectors. Financial stocks are excluded from the index as a result of
their special accounting characteristics.
The likely persistence of the accruals anomaly has been widely studied.
While some academics suggest that its effect has weakened over time (for
example, Green, Hand, Soliman, 2009), others argue that it will persist as
a reflection of behavioural inefficiencies among investors (Hirshleifer, Hou,
Teoh, 2012). Additionally, Deutsche Banks policy of combining accruals
and ROIC to measure a companys quality score means that low accruals
must be complemented by a real economic return.
The low beta anomaly is not a recent discovery: it was pointed out over
four decades ago (see Black, Jensen, Scholes, 1972) and confirmed by
Haugen and Baker in 1991 (Haugen, Baker, 1991). In other words, this
factor risk premium is one of the most well-established in academic
literature.
The most popular explanations for the existence of the low-beta anomaly
are behavioural. According to such theories, many investors overpay for
perceived lottery stocks - i.e., those that promise high rates of return -
leaving less glamorous low-beta stocks relatively underpriced and with the
ability to outperform. In chasing such stock market winners, investors may
be suffering from the behavioural trait of overconfidence (most
respondents to surveys seem to think they are better-than-average drivers,
or that they can outperform the stock market).
The persistence of the returns from low-beta investing has been well-
documented: Frazzini and Pedersen (2011) found that low-beta stocks had
outperformed in 18 of 19 global equity markets they studied. The authors
also documented a low-beta effect in government, corporate bond and
futures markets.
For example, during inflationary growth periods quality does relatively well,
while momentum and value tend to outperform low beta. In a stagflationary
period low beta does well, while momentum and quality outperform value.
The value factor performs best in reflationary and disinflationary periods
(see Figure 13, where the performance of the capitalisation-weighted
MSCI World index is also shown for reference).
Source: Deutsche Bank AG. The returns shown for the value, quality, momentum and low beta factors are based on the
returns of the Deutsche Bank Equity Factor Indices of the same name over the period 31.12.2000-31.12.2014. The Deutsche
Bank Equity Factor Indices have no prior operating history and the returns illustrated are based on the retroactive application
of the index methodology. Performance is calculated in total return USD and shown gross of dividend withholding tax,
rebalancing and index costs. Past performance, actual or simulated, is not a reliable indicator of future returns.
Equal Weighting;
Risk Parity Weighting (given the similar historical volatilities of the
four factors, this allocation is broadly similar to equal-weighting);
Momentum-based allocation (e.g., selecting the two of the four
factors with the highest 11-month momentum and allocating 70%
and 30%, respectively, to the factors with the highest and second-
highest momentum, respectively).
3
The DB Quantitative Strategy Group was ranked #1 in both the 2011 & 2012 All-Europe Institutional
Investor Research Survey and the 2011 & 2012 US Research Institutional Investor Survey. Both the
US and Europe teams were ranked in the top 3 in the Greenwich Survey for 2011.
Source: Deutsche Bank AG, Bloomberg LP, 31.10.2001 31.12.2014. The DB Equity Factor Indices have no prior operating
history before September 2014. All performance data is simulated and calculated by means of a retrospective application of
the index methodology before the launch date . Performance is calculated in total return USD and shown gross of dividend
withholding tax, rebalancing and index costs. Past performance, actual or simulated, is not a reliable indicator of future
results.
vs MSCI World over previous one year period.
2
vs MSCI World over the observation window starting on 31.10.2000 and ending on 31.12.2014.
References
Allen, E., Larson, C., Sloan, R., Accrual Reversals, Earnings and Stock
Returns, 2011
Alvarez, M-A., Kassam, A., Mesomeris, S., Factor Neutralization and Beyond,
2010
Ang, A., Goetzmann, W., Schaefer, S., Evaluation of Active Management of
the Norwegian Government Pension Fund Global, 2009
Asness, C., Moskowitz, T., Pedersen, L., Value and Momentum Everywhere,
2012
Baker, M., Bradley, B., Wurgler, J., Benchmarks as Limits to Arbitrage:
Understanding the Low-Volatility Anomaly, 2011
Bender, J., Briand, R., Nielsen, F., Stefek, F., A New Approach to
Diversification, 2010
Black, F., Jensen, M., Scholes, M., The Capital Asset Pricing Model: Some
Empirical Tests, 1972
Brightman, C., Expected Return, 2012
Bruder, B., Roncalli, T., Managing Risk Exposures Using the Risk Budgeting
Approach, 2012
Chan, K., Chan, L., Jegadeesh, N., Lakonishok, J., Earnings Quality and Stock
Returns, 2001
Daniel, K., Moskowitz, T., Momentum Crashes, 2013
Fairfield, P., Whisenant, S., Yohn, T., Accrued Earnings and Growth:
Implications for Future Profitability and Market Mispricing, 2003
Fama, E., French, K., The Cross-Section of Expected Stock Returns, 1992
Frazzini, A., Pedersen, L., Betting against Beta, 2011
Graham, B. and Dodd, D., Security Analysis, 1934
Green, J., Hand, J., Soliman, M., Going, Going, Gone? The Demise of the
Accruals Anomaly, 2009
Haugen, R., Baker, N., The Efficient Market Inefficiency of Capitalization-
Weighted Stock Portfolios, 1991
Hirshleifer, D., Hou, K., Teoh, S., The Accrual Anomaly: Risk or Mispricing?,
2012
Jegadeesh, N., Titman, S., Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency, 1993
Lan, Mercado, Rajendra, Gademsetty, Deutsche Bank ETF Annual Review &
Outlook, 2015
Markowitz, H., Portfolio Selection, 1952
Mesomeris, S., Wang, Y., Salvini, M., Avettand-Fenoel, J-R., A New Asset
Allocation Paradigm, 2012
Munnell, A., Aubry, J-P., Hurwitz, J., How Sensitive is Public Pension Funding
to Investment Returns?, 2013
Rajan, A., The Alpha behind Alpha: Rebooting the Pension Business Models,
2014.
Sharpe, W., Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk, 1964
Sloan, R., Do Stock Prices Fully Reflect Information in Accruals and Cash
Flows about Future Earnings?, 1996
Disclaimer
This marketing communication is intended for professional clients / qualified investors only.
The information contained in this document does not constitute investment advice. Complete
information on the sub-funds including risks can be found in the prospectus of Concept Fund
Solutions plc ("CFS") as well as the relevant supplements in their prevailing version. These and
the relevant key investor information documents constitute the only binding sales documents for
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Investors can obtain these documents along with copies of the articles of association and the
latest published annual and semi-annual reports from the Paying and Information Agent,
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free of charge, or download them from www.etf.db.com.
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Investors can obtain these documents for sub-funds that are admitted for distribution in Austria,
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