For professional investors only

Low volatility equities: think outside the box

I Low volatility equities: think outside the box I 3

Overview
The last five years have seen considerable volatility in global equity
markets. Unsurprisingly this has led to a certain wariness on the part of many investors with regard to equities.

Whilst understandable, if this disaffection with equities translates into

lower equity holdings, we believe investors risk missing opportunities in that asset class best qualified to provide positive real returns.

Low-volatility investing, grounded in the findings of quantitative finance,

exploits the higher risk-adjusted returns generated by low risk stocks.

In the past a low-volatility portfolio, optimised to have low absolute

risk, has generally delivered superior returns and better risk-adjusted returns than the market index: this has occurred over the long term.1

By not following the herd and instead opting for a low-volatility

strategy via run-of-the-mill stocks, we believe an investor could actually obtain better returns.

1 Source: Demystifying Equity Risk-Based Strategies: a simple Alpha plus Beta description, Raul Leote de Carvalho, Xiao Lu, Pierre Moulin, The Journal of Portfolio Management, Vol. 38, No. 3, Copyright 2012, Institutional Investor, Inc., published in final form at: http://www.iijournals.com/toc/jpm/38/3

For professional investors only

4 I Low volatility equities: think outside the box I

Seeking higher returns with low-volatility stocks

An approach to equity investing targeting superior returns with low-volatility stocks under controlled risk1 Empirical data have shown long-term outperformance2 A compelling investment approach, particularly in risk-off/risk-on periods, that could reap rewards for not following the herd We offer active and tailor-made strategies and funds Risk preferences can be adjusted over time if the environment changes Our approach is transparent, straightforward and can keep tracking error in check What is it all about?
Our quantitative analysts use statistical methods to analyse market prices and devise model-based strategies that take account of the risk of a stock. They do not look at the companys underlying business model, nor at its competitive position or the relative valuation that fund managers and investors use as a base for their share price expectations. They look at the variation of a stocks price and how the stock interacts with and reacts to market events. Generically this approach is known as a risk-based approach to investing. This approach has evolved over the years as academic research has demonstrated that a systematic approach, exploiting specific risk characteristics of a financial asset, can improve the trade-off between return and risk. Back in 1972, Professors Bob Haugen and James Heins discovered that low-risk stocks had in fact produced higher returns than those of high-risk stocks, at least since 19263. These and further studies have shown that the anomaly
4

French broker Jules Regnault in 1863 and French mathematician Louis Bachelier in 1900, assume that high-volatility stocks should have a higher return to compensate for the bigger risk. CAPM, a model for pricing individual securities or a portfolio, was developed in the early 1960s by several people, among whom William Sharpe, Harry Markowitz and Merton Miller jointly won a Nobel prize in economics. Under CAPM, the sensitivity of the price of an asset to the general market is called beta. In the 1990s, Eugene Fama and Kenneth French refined the approach and detailed the components of beta. They found that portfolios tilted towards value stocks of small capitalisations outperformed the market capitalisation portfolio5. The classic models are still in use in mainstream asset allocation and market pricing. Yet the data do not always fit these models. Rather than trying to find a super model that better fits the data, Haugen and others started to exploit the low-volatility anomaly. We now offer you this opportunity via an approach developed by our financial engineers that aims to meet investors needs in todays equity markets delivering, over time, equity-like returns at lower levels of risk.

existed over the period from 1926 to 1993, and our own work extends that to 2011. The classical asset-pricing model (CAPM) and the underlying efficient market hypothesis, with roots going back to work by

1 There is no guarantee that the performance objective will be achieved. Past performance or achievement is not indicative of current or future performance. 2 Source: Demystifying Equity Risk-Based Strategies: a simple Alpha plus Beta description, Raul Leote de Carvalho, Xiao Lu, Pierre Moulin, The Journal of Portfolio Management, Vol. 38, No. 3, Copyright 2012, Institutional Investor, Inc., published in final form at: http://www.iijournals.com/toc/jpm/38/3 3 Source: On the Evidence Supporting the Existence of Risk Premiums in the Capital Market, Robert A. Haugen and A. James Heins, Wisconsin working Paper Dec. 1972. 4 Source: R. Haugen, and Nardin Baker (1991), The Efficient Market Inefficiency of Capitalization-Weighted Stock Portfolios, Journal of Portfolio Management, vol. 17, No.1, pp. 3540, see also Baker, N. and R. Haugen (2012) Low Risk Stocks Outperform within All Observable Markets of the World. Chan, L., J. Karceski, and J. Lakonishok (1999), On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model, Review of Financial Studies, 12, pp. 937974. 5 Source: Fama, Eugene F.; French, Kenneth R. (1993). Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics

How does it work?

Low-volatility stocks can be seen as boring. Many fund managers do not just want steady returns, they want superior returns, for their professional pride, for their bonus, for their clients. Their future career and compensation depend on their ability to deliver higher returns, which they expect to find in riskier stocks. And this leads to a pumped-up demand for high risk stocks. Moreover, high risk stocks are typically story stocks those with a lot of news flow that make them easy to sell. Low-volatility stocks are those in profitable businesses with little leverage and no surprises. Dont expect your lottery ticket into a big bonus there. Or try convincing a CIO to add ketchup-maker Heinz to the model portfolio instead of the hot IT stock Apple! However, the reality is that patience is ultimately rewarded. While the outperformance of low-volatility stocks has now been documented for almost 90 years, there has recently been more interest in such stocks. One fact holds true: low-volatility stocks are particularly interesting in difficult or uncertain market environments. With the increased market volatility of the last three years, the attributes of defensive stocks have come to the fore. Low-volatility stocks are not only defensive and should therefore outperform a conventional market-cap index in falling markets they also come with alpha, which means that they outperform by a lot more than predicted by their beta. And because of their alpha, they manage to keep up with the marketcap index even in rising markets. It is only when equity markets rise too fast that they lag. But then, they still have competitive absolute returns in such periods. A portfolio invested in lowvolatility stocks is more weather proof. Investors dont need to worry about market timing as the portfolio is resilient in difficult times and performs well in good times. A decade of erratic returns in the equity markets has been pushing equity investors to look for approaches to invest in equity markets that differ from market capitalisation and generate better riskadjusted returns. Now several systematic, risk-based approaches to constructing portfolios are among the hottest topics in equity management. Some of them involve quite elaborate use of portfolio optimisers and a number of hypotheses to justify their use. Examples are the minimum variance, maximum diversification, equal-risk contribution approaches. All seem to have outperformed the market-cap index for many years and with lower volatility than the market-capitalisation indices.

6 I Low volatility equities: think outside the box I

Prove it!
William Sharpe invented and gave his name to the Sharpe ratio in 1966 and refined it in 1994. The ratio measures how well the return of an asset compensates the investor for the risk taken. The higher the ratio, the better it is. Our quantitative analysts have looked at the stocks in the MSCI World index of a thousand shares, over the period from January 1995 to December 2010. Thus, our research described above indicates a much better They looked at the volatility of the shares and put them in five equally-weighted groups from low-vol to high-vol. Exhibit 1: Sharpe Ratio of stocks ranked by volatility into equally weighted quintiles (Global Universe: Jan 1994 - Dec 2010)
0.70 0.60 Sharpe Ratio 0.50 0.40 0.30 0.20 0.10 1 2 3 4 5

These five groups are shown in exhibit 1 below. The lowvolatility group had an average volatility of 13.9%, over half that of the highest volatility group (27.4%). The Sharpe ratio of the low-vol group, at 0.61, was almost twice that of the highest group. The excess return over the cash rate was at 8.6% somewhat lower than the 9.4% of the highest volatility group, but above groups two and four.

return for risk at a lower volatility.

Lower volatility
Source: BNP Paribas AM, MSCI, Exshare

Higher volatility

I Low volatility equities: think outside the box I 7

Whats been going on so far?

THE FIRST-GENERATION RISK-BASED PORTFOLIO CONSTRUCTION STRATEGIES
There are broadly speaking five well-known first-generation risk-based portfolio construction strategies. All but the first provide exposure to low-volatility stocks.

Equally weighted (EW)

All stocks have equal weight

Minimum variance (MV) Portfolio seeks lowest ex-ante volatility Maximum diversification (MD)
Portfolio maximises the diversification ratio to spread risk

Equal risk budgeting (ERB) The stocksweights are inversely proportional

to their volatility

Equal risk contribution (ERC) The weights are chosen so that the risk contribution
is the same

A closer look at these strategies (see exhibits 2 and 3 below) shows that they are closely related and that they are sub-optimal.

The volatility anomaly explains most of the tracking error risk and excess returns, but the strategies were not designed specifically to fully exploit the anomaly.
Exhibit 2: Risk characteristics of first generation risk-based portfolio construction strategies Mkt Excess return over RF Volatility Sharpe ratio Excess return over BM Tracking error Information ratio Beta Maximum Drawdown Annual turnover -56% 10% 2.1% 18.1% 0.12 EW 5.7% 18.2% 0.31 3.6% 5.1% 0.70 0.96 -58% 39% ERB 5.9% 16.5% 0.36 3.8% 5.4% 0.70 0.87 -55% 37% ERC 5.6% 14.8% 0.38 3.5% 6.6% 0.52 0.81 -53% 58% MV long only 5.2% 9.9% 0.52 3.1% 13.1% 0.23 0.39 -29% 151% MD long only 4.8% 11.5% 0.41 2.6% 12.1% 0.22 0.48 -39% 162% MV 6.3% 9.1% 0.70 4.2% 15.2% 0.28 0.27 -22% 220% MD 6.2% 10.8% 0.58 4.1% 14.5% 0.28 0.36 -31% 296%

Source: R Leote de Carvalho, X Lu and P Moulin, The Journal of Portfolio Management, Spring 2012, Vol. 38, No. 3

For professional investors only

8 I Low volatility equities: think outside the box I

The pitfalls of these first-generation low-volatility strategies are that:

MV and MD are over-invested in defensive sectors MV and MD require many constraints to make them practical The beta and the tracking error risk against the market EW, ERB and ERC put too much focus on smaller cap stocks cap index are left at the mercy of the markets The risk budget allocated to the low-volatility anomaly is not controlled

Exhibit 3: Correlation of excess returns over MSCI World Index (Period dating from Jan-1997 to Dec-2010) EW EW ERB ERC MD long only MV long only
Source: R Leote de Carvalho, X Lu and P Moulin, The Journal of Portfolio Management, Spring 2012, Vol. 38, No. 3

ERB 88% 100%

ERC 79% 97% 100%

MD long only 33% 61% 75% 100%

MV long only 25% 57% 71% 96% 100%

100%

Whats new then?

At BNP Paribas Investment Partners (BNPP IP) our financial engineering department has been working on second-generation approaches.
These (1) focus on the volatility anomaly and efficient strategies to profit from it; (2) remain simple and transparent, removing all unnecessary complexity; and (3) correct the pitfalls of first generation strategies

We believe that:
Low-volatility stocks offer higher Sharpe ratios. Investors should select a priori the stocks with

The volatility anomaly is a sector-wide phenomenon

Adding constraints to traditional minimum variance

the lowest volatility in each sector, and then

Investors should build portfolios invested in these

portfolios is not the only way to address the high tracking error problem generally observed

stocks which take into account their specific constraints

For professional investors only

I Low volatility equities: think outside the box I 9

What can BNP Paribas Investment Partners offer?

We designed the BNP Paribas L1 Equity World Low Volatility fund1 with the aim of reducing risk versus the market cap weighted benchmark by 20% within a tracking error range of 5% to 7%2.

The fund offers downside protection3 with an asymmetric return profile

Largely aims to outperform the market cap index in falling markets. Aims to keep up with the market when its rising thanks to the positive alpha of the least volatile stocks.

It is particularly well suited to investors measured against market capitalisation benchmarks:

Proprietary strategy designed to take advantage of the low-volatility pricing anomaly Corrects the problem of very high tracking error of traditional minimum-variance strategies Well diversified equity portfolio exploiting the low volatility anomaly from all economic sectors and not only defensive ones.

Using the fund to complement or substitute the market cap index in portfolios could:
Lower the overall risk Improve risk-adjusted returns over the long term

For a complete description and definition of risks, please consult the last available prospectus of the fund. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

1 BNP Paribas L1 Equity World Low Volatility is a Compartment of the BNP Paribas L1 UCITS IV Compliant SICAV registered under the Luxembourg law. The fund is exposed as appropriate and including but not limited to the following risks: Credit, liquidity, volatility, currency and interest rate risk, the financial condition of the underlying obligors, general economic conditions, market price volatility, the condition of certain financial markets, political events and developments or trends in any particular industry. 2 These internal guidelines are mentioned for your information only and are subject to change. Prospectus guidelines are leading. 3 BNP Paribas Investment Partners doesnt provide any formal capital protection of the fund. No information given or any term used herein shall be interpreted to provide such protection.

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10 I Low volatility equities: think outside the box I

Questions & Answers

If many investors exploit the anomaly, will it not disappear? If the low-volatility anomaly is such a compelling investment proposition why HAS IT NOT become more prevalent?
The answer to this question is again to be found in the drivers of human behaviour in the good times, when money is easy and equities markets are rallying investors seek to take full advantage of the upside. They do not want to give up any of the potential outperformance in order to limit downside risk. All this changes when recessionary fears take hold and equity markets underperform. In the past the application of low volatility investing has been slowed by bull markets in equities where investors have seen little need for a safety net.

We believe that CAPM will remain the dominant portfolio construction model and attract the lions share of invested capital. Human behaviour is not easily changed, so many investors are likely to continue chasing risky stocks in the hope of quick returns. We expect the low volatility anomaly will be around for many years to come.

Where can I get more information? Your dedicated sales contact at THEAM will be happy to provide you with further information.

I Low volatility equities: think outside the box I 11

References Carvalho, R.L., Lu X., Moulin P., Demystifying Equity RiskBased Strategies: A Simple Alpha plus Beta Description, The Journal of Portfolio Management, Spring 2012 Vol. 38, No. 3 http://www.iijournals.com/doi/abs/10.3905/jpm.2012.2012.1.023 Ang, A., R. J. Hodrick, Y. Xing, and X. Zhang. The Cross-Section of Volatility and Expected Returns. The Journal of Finance, Vol. 61, No. 1 (2006), pp. 259-299. Baker, M., B. Bradley, and J. Wurgler. Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly. Financial Analysts Journal, Vol. 67, No. 1 (2011) pp. 40-54. Blitz, D. C., and P. van Vliet. The Volatility Effect. The Journal of Portfolio Management, Vol. 34, No. 1 (2007) pp. 102-113. Clarke, R., H. de Silva, and S. Thorley. Minimum-Variance Portfolio Composition. The Journal of Portfolio Management, Vol. 37, No. 2 (2011) pp. 31-45. Choueifaty, Y., and Y. Coignard. Towards Maximum Diversification. The Journal of Portfolio Management, Vol. 34, No. 4 (2008) pp. 40-51. Fama, E. F., and K. R. French. The Cross-Section of Expected Stock Returns. Journal of Finance, Vol. 47, No. 2, (1992) pp. 42765. Fama, E. F., and K. R. French. The Capital Asset Pricing Model: Theory and Evidence. The Journal of Economic Perspectives, Vol. 18, No. 3 (2004) pp. 25-46. Haugen, R., and N. Baker. The Efficient Market Inefficiency of Capitalization-Weighted Stock Portfolios. The Journal of Portfolio Management, Vol. 17, No. 3 (1991) pp. 35-40. Maillard, S., T. Roncalli, and J. Teiletche. The Properties of Equally-weighted Risk Contributions Portfolios. The Journal of Portfolio Management, Vol. 36, No. 4 (2010) pp. 60-70. Markowitz, H. Portfolio Selection. Journal of Finance, Vol. 7, No. 1 (1952) pp. 7791. Sharpe, W. F. Capital Asset Prices: A Theory of Market Equilibrium under conditions of Risk. Journal of Finance, Vol. 19, No. 3 (1964) pp. 425-442. Sharpe, W. F. A Simplified Model for Portfolio Analysis. Management Science, Vol. 9, No. 2 (1963) pp. 277-293.

This material is issued and has been prepared by BNP Paribas Asset Management S.A.S. (BNPP AM)*, a member of BNP Paribas Investment Partners (BNPP IP)** . This material is produced for information purposes only and does not constitute: 1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever or 2. any investment advice. This material makes reference to certain financial instruments (the Financial Instrument(s)) authorised and regulated in its/their jurisdiction(s) of incorporation. No action has been taken which would permit the public offering of the Financial Instrument(s) in any other jurisdiction, except as indicated in the most recent prospectus, offering document or any other information material, as applicable, of the relevant Financial Instrument(s) where such action would be required, in particular, in the United States, to US persons (as such term is defined in Regulation S of the United States Securities Act of 1933). Prior to any subscription in a country in which such Financial Instrument(s) is/are registered, investors should verify any legal constraints or restrictions there may be in connection with the subscription, purchase, possession or sale of the Financial Instrument(s). Investors considering subscribing for the Financial Instrument(s) should read carefully the most recent prospectus, offering document or other information material and consult the Financial Instrument(s) most re-cent financial reports. The prospectus, offering document or other information of the Financial Instrument(s) are available from your local BNPP IP correspondents, if any, or from the entities marketing the Financial Instrument(s). Opinions included in this material constitute the judgment of BNPP AM at the time specified and may be subject to change without notice. BNPP AM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, ac-counting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective clients investment portfolio. Given the economic and market risks, there can be no assurance that the Financial Instrument(s) will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. Past performance is not a guide to future performance and the value of the investments in Financial Instrument(s) may go down as well as up. Investors may not get back the amount they originally invested. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes. This document is directed only at person(s) who have professional experience in matters relating to investments (relevant persons). Any investment or investment activity to which this document relates is available only to and will be engaged in only with Professional Clients as defined in the rules of the Financial Services Authority. Any person who is not a relevant person should not act or rely on this document or any of its con-tents. *BNPP AM is an investment manager registered with the Autorit des marchs financiers in France under number 96-02, a simplified joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris 319 378 832. www.bnpparibas-am.com ** BNP Paribas Investment Partners is the global brand name of the BNP Paribas groups asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner. This document is an abridged and simplified version of the following article: Demystifying Equity Risk-Based Strategies: an Alpha plus Beta description, Raul Leote de Carvalho, Xiao Lu, Pierre Moulin, The Journal of Portfolio Management, Vol. 38, No. 3, Copyright 2012, Institutional Investor, Inc., is published in final form at: http://www.iijournals.com/toc/jpm/38/3

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