CSV Analysis - Qwafafew

Jose Menchero
Global Cross-Sectional
Volatility Analysis
2009. All rights reserved.
Outline
Global Factor Model
Industry versus Country
Diversification Potential, Correlation, and MAD
Regional and Size Differences
Cross-Sectional Volatility (CSV) Analysis
Why is CSV important?
CSV Factor Decomposition
Empirical Results: Styles, Industries, Countries
2
Global Factor Model
Global Factor Model
Model derived from Barra Global Equity Model (GEM2):
1 World factor
Country factors with (0,1) exposure
24 Industry Groups (GICS
) with (0,1) exposure

8 style factors (derived from GEM2)
Estimate factor returns by regression:
4
n
s
s ns
i
i ni
c
c nc w n
u f X f X f X f r + + + + =

Factor Models for Study
Build separate factor models for each region:
48 countries in MSCI ACWI IMI
24 emerging markets in MSCI ACWI IMI
16 countries in MSCI Developed Europe (ACWI IMI)
Use global-relative standardization for style factors
Estimate models using cap-weighted (WLS) and equal-
weighted (OLS) regression
5
Estimating Factor Returns
6
is the weight of stock n in factor portfolio k
n
s
s ns
i
i ni
c
c nc w n
u f X f X f X f r + + + + =

O =
n
n kn k
r f
Pure factor returns
Constraint:
0
c c
c
w f =
Cap-weighted country factor returns

sum to zero
Constraint:
0
i i
i
w f =
Cap-weighted industry factor returns

sum to zero
kn
O
Interpreting Factor Portfolios
Pure country factor portfolios go long the country and go
short the World; they have zero industry exposure
Pure industry factor portfolios go long the industry and go
short the World; they have zero country exposure
Pure style factor portfolios have unit exposure to the style
and zero exposure to all other factors
Adding World factor to country (industry) factor creates
100% net-long factor with neutral industry (country)
exposures
7
Pure Pure Pure Pure Pure
Market World Japan US Auto Volatility
Segment Factor Factor Factor Factor Factor
World (Net) 100.00 0.00 0.00 0.00 0.00
Long 100.00 109.75 66.03 128.46 62.32
Short 0.00 -109.75 -66.03 -128.46 -62.32
Japan (Net) 10.72 89.28 -10.72 0.00 0.00
Long 10.72 89.28 0.35 45.98 5.76
Short 0.00 0.00 -11.07 -45.98 -5.76
US (Net) 35.42 -35.42 64.58 0.00 0.00
Long 35.42 6.31 64.64 20.30 22.91
Short 0.00 -41.73 -0.06 -20.30 -22.91
Auto (Net) 2.41 0.00 0.00 97.59 0.00
Long 2.41 6.71 0.84 97.59 1.29
Short 0.00 -6.71 -0.84 0.00 -1.29
Japan Auto (Net) 1.15 6.71 -0.47 45.98 0.16
Long 1.15 6.71 0.09 45.98 0.41
Short 0.00 0.00 -0.56 0.00 -0.25
US Auto (Net) 0.18 -0.90 0.55 8.18 0.45
Long 0.18 0.00 0.55 8.18 0.46
Short 0.00 -0.90 0.00 0.00 0.00
Example of Pure Factor Portfolios (6-30-2009)
Country factors
have zero
exposure to
industries.
Industry factors
have zero
exposure to
countries.
Adding World
factor to country
factors produces
100% net-long
portfolio in a single
country, with
neutral industry
exposures
8
Industry vs Country
The Algebra of Country/Industry Risk
10
w
f (return of World factor)
k
f (return of long/short country/industry factor)
return of net long country/industry factor
k w k
f f f = +
1/ 2
2 2
,
2
k w k w k k w
o o o o o
(
= + +

Volatility of net long
country/industry factor
World factor can be added to country (industry) factor to create
100% net long factor with neutral industry (country) exposure
The Geometry of Country/Industry Risk
11
k
u
k
u
k
o
k
o
w
o
2 2 2
,
2
k w k w k k w
o o o o o = + +
Variance of net long factor
( )
cos
k k
u =
( )
cos
k k
u =
Correlation of long/short factor with World
Correlation of net long factor with World
k
o As decreases, net long
factor becomes more
correlated with the World
Diversification Potential (DP) and Correlation
Diversification Potential measures volatility reduction that can
be achieved by investing in the World portfolio rather than
the country factor or industry factor
Use either equal-weighted or regression-weighted averages
12
k
k
w
DP
o
o
=
k
k
k
w
DP w
o
o
| |
=
|
\ .
Diversification
Potential
k k
k
w =
Mean correlation between countries

or industries and the World
DP and Correlation for World (48 Countries)
13
Countries dominated
from 1997-1999
Industries dominated
from 2000-2002
Overall, the two effects
are comparable strength
DP was high during
internet bubble period
DP is now at an all-time
low
Year
1997 1999 2001 2003 2005 2007 2009
V
a
l
u
e
0.4
0.6
0.8
1.0
1.2
1.4
1.6
Countries (World)
Industries (World)
Diversification
Potential
Correlation
Cap-weighted Results
DP and Correlation for EM (24 Countries)
For emerging markets,
country effects always
dominate industries
Even before Oct 2008,
DP seemed to be in
secular decline
DP is now at an all-time
low
14
Year
1997 1999 2001 2003 2005 2007 2009
V
a
l
u
e
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
Countries (EM)
Industries (EM)
Diversification
Potential
Correlation
DP and Correlation for Dev. Europe (16 Countries)
For developed Europe,
industry effects clearly
dominate countries
Industry diversification
was particularly strong
during internet bubble
15
Year
1997 1999 2001 2003 2005 2007 2009
V
a
l
u
e
0.4
0.6
0.8
1.0
1.2
1.4
1.6
Countries (Euro 16)
Industries (Euro 16)
Diversification
Potential
Correlation
Diversification Potential: Empirical Results
Period: Jan-97 to Jul-09, Cap-Weighted Regression
Industries dominate countries in Europe
Countries dominate industries in emerging markets
Country DP increases for equal-weighted case due to
effect of highly volatile small countries
16
Country (Cap Weighted) (Equal Weighted)
Scheme Countries Industries Countries Industries
48 ACWI 1.21 1.19 1.68 1.18
16 Europe 1.11 1.22 1.22 1.26
24 Emerging 1.41 1.17 1.54 1.21
Diversification Potential: Small-cap vs Large-cap
Sample period: Jan-97 to Jul-09 (151 months)
OLS probes small-cap stocks, WLS probes large-caps
Countries dominate industries when using OLS regression
Country effects remain strong for small-cap stocks
Industry effects are weaker at the small-cap level
17
Country Regression (Regression Weighted)
Scheme Scheme Countries Industries
48 ACWI WLS 1.21 1.19
48 ACWI OLS 1.38 1.09
World Volatility: Cap-weighted vs Equal-weighted
Volatility of World
portfolio is largely
insensitive to stock-
weighting scheme
18
Year
1997 1999 2001 2003 2005 2007 2009
W
o
r
l
d

F
a
c
t
o
r

V
o
l
a
t
i
l
i
t
y
0
5
10
15
20
25
30
35
40
45
Cap Weighted (WLS)
Equal Weighted (OLS)
Volatility Ratio of OLS-to-WLS (48 Countries)
Country factors retain
strength in small-cap
segment
Industry factors weaken
in the small-cap regime
19
Year
1997 1999 2001 2003 2005 2007 2009
V
o
l
a
t
i
l
i
t
y

R
a
t
i
o

(
O
L
S
/
W
L
S
)
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
Countries (OLS/WLS)
Industries (OLS/WLS)
(OLS)
(WLS)
k
k
k
VR
o
o
=
1
k
k
VR VR
K
=

Mean Absolute Deviation (MAD) Measure
MAD measures the cap-weighted active return from
tactical allocation to the segment with perfect foresight
Compute rolling 12-month average
20
( )
k k
k C
MAD C w f
e
=
( )
k k
k I
MAD I w f
e
=
Mean Absolute Deviation, Countries

Mean Absolute Deviation, Industries
MAD for World (48-Country Model)
Use 12-month rolling
average
Countries dominate prior to
1999
Industries dominate from
2000-2003
Industries and countries
are comparable since 2003
21
Year
1997 1999 2001 2003 2005 2007 2009
M
A
D

(
p
e
r
c
e
n
t

m
o
n
t
h
l
y
)
0
1
2
3
4
5
Countries (World)
Industries (World)
MAD for Developed Europe (16-Country Model)
At start of period,
industries and countries
were comparable
Industries have strongly
dominated countries in
Europe since 1998
22
Year
1997 1999 2001 2003 2005 2007 2009
M
A
D

(
p
e
r
c
e
n
t

m
o
n
t
h
l
y
)
0
1
2
3
4
5
Countries (Dev. Europe)
Industries (Dev. Europe)
MAD for Emerging Markets (24-Country Model)
Country effects were
strongest in 1998-1999
For Emerging Markets,
countries strongly
dominate industries over
entire sample period
23
Year
1997 1999 2001 2003 2005 2007 2009
M
A
D

(
p
e
r
c
e
n
t

m
o
n
t
h
l
y
)
0
1
2
3
4
5
6
7
8
Countries (EM)
Industries (EM)
Cross-Sectional Volatility
(CSV) Analysis
What is Cross-Sectional Volatility (CSV)?
25
Return (percent)
-100 -80 -60 -40 -20 0 20 40 60 80 100
C
o
u
n
t
0
200
400
600
800
1000
1200
MSCI All Country
World Investable
Market Index
(ACWI IMI)
October 2008:
Mean Return: -23%
CSV: 18%
Return Distribution
Why is CSV Important?
26
CSV measures the opportunity for active management:
Aggressiveness Opportunity Skill
( )
A
A n n
n
R w r R =
Active Return
( )
( )
( )
2
2
2
2
1
( )
( )
A
n n
A
n
A n n
A
n n
n n
n n
w r R
R N w r R
N
w r R

Active Weight (Percent)
-1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5
R
e
l
a
t
i
v
e

R
e
t
u
r
n

(
P
e
r
c
e
n
t
)
-80
-60
-40
-20
0
20
40
60
80
100
120
Example: October 2008
27
Portfolio: MSCI World Value
Benchmark: MSCI ACWI IMI
Portfolio Return -15.80%
Benchmark Return -17.36%
Aggressiveness 5.11
Opportunity (CSV) 17.80%
Skill 0.0172
Active Return 1.56%
A Brief Digression: Risk Attribution
Identifies three drivers of time series volatility
Risk contributions are intuitive and fully additive
Aligns risk attribution model with investment process
28
t m mt
m
R x g =
Return Attribution, Period t

m
x =
Source Exposure;
( ) ( ) ( )
,
m m m
m
R x g g R o o =
Risk Attribution
x-sigma-rho formula
mt
g = Source Return
Exact CSV Decomposition
Identifies three drivers of cross-sectional volatility
Volatility contributions are intuitive and fully additive
CSV can be attributed to individual factors!
29
n n n
r u | = +
Return Decomposition (factor vs specific)
Explained CS Volatility
x-sigma-rho formula
( ) ( )
( ) ,
k k k
k
f X X o | o | =
n k nk
k
f X | =
Linear Factor Structure

Approximate CSV Decomposition
Collinearity among GEM2 factors is typically small
Reasonable and useful approximation:
Contribution to explained CSV is roughly proportional to
the squared factor return and the variance of factor
exposures
30
( )
( )
2
2
( )
k
k
k
X
f
o
o |
o |
~
No-collinearity
Approximation
Percent in Segment (p)
0 10 20 30 40 50
V
a
r
i
a
n
c
e

o
f

E
x
p
o
s
u
r
e
s
0.00
0.05
0.10
0.15
0.20
0.25
0.30
Variance of Factor Exposures
31
Style factors have cross-
sectional variance of 1
Country & Industry factors have
maximum CS variance of 0.25
( )
2
var( ) /100
k
X p p =
Typical CS variance of Country
& Industry factors may be 0.02
Explained vs Total CSV (12m Rolling Average)
32
Year
1997 1999 2001 2003 2005 2007 2009
M
o
n
t
h
l
y

C
S
V

(
P
e
r
c
e
n
t
)
0
2
4
6
8
10
12
14
16
Explained CSV
Total CSV
Wide variation in
CSV over time:
CSV peaks above
14% in 2000
CSV dips below 7%
from 2005-2007
Explained-to-Total CSV Ratio
33
Year
1997 1999 2001 2003 2005 2007 2009
C
S
V

R
a
t
i
o

(
r
o
l
l
i
n
g

1
2
m

a
v
e
r
a
g
e
)
0.3
0.4
0.5
0.6
0.7
CSV Ratio (Explained/Total)
CSV Ratio is
remarkably stable
about 0.5
Square of CSV
ratio is the Relative
R-squared of model
Explained CSV Attributed by Factor Type
34
Year
1997 1999 2001 2003 2005 2007 2009
M
o
n
t
h
l
y

C
S
V

(
P
e
r
c
e
n
t
)
0
2
4
6
8
10
Explained CSV
Countries
Industries
Styles
Contributions to
explained CSV vary
greatly over time
Countries dominate
prior to 1999
Styles dominate
from 2000-2004
Attribution of Styles CSV
35
Year
1997 1999 2001 2003 2005 2007 2009
M
o
n
t
h
l
y

C
S
V

(
P
e
r
c
e
n
t
)
0
1
2
3
4
5
Styles
Volatility
Momentum
Volatility factor is
largest contributor to
Styles CSV
In 2001, Volatility
contributes one-fourth
of total explained CSV
(about 2% of 8%):
( )
( )
2
2 2
1
4
8
k
k
X
f
o
o |
~
Monthly volatility of
Volatility factor
Year
1997 1999 2001 2003 2005 2007 2009
M
o
n
t
h
l
y

C
S
V

(
P
e
r
c
e
n
t
)
0
1
2
3
Countries
Japan
USA
Attribution of Countries CSV
36
In 2006, Japan
contributes one-tenth of
the total explained CSV
Thats 40 bps (of 4%)
( )
( )
2
2 2
(0.1)
4
4
k
k
X
f
o
o |
~
Japan factor
Attribution of Industries CSV
37
In 2006, Energy
contributes one-eighth of
the total explained CSV
Thats 50 bps (of 4%)
( )
( )
2
2 2
(0.1)
(4.5)
4
k
k
X
f
o
o |
~
Energy factor
Year
1997 1999 2001 2003 2005 2007 2009
M
o
n
t
h
l
y

C
S
V

(
P
e
r
c
e
n
t
)
0
1
2
3
Industries
Energy
Semiconductors
Summary
CSV represents the opportunity for active management
CSV can be attributed to individual factors
Styles, countries, and industries dominate over different periods
The relative strength of countries versus industries can be
measured by the Diversification Potential (DP) or MAD
Countries dominate industries in EM, vice versa in Dev. Europe
Country factors persist in small-cap regime; industries weaken
Recent decline of DP due to increased volatility of World factor,
not decline in volatility of country or industry factors
38
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39
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40
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RV0809

CSV Analysis - Qwafafew

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Jose Menchero

) with (0,1) exposure

Cap-weighted country factor returns

Cap-weighted industry factor returns

Mean correlation between countries

Mean Absolute Deviation, Countries

Return Attribution, Period t

Linear Factor Structure

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