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Global Equity Market Neutral Strategy A unique approach to style-based absolute return investing

Systematic equity expertise Having developed his first style strategy in 2003, Erik Rubingh has been leading our Systematic Strategies team since 2007. Extending and enhancing our capabilities over time the team has developed an innovative True Styles approach that has been successfully employed within a range of strategies, both long and long / short.

2016

2015

Team AUM over £3bn*

Managing style based strategies since 2003

2013 2010 2003 True Style strategy first developed by Erik Rubingh at ABP Investments

2008

2007 Erik joined as Head of Systematic Equity. The core portfolio management team has been working together since 2007

Launched regional versions of the strategy using the True Style approach

Launch of the global strategy utilising the True Styles approach

Launch of equity market neutral long/short strategy for F&C Diversified Growth Fund

Launch of F&C Global Equity Market Neutral Fund with 10% volatility target

Erik Rubingh, Head of Systematic Strategies Erik Rubingh is Head of the Systematic Strategies team. He joined the company in July 2007. Prior to joining us, Erik worked at ABP Investments (now APG Investments), first as Senior Portfolio Manager in the Global Quantitative Strategies Group and later as Head of that group. Erik graduated from Groningen University with an MSc in Econometrics. He is also a CFA charterholder.

* BMO Global Asset Management, 30 September 2016

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Global Equity Market Neutral Strategy A systematic equity market neutral investment strategy focusing on style premia and aiming to deliver attractive absolute returns with low correlation to traditional asset classes.

Absolute return strategy

 The strategy aims to deliver positive absolute returns regardless of market conditions*.

Correlation of Global Equity Market Neutral Strategy to key traditional asset classes 1

0.19

The strategy targets a return of 7% over the

0.21

risk free rate with 10% target volatility.

Rationale for style based approach supported by academia and empirical evidence.

 Low correlation is achieved with traditional asset classes including bonds, equities and hedge fund indices.

-1

Global Govt Bonds

Global Corporate Bonds

0.00 -0.09

-0.06

Global High Yield

Global Equities

-0.06 Emerging Equities

Global Hedge Funds

Source: BMO Global Asset Management, Factset, Bloomberg 1 October 2014 – 30 September 2016 – daily observations. Indices quoted: BofA Merrill Lynch Global Government; BofA Merrill Lynch Global Corporate; BofA Merrill Lynch Global High Yield; MSCI World Index; MSCI EM (Emerging Markets); HFRX Global Hedge Fund (USD). Past correlations are not indicative of future correlations.

Understanding portfolio returns

 Typical portfolio returns are comprised of two

elements – beta (the market return) and alpha (outperformance of the market).

 Outperformance is often a result of persistent

Style premia

exposure to certain styles; the remainder may be attributable to stock picking.

 Style-based investing aims to add value through

focused exposure to defined styles and the ‘premia’ they generate whilst reducing exposure to stock-specific risk.

Beta+Alpha

Beta+Style+Alpha

Source: BMO Global Asset Management. For illustrative purposes only. *The strategy aims to deliver a positive return regardless of market conditions but such a positive return is not guaranteed. Capital is at risk and an investor may receive back less than the original investment.

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What is an equity style? Styles are quantifiable characteristics of securities that determine the return and volatility of those securities. It has been shown academically that a significant amount of investment returns can be explained by styles. These styles have demonstrated persistent positive returns associated with them over time. These style premia can either be used to improve the risk adjusted returns of equity portfolios or, as we do in this market neutral strategy, captured to provide positive absolute returns independent from equity markets.

What styles do we target within the strategy? We have carefully selected a combination of styles that have been recognised for positive returns, in academic and empirical research, over a sustained period (size, low volatility, momentum, value and growth at a reasonable price: GARP). We believe that this combination of styles is an effective way to capture excess returns available in equity markets.

Growth at a reasonable price

Stocks with good growth, moderate valuations and good quality financial statements represent ‘the best of all worlds’

Low volatility

Aversion to leverage and the ‘lottery effect’ lead to low risk stocks performing better than expected under traditional finance theory

Momentum

Under reaction to news and extrapolation of past trends lead to past winners continuing to win and past losers continuing to lose

Size*

 igher (diversifiable) risk of smaller companies leads to better returns of smaller H companies as a group

Value

E xcessive pessimism about the prospects of ‘dull’ companies and optimism about ‘glamour’ companies leads to mispricing

*Size is implemented on a periodic basis in the market neutral strategy

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“We employ a systematic approach that intelligently combines exposure to a range of styles extracted from the MSCI World Index universe.” Erik Rubingh, Head of Systematic Strategies.

Observed returns to selected styles 1000 900 800 700 600 500 Logarithmic scale

400 300 200 100

0

Value

Size

Low Risk

Jun 15

May 16

Jul 14

Aug 13

Oct 11

Sep 12

Nov 10

Dec 09

Jan 09

Feb 08

Mar 07

Apr 06

Jun 04

May 05

Jul 03

Aug 02

Oct 00

Sep 01

Nov 99

Dec 98

Jan 98

Feb 97

Mar 96

Apr 95

Jun 93

May 94

Jul 92

Aug 91

Oct 89

Sep 90

Nov 88

Dec 87

-20

Momentum

Source: BMO Global Asset Management, Factset. January 1988 to 30 September 2016. The returns represent the outcome of buying the top 20% of stocks with each particular attribute and selling the bottom 20%, rebalanced monthly, and do not include any transaction costs. This information is not a representative investment strategy but an indication of the efficacy of each style. A logarithmic scale shows two equal percent changes plotted as the same vertical distance on the scale.

Buying rising stocks and selling falling stocks leads to excess outperformance of about 1% per month (1965-1989) – “the momentum factor” Jegadeesh & Titman (1993)

Small cap stocks outperform large cap stocks over the long term (1962-1989) – “the size factor” Cheap stocks (based on fundamental rations such as price-tobook or price-to-earnings) outperform “expensive” stocks – “the value factor”

Over the past 40 years, high volatility and high beta stocks in U.S. markets have substantially underperformed low volatility and low beta stocks. – “low volatility factor” Baker, Bradley, Wurgler (2009)

Fama & French (1992)

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The importance of our ‘True Styles’ approach While exploitation of styles alone is an attractive concept, using only the ‘raw’ styles (e.g. book-to-price for value) may not be the best approach. What we need to consider is that the various styles can be driven by shared components.

For example A small Italian retailer may look cheap from its book-to-price ratio, but if all Italian stocks are cheap, does it really represent value? Before we can come to a conclusion, we need to remove the shared elements that contribute to the valuation to discover the ‘True Styles’. From Styles...

... to ‘True Styles’ Low volatility Low volatility

Low volatility

GARP

Value

Value

Low volatility True Value True GARP

True GARP

True Value

GARP Momentum

Size

Size Momentum

Raw styles are attractive but not necessarily independent. This can lead to: Lower return characteristics  Lower diversification benefits

Over a number of years we have developed and refined a methodology that extracts the ‘True Styles’. Our methodology removes the shared components from the raw variables, simultaneously, to come to an improved metric of the desired style. Not only does the ‘True Styles’ methodology greatly improve the predictive power of the styles; by removing the shared components it also lowers the correlations significantly, thereby improving the diversification benefits. The following is an example, utilising true value style, of how we create our portfolios to neutralise other influencing styles.

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True Momentum

Size

True Momentum

True size

Our unique ‘True Styles’ approach:  Isolates the desired style Aims to improve long-term return  Lowers correlation between styles  Greatly improves predictive power

‘True Styles’ example: Value Step one: We take a list of the stocks that make up the MSCI World Total Return Index and their book-to-price ratios, where a high value indicates a stock is cheap and a low value indicates a stock is expensive. Step two: We adjust the book-to-price ratios to remove the effect of other styles as well as country and sector effects. We now have a list of stocks in the MSCI World Total Return Index and their ‘true’ book-to-price ratio. The true book-to-price ratio indicates the cheapness of a stock relative to other similar stocks. This is also how active managers like to compare stocks – they will buy a stock that is cheap relative to its peers. Step three: We create a portfolio which maximises the exposure to the book-to-price ratio. This value portfolio is now less likely to include stocks that have negative momentum for example.

‘True Styles’ in focus Taking the value style as an example, the ‘True Styles’ methodology increases the risk-adjusted returns generated by book-to-price, with a significant enhancement to the Sharpe Ratio. Back-tested simulated performance (Raw Value Style vs. True Value Style) 1000 800

Low volatility

600 500 400 300

True Value

200

Raw Value

Dec 15

Dec 13

0.35 1.16 Dec 14

12.5% 4.8% Dec 11

4.4% 5.6%

Dec 12

Sharpe Ratio

Dec 10

Volatility (annualised)

Dec 07

Dec 05

Dec 06

Dec 01

Dec 02

Dec 99

Dec 00

Dec 97

Dec 98

Dec 95

Dec 96

Dec 93

Dec 94

Dec 91

Dec 92

Dec 89

Dec 90

Dec 87

- 20

Dec 03

Raw value style True value style

0

Dec 04

True size

Dec 88

True Momentum

Return (pa)

Dec 09

100

Dec 08

True GARP

True Value

Source: BMO Global Asset Management, Factset, gross of fees. All data from January 1988 to 30 September 2016. The returns represent the outcome of buying the top 20% of stocks with each particular attribute and selling the bottom 20%, rebalanced monthly, and do not include any transaction costs. A logarithmic scale shows two equal percent changes plotted as the same vertical distance on the scale. The backtested performance shown is for illustrative purposes only and does not represent actual results. It is based on an analysis of past market data with the benefit of hindsight and it does not reflect the reinvestment of dividends, interest, capital gains, withholding taxes, the deductions of fees, commissions or any other expenses a client would have to pay. Actual results may significantly differ from the returns being presented. Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Benefits of diversification – low correlation between styles Low Volatility

True Size

True True Value Momentum

Low Volatility

1

True Size

-0.18

1

True Momentum

0.22

-0.07

1

True Value

-0.16

-0.07

-0.24

True GARP

-0.02

Reducing absolute correlation between styles True GARP

In this bar chart, we show how our refined individual True Style exposures demonstrate lower correlations with other styles than their raw style counterparts do. 1

-0.20

-0.08

-1

1 0.27

Raw Styles

1

Source: BMO Global Asset Management, Factset, Bloomberg, JPMorgan January 1988 to 30 September 2016, net of cost assumptions, net of dividend tax differential. Historical simulations till 12/2013, live thereafter.

Value – Momentum

Value – Size

Size – Momentum

True Styles

Source: BMO Global Asset Management correlations of observed style returns. Data as of 30 September 2016.

Market neutral construction We minimise operational complexity in the strategy by taking exposure to our selected ‘True Styles’ through a repeatable systematic process, operating within a robust risk framework. We outline the key stages below. Individual market neutral ‘True Styles’ portfolios Custom optimisation tool maximises desired styles within strict country/sector/ stock limits and minimises stock specific risk.

1

2

Multi-style portfolio

The style portfolios are combined into one multi-style portfolio using an (active) Equal Risk Contribution methodology.

3

Define risk level

Small positions are trimmed and portfolio is adjusted to get to desired risk level.

Ongoing monitoring and rebalancing Model run monthly, although not every portfolio transacts each month with turnover capped to limit transaction costs.

4

‘Equity Market Neutral’ - An investment strategy that seeks to exploit differences in stock prices by being long and short in stocks within markets, sectors, industries or countries. This strategy is intended to create returns that, over an extended period of time, are uncorrelated with general equity market performance, however this cannot be guaranteed and over discrete periods there may be a high degree of positive or negative correlation.

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Contact us Institutional Business +44 (0)20 7011 4444 [email protected] bmogam.com

© 2016 BMO Global Asset Management. All rights reserved. BMO Global Asset Management is a trading name of F&C Management Limited, which is authorised and regulated by the Financial Conduct Authority. CM10891 (10/16).