Six Sigma for Investing: Delusions of Adequacy
Chris Jenkins, CIMA® Vice President Independent, Bank & NYSE Division Franklin Templeton Distributors, Inc.
What Are Your Clients’ Expectations? S&P/TSX - December 1997 to December 2007 $28,000
$24,000
$20,000
$16,000
$12,000
$8,000 Dec-97 Dealer Use Only
Dec-99
Dec-01
Source: Source: S&P/TSX, Globe Hysales
Dec-03
Dec-05
Dec-07
The Impact of Real Returns January 1987 to December 2006 Investor Return vs. Investment Return1 11.8%
4.3%
S&P 500 Index Dealer Use Only
Average Equity Fund Investor's Annualized Return
3.0% Inflation
1. “Quantitative Analysis of Investor Behavior,” Dalbar, Inc., 2007. The S&P 500 is an unmanaged index; one cannot invest directly in an index.
Jumping Out of the Market Could Cost Money The risk is missing the day the market begins recovering S&P/TSX – 10 Years Ending December 31, 2007
Average Annual Return
Growth of $10,000
Fully Invested
9.47%
$24,720
Missed 10 Best Days
5.26%
$16,660
Missed 20 Best Days
1.91%
$12,061
Missed 30 Best Days
-0.96%
$9,090
Missed 40 Best Days
-3.35%
$7,154
Missed 50 Best Days
-5.48%
$5,755
Missed 60 Best Days
-7.43%
$4,706
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Source: Bloomberg as of December 31, 2007. Distributions are reinvested.
Six Sigma Uses data and statistical analysis to measure and improve a company’s operational performance Identifies and eliminates “defects” in manufacturing and servicerelated processes
Six Sigma Statistical Goal 3.4 defects per million opportunities or 99.99966% perfection
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Industry Defects Industries operating at 97% or a level below Six Sigma, could lead to the following results:1, 2 5,000 incorrect surgical procedures per week 20,000 articles of mail lost per hour 200,000 incorrect drug prescriptions each year One hour of unsafe drinking water per month Two long or short landings at a major airport each day 50 newborn babies dropped each day
Dealer Use Only
1. Source: Rath & Strong in Motion; www.rathstrong.com. 2. Source: USA Today; “Feds to Unleash Six Sigma on Terrorism,” 10/31/02.
Case Study: GE Delivery time of its plastic products Existing Process
Improved Process
20 15 10 30 5
17 2 5 12 4
16 Days
8 Days
Average Cycle
Average
50% Improvement Dealer Use Only
Source: Jack – Straight From the Gut by Jack Welch with John Byrne. Copyright 2001. Published by Warner Books.
Case Study: GE Customer Expectation: 8 Days
Improved Process
17 2 5 12 4 8 Days 2
(-6) Six Days Early
Dealer Use Only
8
(+9) Nine Days Late
Source: Jack – Straight From the Gut by Jack Welch with John Byrne. Copyright 2001. Published by Warner Books.
17
The Idea of Six Sigma Customers Feel the Variance, Not the Average “Often, our inside-out view of the business is based on average or mean-based measures of our recent past. Customers don’t judge us on averages, they feel the variance in each transaction. Six Sigma focuses first on reducing [investment] variation and then on improving capability.” “Customers value consistent, predictable business [investments] that deliver world-class levels of quality. This is what Six Sigma strives to produce.”
Dealer Use Only
Source: www.ge.com/sixsigma.
Case Study: GE
Reduce the Variance
7 9 9 8 7 8 Days
Dealer Use Only
1. Source: Jack – Straight From the Gut by Jack Welch with John Byrne. Copyright 2001. Published by Warner Books.
Agenda Expectations vs. Reality Making Sense of Averages Reducing Portfolio Risk
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Expectations vs. Reality
What Is Expected? Average Annual Total Returns Since Inception For the Period Ending 12/31/07 Average Annual Total Return S&P 500 Composite
7.10%
1926
Russell 2000®
12.77%
1979
MSCI EAFE
11.56%
1970
MSCI World
10.77%
1970
DEX Universe Bond Total Return
10.23%
1980
7.10%
1973
10.41%
1980
S&P/TSX Composite Blend: 60% S&P/TSX, 40% DEX Universe
Dealer Use Only
Inception
Source: Globe Hysales, as of December 31, 2007.
Missed Expectations? One-Year Holding Periods through 12/31/07 Average Annual Total Return
Inception
+/- 10% of Average Annual Total Return
S&P 500 Composite
7.10%
1926
2 of 81
Russell 2000®
12.77%
1979
0 of 28
MSCI EAFE
11.56%
1970
4 of 37
MSCI World
10.77%
1970
2 of 37
DEX Universe Bond Total Return
10.23%
1980
4 of 27
7.10%
1973
2 of 34
10.41%
1980
3 of 27
S&P/TSX Composite Blend: 60% S&P/TSX, 40% DEX Universe
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Source: Globe Hysales, as of December 31, 2007
Missed Expectations? Mutual Fund Holding Periods (in years) Average investor retention rates based on the past: Type of Investor:
1 Year
3 Years
5 Years
10 Years
20 Years
Average Equity Investor
4.3
4.3
3.7
3.3
3.0
Average Fixed Income Investor
3.7
3.5
3.2
3.1
3.2
Average Asset Allocation Investor
5.2
5.4
5.0
4.7
4.2
Dealer Use Only
Source: “Quantitative Analysis of Investor Behavior,” Dalbar, Inc., 2007.
Missed Expectations? Five-Year Holding Periods through 12/31/07 Average Annual Total Return
Inception
+/- 10% of Average Annual Total Return
S&P 500 Composite
7.10%
1926
4 of 77
Russell 2000®
12.77%
1979
1 of 24
MSCI EAFE
11.56%
1970
4 of 33
MSCI World
10.77%
1970
0 of 33
DEX Universe Bond Total Return
10.23%
1980
3 of 23
7.10%
1973
2 of 30
10.41%
1980
2 of 23
S&P/TSX Composite Blend: 60% S&P/TSX, 40% DEX Universe
Dealer Use Only
Source: Globe Hysales, as of December 31, 2007
Missed Expectations? Three-Year Holding Periods through 12/31/07 Average Annual Total Return
Inception
+/- 10% of Average Annual Total Return
S&P 500 Composite
7.10%
1926
7 of 79
Russell 2000®
12.77%
1979
5 of 26
MSCI EAFE
11.56%
1970
3 of 35
MSCI World
10.77%
1970
1 of 35
DEX Universe Bond Total Return
10.23%
1980
5 of 25
7.10%
1973
5 of 32
10.41%
1980
4 of 25
S&P/TSX Composite Blend: 60% S&P/TSX, 40% DEX Universe
Dealer Use Only
Source: Globe Hysales, as of December 31, 2007
The Impact of Range of Returns S&P/TSX Average Annual Returns Over Rolling Periods For the 30-Year Period Ended 02/29/081 90% 80%
86.9%
70% 60% 50% 40% 35.7%
30%
27.8%
20% 10%
13.7%
11.4%
0%
16.8% 10.6%
10.2% 6.6%
-1.91%
-10%
11.5% 10.5% 9.1%
-11.1%
-20% -30% -40%
-39.2% 1-Year
3-Year Average Annual Total Return
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5-Year Best Average Annual Total Return
10-Year Worst Average Annual Total Return
Source: Globe HySales. Past performance does not guarantee future results.
25-Year
Making Sense of Averages
The Three Averages • Arithmetic Average - Value obtained by dividing the sum of a set of quantities by the number of quantities in the set +50 – 50 = 0 0÷2=0 • Time-Weighted Return or Investment Return - Calculated by multiplying a series of numbers and taking the nth root of the product (1 + r)t – 1
• Dollar-Weighted Return or Investor Return - Measures the present value of an investment's cash inflows with the present cost of the investment
CF 0 (1 + R DW ) 2 + CF 1 (1 + R DW ) = TV Dealer Use Only
Time-Weighted Return Investment Return and the Impact of Compounding Year One: $100,000 X 50% = $150,000 Year Two: $150,000 X -50% = $75,000
1/ 2
(1.50)(.50)
Dealer Use Only
− 1 = −13%
Dollar-Weighted Return In 1999, XYZ Fund was up 50%, however we decided to purchase the Fund on January 1, 2000, only to watch it drop 50%.
CF0 (1 + RDW ) + CF1 (1 + R DW ) = TV 2
$0 (1.5)2 + $100,000 (.5) = $50,000 Investor Return = -50%
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The Investor Experience Growth of a $10,000 Investment vs. Net Flows ($Millions) For the 10-Year Period Ended 12/31/071 $35
$60,000
$30
$50,000
$25 $20
$40,000
$15
$30,000
$10 $5
$20,000
$0
$10,000
-$5 -$10
$0 Nov-97
Jul-99
Mar-01
Nov-02
Growth of $10,000 Investment Dealer Use Only
Jul-04
Mar-06
Net New Flows
1. Source: Strategic Insight. Lipper, Inc., as of 12/31/07.
Nov-07
The Investor Experience Growth of a $10,000 Investment vs. Net Flows ($Millions) Morningstar Large-Cap Growth Category1 $50
$50,000
$40
$40,000
$30
$30,000
$20
$20,000
$10
$10,000
$0
$0
-$10
-$10,000
-$20
-$20,000
-$30
-$30,000 Q1'95 Q2'96 Q3'97 Q4'98 Q1'00 Q2'01 Q3'02 Q4'03 Q1'05 Q2'06 Q3'07
■
Net New Flows
Dealer UseSource: Only Strategic Insight (Simfund), as of 12/31/07.
■
Growth of $10,000 Investment
The Investor Experience “A dollar-weighted-return is not a reflection of how the manager has done in generating the performance. The idea is that while a fund may have provided good returns on a time-weighted basis, the investor experience could be quite different if investors went in and out of the funds at the wrong time.” Paul Kaplan Vice President of Quantitative Research Morningstar
Dealer UseSource: Only Morningstar.com.
Reducing Portfolio Risk
How Do You Define Risk? Beta vs. Standard Deviation Beta – Measures an investment’s relative volatility and the movement of an investment in relation to a benchmark index Standard Deviation – Measures the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution.
Dealer Use Only
Standard Deviation Profile 11% Average Annual Total Return and 15% Standard Deviation
-34%
-15%
-30%
-45% -19%
-4%
+15% 11% 68% 95%
Dealer Use Only
99%
+30% 26%
+45% 41%
56%
Risk vs. Return Relationship Largest 100 Domestic Equity Funds Based on Net Assets For the 15-Year Period Ending 12/31/07 15 Year Risk-Return Chart
18.00
Fund A:
16.00
Fund B:
Risk: 9.90 Return: 13.41
14.00
Risk: 19.77 Return: 15.33
Return (%)
12.00 10.00 8.00 6.00 4.00 2.00 0.00 0.00
5.00
10.00
15.00
20.00
Standard Deviation (%) Dealer Use Only
Source: Morningstar Research Inc. Not all funds are representative due to a fund history of less than 15 years.
25.00
Tale of Two Funds: Risk vs. Return Profile Fund A
Fund B 15% Return, 20% Standard Deviation
13% Return, 10% Standard Deviation
75%
43%
+20
+10 +10
33%
55%
23%
35% +20
+10 13% -10 -10 -10
68%
95%
99%
95%
68%
15%
3%
-5%
-7%
-25%
-17%
Dealer Use Only
+20
-20 -20 -20
-45%
Linking Risk with Investor ReturnTM1 Narrowing the Gap Funds with higher volatility often exhibit large short-term gains, which in turn attracts investors Funds with lower volatility, by contrast, tend not to attract fickle short-term investors with explosive gains and also do a better job of protecting shareholders’ capital during downturns
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1. Source: Morningstar Advisor , Spring 2007, Your Mileage May Vary by Christine Benz and David Kathman.
Lower the Risk to Decrease the Performance Gap1
Morningstar© Category
Time-Weighted Return
Dollar Weighted Return
Performance Gap
Standard Deviation of Average Fund Return
Aggressive Growth
0.37%
0.13%
0.25%
1.31%
Small-Cap Growth
0.91%
0.75%
0.16%
1.00%
Mid-Cap Growth
0.77%
0.64%
0.13%
0.94%
Growth
0.40%
0.26%
0.14%
0.91%
Growth and Income
0.57%
0.51%
0.06%
0.70%
Income-Growth
0.71%
0.68%
0.03%
0.51%
1. Source: “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability”; Journal of Banking and Finance, August 2006. For each fund, calculations include the average monthly arithmetic, geometric and dollar-weighted returns over the entire sample period. Performance gap is the difference between fund geometric and dollar-weighted returns. Funds are divided into objective categories using the CRSP SI-Objective variable, and summary statistics are reported for each objective category. Standard deviations are reported for the average geometric return and performance gap. T-statistics for the mean performance gap are reported in parentheses. Returns are percent per month. Past performance does not guarantee future results. Dealer Use Only
Putting Risk in Its Place “It wasn’t even close. Historic returns did a very poor job of predicting future returns. In contrast, the connection between past risk and future risk was very powerful. Despite very different market conditions, the riskiest funds stayed the riskiest, and the safest funds stayed the safest. The pattern held true along the risk spectrum.”1
Dealer Use Only
1. Source: Morningstar© Advanced Analytics for Principia. “Putting Risk in its Place,” by John Rakenthaler, 5/27/94.
Improving your Clients’ Portfolio through Allocation Importance of diversifying your clients’ Portfolio by asset classes, market capitalization, management style and geographic region: 93% of variability of returns across time is explained by asset allocation 90% of portfolio returns can be attributed to diversification by market capitalization A one-style portfolio is exposed to 65% more risk than a blended-style portfolio Diversification by geographic region can reduce portfolio risk by up to 64% Dealer Use Only
Source: Equisoft, 2007.
Why Diversify? Because winners rotate
Dealer Use Only
Based on Morningstar Research Inc. as of December 31, 2007.
The Predictability of Risk
Dealer Use Only
Based on Morningstar Research Inc. as of December 31, 2007.
Beware of Risk “From the study, it appears that the low-volatility funds with higher levels of return […] perform better in percentage withdrawal mode than do high-return, highvolatility funds.” — Source: FPA Journal, “Sustainable Retirement Withdrawls,” by Ahmet Tezel, Ph.D., 7/04
“Ideally, investors’ sustainable withdrawal in retirement depends not only on expected returns in the future, but also on the variability of returns. — Source: Financial Planning,“Survival of the Fittest,” by Craig L. Israelsen and Keith Sechler, 1/1/05.
“During retirement, a spike in volatility increases the very real possibility that the nest egg will be permanently damaged by a steep market decline.” - Source: Journal of Financial Planning, “In Retirement: What Matters”, May 2001 John Rekenthaler Vice President, Morningstar
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The Mathematical Catch-Up Game Cumulative Gain Required to Return to Original Value1 100%
82%
80%
67% 54%
60% 40% 20%
25%
18%
11%
0% -20%
-10%
-40%
Losses
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-15% Over 1 Year
-20% Over 5 Years with a 5% Withdrawal1
1. Assumes withdrawal and loss are calculated based on initial account value.
How to Reduce Portfolio Risk
σ = Ws σs + Wb σb + 2Ws Wb σs σb ρsb 2
2
2
2
p
Risk of Stocks Risk of Bonds Risk of the Interaction Between Stocks and Bonds Dealer Use Only
Risk of Stocks “The upper left-hand section of the equity style box, including large-cap value, large-cap blend and mid-cap value, represented the funds with the least historic volatility. The lower right-hand corner housed the highest risk funds—small-cap growth, mid-cap growth and small-cap blend. And the rest— large-cap growth, mid-cap blend and small-cap value—fell somewhere in between.1
Dealer Use Only
1. Source: Morningstar® Advanced Analytics for Principia. “Predicting the Future,” by Catherine V. Sanders, 9/1/95.
Risk of Bonds Blend: 60% S&P/TSX, 40% DEX and S&P/TSX Index For the 20-Year Period Ended 02/29/081 15%
February 29, 1988 - February 29, 2008
Annualized Rate of Return
14% 13% 12% 11%
100% S&P/TSX
10% 100% Blend
9% 8% 7% 7%
8%
9%
10%
11%
12%
13%
14%
15%
Risk - Annualized Standard Deviation
Dealer Use Only
Source: Globe Hysales as of 02/29/08. Stocks as represented by the S&P/TSX Index. Bonds/Stocks as represented by the Blend: 60% S&P/TSX, 40% S&P/TSX.. Risk is measured by the annualized standard deviation of monthly total returns. Successive data points on the line represent incremental changes of 20% in the portfolio allocations from 100% stocks / 0% bonds to 0% stocks / 100% blend. Portfolios were rebalanced monthly. Indexes are unmanaged, and one cannot invest directly in an index. Past performance does not guarantee future results.
Risk of Interaction
σ = Ws σ s + Wb σ b + 2Ws Wbσ sσ b ρ sb 2
2
2
2
p
ρ sb = Correlation between stocks and bonds Dealer Use Only
Risk of Interaction “To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little more protection than the uncertain return of a single security”. — Source: Journal of Finance, “Portfolio Selection” by Harry Markowitz., 1952
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Low Correlation Is Key to Reducing Risk Major Investment Index Correlation For the 20-Year Period Ended 12/31/07 1 BMO NB Small Cap 2 LB Global Agg 3 LB US Agg Bond 4 MSCI BRIC 5 MSCI EAFE 6 MSCI Emerg. Mkts 7 MSCI Europe 8 MSCI World 9 Russell 2000 10 S&P/TSX 11 DEX Universe Bond 12 S&P 500 13 S&P/Citigroup
