HARNESSING THE POWER OF FACTORS

© 2016 MSCI Inc. All rights reserved.

Please refer to the disclaimer at the end of this document.

HARNESSING THE POWER OF FACTORS

November 2017

Jean-Maurice Ladure, CFA

Head of Equity Applied Research, EMEA

KEY QUESTION

2

Does Factor Investing provide a credible

alternative to Active Management?

IMPORTANCE OF FACTORS IN EXPLAINING PERFORMANCE

3

“Approximately 70% of all active

returns on the overall fund can be

explained by exposures to systematic

factors”

-Ang, Goetzmann, Schaefer

Report on Norway’s Government Pension Fund

“Alpha decreases from 18 bps to as

low as 3 bps monthly, a reduction of

as much as 80%”

-MSCI’s award winning research paper

“Can Alpha Be Captured by Risk Premia?”

Ang, A., W. Goetzmann, and S. Schaefer, 2009. “Evaluation of Active Management of the Norwegian Government Pension Fund Global”.

Bender, J., Hammond, B. Mok, W, 2014. “Can Alpha Be Captured by Risk Premia?”. Journal of Portfolio Management, Winter 2014.

Portfolio Return

1960s

Alpha

MarketReturn

1980s

Alpha

FactorReturn

MarketReturn

2000s

FACTOR INVESTING IN THE ASSET ALLOCATION PROCESS

4

• “Third Way” between market-cap

passive and active investment

• Factor Investing is not new:

─ Factors have long been used in risk

models and quantitative investment

strategies

─ They also can explain part of the long

term portfolio performance of

fundamental active investors*

• Factor indexes provide a

transparent, rules-based and cost-

effective method to seek

systematic exposure to Factors

Market Return

Transparent Implementation

Active Return

Passive Investing

DiscretionaryImplementation

FactorInvesting Active

Management

6 KEY FACTORS

*For example, see “Buffett’s Alpha”, NBER Paper, Andrea Frazzini, David Kabiller and Lasse Pedersen, December 2013

DIFFERENT APPROACHES TO CONSTRUCT FACTOR INDEXES

5

Pure

Factors

Mkt Neutral

Factor Indexes

Long Short

Factor Indexes

Optimized Factor Indexes

High Exposure Factor Indexes

High Capacity Factor Indexes

Market Cap Benchmark Indexes

• Higher Factor Exposure

• Higher Complexity

• Lower Investability

MSCI Market Neutral Barra Factor Indexes

MSCI Long Short Barra Factor Indexes

MSCI Enhanced Value Index

MSCI Value

Weighted Index

MSCI ACWI IMI

MSCI Minimum Volatility Index

Examples of existing MSCI factor indexes based on different factor index construction methodologies:

FACTORS SHOW LONG TERM OUTPERFORMANCE

6

COMBINING FACTORS IN THE LONG-TERM

7

USE CASE #1 – TARGETING SPECIFIC FACTORS

8

“ I believe in the long term premium

of some factors and would like to

benefit from a combination of those”

• A common definition of quality companies is “high

profitability, earning persistency, and low leverage”

• Financial quality descriptors are readily available in financial

statement

• Quality companies tend to be expensive

• Leading to the opportunity to combine Quality and Valuation

USE CASE #1 – INVESTING IN QUALITY FACTOR

9

PROFITA

BILITY

EARNINGS

QUALITY

FINANCIAL

LEVERAGE

Financial Quality

MSCI QUALITY MIX: HOW IT PERFORMS

10

Key Metrics

MSCI ACWIACWI

Quality

ACWI Sector

Neutral

Quality

ACWI Factor

Mix A-series

(USD)

Total Return* (%) 5.7 7.1 6.8 7.5

Total Risk (%) 15.4 13.9 14.7 12.9

Return/Risk 0.37 0.51 0.46 0.58

Sharpe Ratio 0.23 0.36 0.32 0.42

Active Return (%) 0.0 1.4 1.2 1.8

Tracking Error (%) 0.0 4.0 2.7 3.3

Information Ratio NaN 0.35 0.44 0.56

Historical Beta 1.00 0.87 0.94 0.83

No of Stocks*** 2417 497 596 2405

Turnover** (%) 3.3 23.1 29.1 20.1

Price To Book*** 2.2 4.3 3.3 2.4

Price to Earnings*** 18.3 16.8 15.7 17.4

Dividend Yield*** (%) 2.3 2.1 2.4 2.5

Period: 31-Dec-1998 to 31-Oct-2017

* Gross returns annualized in USD

** Annualized one-way index turnover over index reviews

*** Monthly averages

The definitions of all statistical parameters are available in the Appendix

Performance (%)

MSCI ACWIACWI

Quality

ACWI Sector

Neutral

Quality

ACWI Factor

Mix A-series

(USD)

YTD 20.2 23.7 20.5 19.1

1 Yr 23.7 24.7 23.0 21.4

3 Yr 8.5 10.3 8.0 9.2

5 Yr 11.4 12.8 11.0 11.7

10 Yr 4.3 7.3 5.5 6.1

Gross returns in USD for the period ending 31-Oct-2017

Returns are annualized for periods longer than one year

USE CASE #2 – EQUITY RISK REDUCTION

11

“ I want to remain invested in equities

but would like to reduce my risk”

USE CASE #2 – EQUITY RISK REDUCTION

12

MSCI Minimum Volatility: How it works?

MSCI MINIMUM VOLATILITY: HOW IT PERFORMS

13

Key Metrics

MSCI ACWIACWI Min Vol

(USD)

Total Return* (%) 5.7 8.3

Total Risk (%) 15.4 10.2

Return/Risk 0.37 0.81

Sharpe Ratio 0.23 0.60

Active Return (%) 0.0 2.6

Tracking Error (%) 0.0 7.9

Information Ratio NaN 0.33

Historical Beta 1.00 0.59

No of Stocks*** 2417 350

Turnover** (%) 3.3 24.7

Price To Book*** 2.2 2.5

Price to Earnings*** 18.3 18.7

Dividend Yield*** (%) 2.3 2.7






Performance (%)

MSCI ACWIACWI Min Vol

(USD)

YTD 20.2 15.0

1 Yr 23.7 15.1

3 Yr 8.5 9.1

5 Yr 11.4 11.0

10 Yr 4.3 6.9



CONCLUSIONS – AND A WORD OF CAUTION

14

Allocation to Multi Factor Strategies

Investment

Horizon

Investment

Beliefs

Governance

Structures

Diversified

Exposure

• Factor based strategies have historically produced long-term outperformance

but have also experienced significant multi-year periods of underperformance

• Factor investing requires strong investment beliefs that the historical premium

will persist and governance structures to withstand underperformance periods

• Allocating to multiple factors may provide investors with a transparent, flexible

and cost-effective way to seek diversified exposure to a portfolio of risk premia

APPENDIX

USE CASE #3 – RISK/RETURN ENHANCEMENT

16

• The DMF index had higher absolute and risk

adjusted historical performance

• The DMF approach produced higher active

return, higher tracking error and IR

• Total risk and historical beta similar and close to

the parent index

• Turnover similar while DMF index approach had

lower average valuations

Key Metrics

MSCI World

World

Diversified

Factor Mix

World

Diversified

Multiple-factor

Total Return* (%) 5.5 7.8 10.0

Total Risk (%) 15.0 13.9 15.2

Return/Risk 0.37 0.56 0.66

Sharpe Ratio 0.23 0.41 0.52

Active Return (%) 0.0 2.3 4.5

Tracking Error (%) 0.0 2.8 4.1

Information Ratio NaN 0.81 1.10

Historical Beta 1.00 0.91 0.98

No of Stocks*** 1621 1621 448

Turnover** (%) 2.9 30.8 40.1

Price To Book*** 2.2 2.1 1.9

Price to Earnings*** 18.8 17.7 13.9

Dividend Yield*** (%) 2.3 2.6 2.3






Performance (%)

MSCI World

World

Diversified

Factor Mix

World

Diversified

Multiple-factor

YTD 18.8 19.7 22.5

1 Yr 23.3 22.3 27.3

3 Yr 8.7 9.6 10.8

5 Yr 12.2 12.6 14.5

10 Yr 4.7 5.5 6.9



TRANSPARENCY IN PERFORMANCE ATTRIBUTION

17

2.34

4.17

Risk Indices

VALUE0.30 0.55 0.23

0.35 0.61 -0.02

BtoP Earn. Yield LT Reversal

MOM.0.98

1.19

Momentum

QUALITY0.18 0.07 0.19 0.28 0.080.04 0.06 0.22 0.31 0.00

Leverage Earn. Qlty Inv. Qlty Profitability Earn. Var.

Index: World Diversified Multiple-factorPeriod: 31-Dec-1998 to 31-Oct-2017

Return (%)

Risk (% Std Dev)

Annualized Gross Returns

Total

9.98

15.24

5.51 4.48

15.03 4.08

Benchmark Active

0.04

0.63 0.77 1.70 2.01

0.02 0.28 -0.03

Asset

Selection Selection

Currency Countries Industries

0.07 0.460.14

Growth Liquidity

0.08 -0.03 -0.18

Div. Yield

1.01 0.66

0.31 0.42

Beta Res. Vol.

SIZE1.85 0.77

0.58 0.23

Size Mid Cap

TRENDS IN FACTOR INVESTING

18

OVER USD 210 BILLION IN ASSETS

BENCHMARKED TO MSCI FACTOR

INDEXES AS OF MARCH 2017

Data as of March, 2017 and reported as of June,2017 by eVestment, Morningstar, Bloomberg and MSCI.

4 years CAGR: 40%

0

50

100

150

200

250

Ma

r'1

3

Se

p'1

3

Ma

r'1

4

Se

p'1

4

Ma

r'1

5

Se

p'1

5

Ma

r'1

6

Se

p'1

6

Ma

r'1

7

FACTOR INDEX AUM GROWTH

CAGR: 41%

THE MSCI FAMILY OF STANDARD SINGLE FACTOR INDEXES

19

Factors High Capacity Factor Indexes High Exposure Factor Indexes

Value MSCI Value Weighted Index MSCI Enhanced Value Index

Size MSCI Size Tilt Index MSCI Equal Weighted Index

Momentum MSCI Momentum Tilt Index MSCI Momentum Index

Yield MSCI Dividend Tilt Index MSCI High Dividend Yield Index

Quality MSCI Quality Tilt Index MSCI Quality Index

Volatility MSCI Volatility Tilt Index MSCI Minimum Volatility IndexLOW VOLATILITY

HIGH YIELD

QUALITY

MOMENTUM

VALUE

SIZE

MSCI SINGLE FACTOR INDEXES METHODOLOGY OVERVIEW

20

Index Enhanced Value Equal Weighted Momentum Quality High Dividend Yield Minimum Volatility

Objective

• High exposure to

the value factor +

low exposure to

all other factors

• Negative size

factor exposure +

low exposure to

all other factors


momentum + low

exposure to all

other factors


the quality factor

+ low exposure to

all other factors


dividend yield +

low exposure to

all other factors

• Negative volatility

factor exposure +

low exposure to all

other factors

Selection

• PB + PE + EV/CFO

(except Financial)

• Calculate sector

relative scores

• Select highest

score securities

• By applying equal

weight across the

parent index we

overweight lower

capitalization

parent index

constituents

• 6m and 12m risk

adjusted return

(excluding 1m)

• Calculate scores

across universe

• Select highest

score securities

• ROE + D/E + Low

Earn Variability

(EPS g in last 5Y)

• Calculate scores

across universe

• Select highest

score securities

• Yield (YLD > 1.3x)

• Quality (QTY > 0)

• Persistency

(5Y DPSG > 0)

• Sustainability

(exc top 5% PR)

• Yield Trap (R<<0)

• Security selection

based on min var

optimization

• Covariance matrix

from Barra GEM2

risk model

Weighting • Score x Mkt Cap • Equal Weights • Score x Mkt Cap • Score x Mkt Cap • Mkt Cap Weights• Weights based

on optimization

Constraints • Sector neutral • No constraints • Max 5% Weight • Max 5% Weight • Max 5% Weight

• 1.5% or 20x BM

• Constraints on

countries, sectors

and other factors

Rebalancing• Semi annual /

buffers• Quarterly

• Semi annual /

buffers

• Conditional

rebalancing

• Semi annual /

buffers

• Semi annual /

buffers

• Semi annual /

max 20% TO

Table provides methodology highlights. Details can be found in the Index Methodology books available on msci.com.

WORLD SINGLE & MULTI INDEXES – HIGH EXPOSURE

21

Key Metrics

World

World

Minimum

Volatility (USD)

World Equal

Weighted

World

Enhanced

Value

World High

Dividend Yield

World

MomentumWorld Quality

World

Diversified

Factor Mix

World

Diversified

Multiple-factor

Total Return* (%) 5.5 7.1 8.2 9.9 6.6 8.1 6.8 7.8 10.0

Total Risk (%) 15.0 10.7 16.2 17.2 14.9 15.4 13.4 13.9 15.2

Return/Risk 0.37 0.67 0.51 0.58 0.44 0.52 0.51 0.56 0.66

Sharpe Ratio 0.23 0.47 0.38 0.45 0.30 0.39 0.35 0.41 0.52

Active Return (%) 0.0 1.6 2.7 4.4 1.1 2.6 1.3 2.3 4.5

Tracking Error (%) 0.0 7.5 4.6 5.8 5.7 8.2 4.2 2.8 4.1

Information Ratio NaN 0.22 0.59 0.77 0.19 0.31 0.30 0.81 1.10

Historical Beta 1.00 0.63 1.03 1.08 0.92 0.88 0.86 0.91 0.98

No of Stocks*** 1621 281 1621 396 392 346 298 1621 448

Turnover** (%) 2.9 25.0 16.7 35.6 18.9 95.4 23.1 30.8 40.1

Price To Book*** 2.2 2.5 1.7 1.2 2.1 3.0 4.6 2.1 1.9

Price to Earnings*** 18.8 19.1 22.6 14.7 14.1 22.2 17.2 17.7 13.9

Dividend Yield*** (%) 2.3 2.6 2.3 2.8 3.9 1.7 2.1 2.6 2.3






Performance (%)

World

World

Minimum

Volatility (USD)

World Equal

Weighted

World

Enhanced

Value

World High

Dividend Yield

World

MomentumWorld Quality

World

Diversified

Factor Mix

World

Diversified

Multiple-factor

YTD 18.8 14.5 19.0 17.6 15.4 29.7 21.8 19.7 22.5

1 Yr 23.3 15.3 22.4 23.3 18.6 32.1 24.2 22.3 27.3

3 Yr 8.7 10.1 8.9 7.8 7.1 13.2 10.4 9.6 10.8

5 Yr 12.2 11.7 12.1 12.9 10.1 14.8 13.2 12.6 14.5

10 Yr 4.7 6.4 4.9 3.9 3.8 6.3 7.7 5.5 6.9



WORLD FACTOR INDEXES – HIGH CAPACITY

22

Key Metrics

MSCI WorldWorld Volatility

TiltWorld Size Tilt

World Value

WeightedWorld Dividend Tilt

World Momentum

TiltWorld Quality Tilt

Total Return* (%) 5.5 6.3 6.9 6.4 6.8 6.6 6.2

Total Risk (%) 15.0 12.8 15.4 15.9 13.5 14.7 14.4

Return/Risk 0.37 0.49 0.45 0.40 0.50 0.45 0.43

Sharpe Ratio 0.23 0.33 0.31 0.27 0.35 0.30 0.28

Active Return (%) 0.0 0.8 1.4 0.9 1.3 1.0 0.6

Tracking Error (%) 0.0 3.5 2.4 3.4 3.8 3.5 1.5

Information Ratio NaN 0.24 0.58 0.27 0.34 0.30 0.43

Historical Beta 1.00 0.84 1.01 1.04 0.87 0.95 0.95

No of Stocks*** 1621 1616 1616 1616 839 1616 1586

Turnover** (%) 2.9 11.5 11.2 17.2 22.7 45.6 11.2

Price To Book*** 2.2 2.4 2.0 1.7 2.4 2.5 2.6

Price to Earnings*** 18.8 17.6 20.2 17.8 15.4 19.8 17.7

Dividend Yield*** (%) 2.3 2.6 2.3 2.7 3.2 2.1 2.2






Performance (%)

MSCI WorldWorld Volatility

TiltWorld Size Tilt

World Value

WeightedWorld Dividend Tilt

World Momentum

TiltWorld Quality Tilt

YTD 18.8 16.8 18.9 17.2 17.7 22.9 19.7

1 Yr 23.3 21.4 22.8 24.4 22.0 26.8 23.8

3 Yr 8.7 8.4 8.7 8.1 8.1 10.6 9.2

5 Yr 12.2 11.6 12.2 11.9 11.1 13.7 12.5

10 Yr 4.7 5.4 4.9 3.9 5.5 5.7 5.8



TRACK RECORD FOR WORLD FACTORS

23

Performance Relative to the World

YTD 1Y 3Y 5Y 10Y 15Y Since '99 Since Live Live Date

MSCI World - - - - - - - -

Minimum Volatility -4.2% -8.0% 1.3% -0.4% 1.7% 0.8% 1.6% 1.5% 14/04/2008

High Dividend Yield -3.4% -4.7% -1.7% -2.1% -0.9% -0.1% 1.1% -0.8% 31/10/2006

Quality 3.0% 1.0% 1.7% 1.1% 3.0% 1.0% 1.3% 1.6% 18/12/2012

Momentum 10.9% 8.9% 4.5% 2.7% 1.6% 2.3% 2.6% 3.4% 11/12/2013

Enhanced Value -1.2% 0.0% -0.9% 0.7% -0.8% 2.7% 4.4% -1.8% 11/08/2014

Equal Weighted 0.3% -0.9% 0.2% -0.1% 0.2% 2.1% 2.7% 0.6% 22/01/2008

Diversified Multiple-factor 3.7% 4.1% 2.0% 2.3% 2.2% 3.6% 4.5% 1.3% 19/03/2015

Note: Al l returns are in USD, Gross , annua l i s ed except YTD

As of end of October 2017

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Documents

HARNESSING THE POWER OF FACTORS