INTEGRATING ALL SOURCES OF PERFORMANCE

TO CREATE MORE EFFECTIVE PORTFOLIOS

Sources of Performance and

the Value of Forecasts

Jacques Lussier, Chief Investment Officer

October 2015

2

We Can do Better

Sources of Excess Performance

Changes in Portfolio Design

Beta, Alpha & Luck

How to Structure a Product

When Performance is Not There

An Analysis using the Multi-Factor Approach

An Example of a Complete Product

Conclusion and Recommendation

TABLE OF CONTENTS

WE CAN DO BETTER, BUT HOW?

3

An asset reaches its maximum weight when it is most highly overvalued.

4

It is the philosophy, not the methodology, that determines the capacity to perform.

Indexing Active

Underperforms Outperforms

Luck Expertise Unique skill - forecasting

Diversification – pricing

errors

Diversification –

effective statistics

Balance of risk premiums

Management

approaches

Market structure

Nature of performance

Skill: Portfolio Structuring

Skill: Forecasting

STRUCTURE OF MANAGERS‟ PERFORMANCES

5

𝑀𝑎𝑥.𝑅𝑒𝑡𝑢𝑟𝑛

𝑅𝑖𝑠𝑘 =

Diversifying uncompensated

risks effectively

(Volatility management

approach)

Identifying and/or

diversifying pricing error

(Naive approach)

+

Identifying and

diversifying risk factors

(Factor-based approach) +

Return = Beta + Alpha + Luck

Exposure to risk premiums Market

+

Size

Value

Trends

Quality

etc.

Unique expertise Forecasting returns

Better integration of risk

premiums

Exposure to unknown risk

premium

Diversification of pricing

error

Exposure to

uncompensated risk

Good luck – Announcement of

better profit than anticipated

Bad luck – Report indicating a

particular drug increases

cancer risk

UNDERSTANDING SOURCES OF PERFORMANCE

6

DIFFERENT APPROACHES TO PORTFOLIO STRUCTURING

Equal-weight

Weight based on historical

moving average

Weight based on accounting

variables (RAFI)

Naive approach Volatility management

approach Factor-based approach

Low volatility

Maximum Diversification (TOBAM)

Sampling on risk measures

Equal weighting

Low-Beta market

Small cap

Value style

Trend/momentum style

Multi-factor approach (AQR)

7

Traditional indexes are fully exposed to market risk (β market = 1) and have no exposure to the other

factors (βs of other factors = 0).

Source: IPSOL

Performance of key factors – U.S. equities

Period Market + Size Value Momentum

72-75 -5.8% -6.6% 11.0% 11.3%

76-79 6.8% 16.6% 6.3% 14.4%

80-83 6.9% 7.9% 7.0% 10.7%

84-87 7.2% -6.4% 5.6% 7.2%

88-91 10.7% -2.0% -3.6% 12.2%

92-95 9.2% 1.3% 9.3% 10.3%

96-99 19.3% -3.2% -7.1% 15.9%

00-03 -6.5% 11.2% 16.8% 6.5%

04-07 6.3% -0.8% 4.3% 7.3%

08-11 0.7% 5.7% -1.6% -7.7%

12-15 (June) 17.2% 1.0% -0.9% 3.8%

72-15 (June) 8.2% 3.4% 3.8% 7.5%

BETA – IDENTIFYING AND DIVERSIFYING FACTORS

8

LUCK – DIVERSIFYING UNCOMPENSATED RISKS

Firm Date β S&P500 ret. Firm ret. Explanation

Microsoft 24/04/2015 0.78 0.22% 10.45% Profits better than anticipated

ResMed 24/04/2015 0.48 0.22% -10.47% Sales lower than anticipated

Market portfolios are not necessarily the most efficient at diversifying uncompensated risk.

The objective is to reduce the volatility attributed to uncompensated risks per unit of periodic return.

Lower volatility

=

Higher compounded return

The objective is to manage

volatility more efficiently

Uncompensated risks cannot be forecasted but they can be diversified. This explains why a portfolio‟s risk

is lower than the average risk of its components.

9

ALPHA – IDENTIFYING / DIVERSIFYING PRICING ERRORS

Alpha is also related to diversification

The objective is either to forecast returns (which is difficult) or to diversify pricing error more efficiently

than an index based on market capitalization.

This can be achieved using an allocation method that is not correlated with pricing error.

Traditional indexes assign too much weight to overvalued securities and

too little to undervalued securities.

Firm Period Initial index

weight Initial price Final price Return Comment

Nortel 3/27/2000 to

6/15/2001 35% 143.06 9.86 -93% Large loss on large position

Ford 3/9/2009 to

3/9/2010 0.12% 1.74 12.80 635%

Large gain on small

position

10

A combination of 3 processes:

A sampling process – which securities are authorized in the portfolio

S&P500, equal-weight: Authorized securities in the S&P500 market capitalization

RAFI US 1000: 1000 securities with the highest score based on the Fundamental Index measure on the

NYSE, the AMEX and the NASDAQ. The score is based on a combination of 5-year averages for the sales,

accounting value, cash flow and dividend variables.

An allocation process –weights allocated to the securities

S&P500, equal-weight: 1/N

RAFI US 1000: weight based on score

A rebalancing process

S&P500 – equal-weight: quarterly

RAFI US 1000: annual

An allocation process necessarily creates factor bias, whether intentional or not.

PUTTING TOGETHER A PORTFOLIO – EXAMPLE OF U.S. EQUITIES

When risks other than market risk are not compensated

11

When the impact of uncompensated risks dominates in the short term.

E.g. positive surprises regarding the profits of large growth companies such as Apple

in 2014 and Google in July 2015 and/or when large countries dominate performance,

as in the case of China in 2014 and early 2015.

WHEN DO FACTOR-BASED PRODUCTS UNDERPERFORM?

12

A FEW STRATEGIES AND PRODUCTS EXPLAINED USING THE

FACTOR-BASED APPROACH

* Five-star Morningstar rating. 0.46% and 0.80% management fees respectively have been added to returns from both Fidelity Funds to ensure that all

portfolios are comparable.

One-factor model Equal

weighting

Fundamental

Index

Maximum

Diversification

Fidelity Large Cap

Value Enhanced*

Fidelity Blue Chip

Growth*

Alpha „ 1.59% „ 2.14% „ 2.50% - 1.44% 1.16%

Beta market 1.04 0.94 0.82 0.88 1.03

Five-factor model

Alpha 0.70% - 0.23% - 0.51% - 0.99% 2.34%

Market 1.01 0.99 0.82 0.92 1.02

Size 0.01 - 0.08 0.20 - 0.22 - 0.07

Value 0.27 0.32 0.15 0.33 - 0.15

Momentum - 0.03 0.03 - 0.08 „ 0.16 - 0.04

Low Beta 0.07 0.07 0.26 0.03 - 0.05

• Highly diversified:

• U.S. and international equities – Approximately 200 positions each

• Emerging markets – Exposure to 20 countries

• Resources – Exposure to 24 contracts

• Balanced exposure to all risk premiums:

• Equities - Value, trend/momentum, size, current yield, asymmetry, etc.

• Resources, currency – Value, trend/momentum

• Managing uncompensated risks to improve geometric return

13

IMAGINE A GLOBAL PORTFOLIO THAT INTEGRATES ALL OF THESE

MANAGEMENT APPROACHES

14

PERFORMANCE (CAD)

Absolute return – Annualized Relative return (60/40) – Annualized

You cannot win all of the time, but you

can do much better in the long term.

Scatter plot – Portfolio vs 60/40

CONCLUSION AND

RECOMMENDATIONS

15

KEY MESSAGES

• The best managers do not outperform systematically.

• Only 20% to 30% of active managers beat their targets after fees. This percentage is

structural and is not affected by participant quality but instead by fees.

• Luck is always a significant factor in performance.

• Forecasting returns is not the main source of performance.

16

Three forms of diversification explain much of the long term performance.

WHICH APPROACH IS PREFERABLE – FUNDAMENTAL OR QUANTITATIVE?

17

What does matter:

The process (not necessarily the methodology) and total fees

It doesn‟t matter!

• You cannot tolerate underperformance over 3 to 5 years.

• Sources of creation of enigmatic value

• “Closet Indexing”

• If fees are unreasonable

AVOID ACTIVE MANAGEMENT IN THE FOLLOWING SCENARIOS:

The best managers share a similar philosophy even if the

implementation methodology is different.

JACQUES LUSSIER, President & Chief Investment Officer

514-842-2224, jacques.lussier@ipsolcapital.com

HUGUES LANGLOIS, Director of Research

646-583-2092, hugues.langlois@ipsolcapital.com

GUY DESROCHERS, VP & Chief Compliance Officer

514-842-2225, guy.desrochers@ipsolcapital.com

LUC GOSSELIN, Director of Operations

514-842-2022, luc.gosselin@ipsolcapital.com

18

This document has been prepared for information purpose only, and does not constitute an offer or solicitation to buy or sell any securities, products or

services and should not be construed as specific investment advice. The content of this presentation is proprietary and should not be further

distributed without prior consent of IPSOL Capital Inc.

Les informations et les opinions exprimées dans ce document sont offertes à titre informatif seulement et ne doivent pas être considérées comme une

offre ou une sollicitation visant l‟achat ou la vente d‟un titre, d‟un produit ou d‟un service quelconque, ni interprétées comme un conseil de placement

précis. Le contenu du présent document est la propriété exclusive d‟IPSOL Capital Inc. et ne doit pas être distribué sans son consentement préalable.

368 Notre-Dame West, Suite 301, Montreal, Québec, H2Y 1T9, www.IPSOLCAPITAL.com

Jacques Lussier is a former academician at HEC Montreal and has worked within the financial industry for 18 years at

Desjardins Global Asset Management (DGAM) where he was Chief Investment Strategist until March 2013. During his

career, Jacques has been involved in most segments of the asset management industry: portfolio policy and global

asset allocation for institutional clients, fund of funds management both alternatives and traditional, research leading

to product design and product management in the equity, commodity and asset allocation space and management of

high net worth platforms.

• Jacques earned a M.Sc. in Finance from HEC Montreal and a Ph.D. in International Business from the University

of South Carolina.

• He was President of the CFA Society Montreal from 2013 to 2014 and CFA Institute‟s volunteer of the year in

2015. Jacques is also one of four members of the CFA Institute‟s Research Council for America responsible for

proposing new research avenues.

• He is a board member of Régie des Rentes du Québec and a member of its investment and audit committees. He

is also a member of the advisory board of InvestorLit and the author of the book “Successful Investing Is a

Process” published by Wiley and Bloomberg Press in December 2012. Jacques is currently working on another

book to be published in 2016.

• Jacques is CEO and CIO of IPSOL CAPITAL.

19

JACQUES LUSSIER

19