Private and confidential – institutional investors only – not for public distribution
Combining Alpha and Beta Strategies to Maximize
Risk-Adjusted Returns
Quarter 4 2006
Agenda
ƒ Optimised Beta Portfolio Construction
ƒ Active Manager Risk Budgeting
ƒ Separating Alpha & Beta
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1
Optimal Portfolio Construction Overview
Step One
β
α
Step Two
Asset Efficient
Frontier
Best Active
Managers for
each asset
class
1,2,3 …
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Strategic Asset
Allocation
(Policy)
Active Efficient
Frontier 1,2,3…
2
Optimal Manager
Structure 1,2,3…
Potential return (%)
Asset Efficient Frontier
Large Cap
European Equities
Small Cap
European
Equities
Inflation-Linked Bonds
Short Term Government Bonds
3291-iS-0906
Potential risk (% standard deviation)
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3
Japanese
Equities
Emerging
Market
Equities
Optimised Beta Portfolio
Potential return (%)
Optimised Beta Portfolio
DJ Euro
STOXX 50
DJ Europe
Small Cap
EuroMTS Inflation
Linked Index
JP Morgan Government
Bond Index 1-3yr
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Potential risk (% standard deviation)
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4
MSCI
Japan
MSCI
Emerging Markets
FTSE 100
S&P 500
$ Corp Bond € Corp Bond £ Corp Bond
Use low correlated Betas to build efficient portfolio
£ Corp Bond
€ Corp Bond
$ Corp Bond
FTSE 100
LOW Correlation
HIGH Correlation
* Based on iShares data
Private and confidential – institutional investors only – not for public distribution
S&P 500
5
Example of Optimised Beta Portfolio
Mean-Variance Efficient Frontier and Random Portfolios
x 10-4 8
7
6
Potential return
5
4
3
2
1
0
-1
1
2
3
4
5
Potential risk (% standard deviation)
* sur la base des données iShares
Private and confidential – institutional investors only – not for public distribution
6
6
7
-3
x 10
Evaluating Active Manager Risk
ƒ Alpha is the manager’s return relative to the benchmark
ƒ Active manager risk is how much tracking error a manager risks
while attempting to add alpha
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7
A Model of Active Manager Returns
Illustration of 5.8% hypothetical tracking error
1/6 of time positive Alpha
at least +5.8% (1 out of 6 years)
2% Risk Budget
+5.8%
+2.0%
2/3 of time within
this range
(4 out of 6 years)
-2.0%
-5.8%
1/6 of time negative Alpha is at
least -5.8%
(1 out of 6 years)
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8
A Model of Active Manager Returns
After fees and costs
Before fees and costs
+5.8%
+4.8%
“Good” Managers
Benchmark =
Mgr. Average
Benchmark
Mgr. average = -1%
“Bad” Managers
-5.8%
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-6.8%
Source: Sharpe, “Arithmetic of Active Management,” Financial Analyst Journal, Jan-Feb, 1991. Waring, Whitney, Pirone and Castille, “Optimizing Manager Structure and
Budgeting Manager Risk,” Journal of Portfolio Management 25, Spring 2000.
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9
Expected
active return %
Potential return (%)
Potential return (%)
Traditional Portfolio Construction Framework
Active
Efficient
Frontier
Asset Efficient
Frontier
Desired beta
exposure (Policy)
Active risk %
Potential
risk (% standard
Potential
risk (%standard
deviation)deviation)
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10
Beta example: Inflation-Linked Bonds
ƒ
ƒ The beta you pay for should
be pure and should not exhibit
any statistical deviation
Even simple, liquid betas can
exhibit non-normality of returns
iShares € Inflation Linked Bond,
distribution of daily returns
(21-11-05 and 29-09-06)
iShares € Inflation Linked Bond,
distribution of daily difference with benchmark
(21-11-05 and 29-09-06)
25
150
20
100
15
10
50
5
0
0
-1.5
-1
-0.5
0
0.5
1
-8
1.5
-3
3291-iS-0906
Private and confidential – institutional investors only – not for public distribution
-6
-4
-2
0
2
4
6
8
-3
x 10
x 10
11
Alpha example: Inflation-Linked Bonds
112
110
108
106
KEY
104
Fund 1
102
Fund 2
Fund 3
100
Fund 4
98
Beta
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12
00
0/
2
/1
01
/0
01
*Cumulative performance using weekly data from 01/10/04 to 03/11/06. Beta is represented by the Credit Suisse EuroGovt Inflation linked Index 3-5 years. Funds are
European inflation linked bond funds. These funds may run against different benchmarks and have different nominal durations.
Private and confidential – institutional investors only – not for public distribution
6
6
8/
2
00
01
/0
6/
2
4/
2
/0
01
00
6
6
00
6
01
/0
2/
2
00
5
/1
01
0/
2
/1
01
2/
2
00
00
5
5
01
/0
8/
2
00
01
/0
6/
2
4/
2
/0
01
00
5
5
00
5
01
/0
2/
2
00
4
00
2/
2
/1
01
01
/1
0/
2
00
4
96
Alpha example: Inflation-Linked Bonds
ƒ
Distribution of returns from benchmark
Fund 1: IR 0.00
30
20
20
10
10
0
0
-0.02
-0.01
0
0.01
0.02
Fund 3: IR 0.50
30
-0.02
20
10
10
0
0
-0.01
0
0.01
0.02
-0.02
*Cumulative performance using weekly data from 01/10/04 to 03/11/06
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13
-0.01
0
0.01
0.02
Fund 4: IR 0.43
30
20
-0.02
Fund 2: IR 0.23
30
-0.01
0
0.01
0.02
Beta example: Japanese Equities
iShares MSCI Japan,
distribution of daily returns
(01-10-04 et 29-09-06)
iShares MSCI Japan,
distribution of daily difference with benchmark
(01-10-04 and 29-09-06)
30
80
70
25
60
20
50
15
40
30
10
20
5
10
0
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-0.015
0
-0.01
-0.005
0
0.005
0.01
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0.015
-0.05 -0.04 -0.03 -0.02 -0.01 0
14
0.01 0.02
0.03 0.04
0.05
Alpha example: Japanese Equities
120
110
100
90
KEY
Fund 1
80
Fund 2
70
Fund 3
Fund 4
60
Beta
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*Cumulative performance using weekly data from 05/01/01 to 03/11/06. Beta is represented by the MSCI Japan (local currency). Funds are Japanese equity mutual funds
(with returns in local currency).
Private and confidential – institutional investors only – not for public distribution
15
3
00
2
1/
2
/0
05
05
/1
1/
2
00
2
/0
/0
9/
2
00
2
05
05
05
/0
5/
2
7/
2
00
00
2
2
3/
2
/0
05
05
/0
1/
2
00
2
00
1
05
/1
1/
2
00
05
/0
9/
2
7/
2
/0
05
00
1
1
00
1
00
5/
2
/0
05
3/
2
/0
05
05
/0
1/
2
00
00
1
1
50
Alpha example: Japanese Equities
ƒ
Distribution of returns from benchmark
30
Fund 1: IR 0.62
30
20
20
10
10
0
0
-0.04
25
Fund 2: IR 0.24
-0.02
0
0.02
0.04
Fund 3: IR -0.08
-0.2
40
20
-0.1
0
0.1
0.2
0.02
0.04
Fund 4: IR -0.42
30
15
20
10
10
5
0
-0.05
0
0
0.05
-0.04
*Cumulative performance using weekly data from 05/01/01 to 03/11/06
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16
-0.02
0
Active Risk Budgeting within each asset class
Higher Active Risk
Index Fund 20%
Active Fund 80%
Potential return (%)
Lower Active Risk
Index Fund
Active Fund
65%
35%
MSCI Japan
6% Active risk budget
EuroMTS Inflation Linked Index
2% Active risk budget
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Potential risk (% standard deviation)
International stocks are subject to certain risks of overseas investing including currency fluctuations and changes in political and economic conditions,
which could result significant market fluctuations. These risks are magnified in emerging markets.
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17
Traditional Portfolio Combining Alpha & Beta
Mean-Variance Efficient Frontier and Random Portfolios
x 10
-3
3.5
3
Potential Return %
2.5
2
1.5
1
0.5
0
0
0.005
0.01
0.015
0.02
Potential risk (% standard deviation)
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18
0.025
0.03
Active Efficient Frontier
ƒ How to beat a specific Beta benchmark:
- Strategic allocation of Beta weightings differ from those of benchmark
- Exact replication of benchmark Beta weightings combined with
optimised allocation of active managers
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19
Potential return (%)
Optimal combined Alpha & Beta Portfolio
Active Efficient Frontier
Best Active Portfolio +
Desired beta exposure
Surplus Efficient
Frontier (beta)
Desired beta
exposure
0.16
0.14
Return
0.12
Potential risk (%)
0.1
0.08
0.06
0.04
0
0.1
0.2
0.06
0.08
Risk
% of Alpha
Private and confidential – institutional investors only – not for public distribution
0.1
20
0.12
0.14
0.16
The question is NOT “Active or Passive”
ƒ Optimal portfolios allocate capital in proportion to Information Ratios
and inversely proportional to active risk
ƒ Active and passive managers can be combined within each asset
class to construct optimized portfolio
3291-iS-0906
ƒ Optimized beta portfolio can act as base upon which to construct an
active efficient frontier
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21
iShares a leader in providing innovative funds
DEVELOPED EQUITY
EMERGING EQUITY
CORPORATE BONDS
iShares MSCI World
iShares MSCI Japan
iShares S&P 500
iShares MSCI North America
iShares FTSE 100
iShares MSCI Emerging Markets
iShares MSCI Eastern Europe
iShares MSCI Brazil
iShares MSCI Taiwan
iShares MSCI Korea
iShares MSCI AC Far East ex-Japan
iShares FTSE/Xinhua China 25
iShares € Corporate Bond
iShares £ Corporate Bond
iShares $ Corporate Bond
EUROPEAN/STYLE EQUITY
EQUITY INCOME
GOVERNMENT BONDS
iShares DJ Euro STOXX Value
iShares DJ Euro STOXX Growth
iShares DJ Euro STOXX MidCap
iShares DJ STOXX SmallCap
iShares DJ Euro STOXX 50
iShares DJ STOXX 50
iShares MSCI Europe ex-UK
iShares FTSEurofirst 80
iShares FTSEurofirst 100
iShares DJ Euro STOXX Select Dividend
iShares DJ Asia/Pacific Select Dividend
iShares $ Treasury Bond 1-3
iShares € Government Bond 1-3
PROPERTY & ALTERNATIVES
INFLATION LINKED BONDS
iShares FTSE EPRA European Property
iShares € Inflation Linked Bond
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22
Thank you
For more information, visit
ƒ www.iShares.fr
ƒ Institutional enquiries: +44 (0) 20 7668 8007
ƒ Bloomberg: iShares <GO>
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23
Regulatory information
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Economics and specific risks relating to the iShares DJ Euro STOXX Select Dividend Fund
The investment objective of the Fund is to provide investors with a total return (calculated on a re-invested dividend basis), taking into account both
capital and income returns, which reflects the return on the high dividend paying equity securities of the European Economic and Monetary Union.
By investing in this Fund, the shareholder is assuming that the distribution rate of high dividends as observed in the preceding year, constitutes a
pertinent criteria for the selection of companies who will distribute high dividends for the current year.
The benchmark index of iShares DJ Euro STOXX Select Dividend is calculated on an annual basis (in March) on the basis, inter alia, of the amount of
dividends paid out in the preceding year. It follows that the composition of the index is determined, inter alia, on the basis of the past performance of
companies composing the DJ Euro STOXX index. However, the attention of shareholders is brought to the fact that past performance is not a guide to
future performance and does not remain constant. As a result, it is possible that the index components will not be companies that pay out high
dividends in the current year.
Risks specific to the iShares DJ Euro STOXX Select Dividend, iShares DJ Euro STOXX Growth and iShares DJ Euro STOXX Value Funds
The benchmark indices of the iShares DJ Euro STOXX Select Dividend, iShares DJ Euro STOXX Growth and iShares DJ Euro STOXX Value Funds
are constructed in a systematic manner. The attention of shareholders is brought to the fact that there is no guarantee that the chosen methodology is
pertinent to enable the relevant Funds to achieve their investment objectives.
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25
European iShares index disclaimers
The iShares $ Corporate Bond is not sponsored nor endorsed by Goldman, Sachs &Co. or Goldman Sachs International, Neither Goldman, Sachs & Co. or Goldman Sachs
International makes any representation regarding the advisability of investing in the iShares $ Corporate Bond.
"Standard & Poor's®", "S&P®", "S&P 500®", "Standard & Poor's 500", and "500" are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by Barclays
Global Investors.
The FTSE/Xinhua China 25 Index is calculated by or on behalf of FTSE/Xinhua Index Limited. FTSE/Xinhua Index Limited does not sponsor, endorse or promote iShares funds.
All copyright in the index values and constituent list vests in FXI. “Xinhua” is a service mark of Xinhua Financial Network Limited. All marks are licensed for use by
FTSE/Xinhua Index Limited.
“Dow Jones ”,“STOXX ”,“Dow Jones EURO STOXX 50 Index ”,“Dow Jones STOXX 50 Index ” are trademarks and/or service marks of Dow Jones &Company, Inc. and/or STOXX
Limited and have been licensed for use for certain purposes by the European Exchange-Traded Fund Company plc. The funds of the European Exchange-Traded Fund
Company plc are not sponsored, endorsed, sold or promoted by Dow Jones or STOXX, and neither Dow Jones nor STOXX makes any representation regarding the
advisability of trading in such funds.
iBoxx is a registered trade mark of iBoxx Limited and has been licensed for the use by Barclays Global Investors Limited. iBoxx does not approve, endorse or recommend Barclays
Global Investors Limited or iShares plc. iShares funds are not sponsored, endorsed or sold by iBoxx Limited and iBoxx Limited makes no representation regarding the
suitability of investing in iShares funds.
iShares funds are not sponsored, endorsed, or promoted by MSCI and MSCI bears no liability with respect to any such funds or any index on which such funds are based. The
Prospectus contains a more detailed description of the limited relationship MSCI has with Barclays Global Investors and any related funds, accounts, products or securities.
The Dow Jones EURO STOXX Midcap Index and the Dow Jones EURO STOXX Smallcap Index are proprietary and copyrighted material. The Dow Jones EURO STOXX Midcap
Index and the Dow Jones EURO STOXX Smallcap Index and the related trademarks have been licensed for certain purposes by Barclays Global Investors Limited.
iShares DJ Euro STOXX MidCap and iShares DJ Euro STOXX SmallCap are not sponsored, sold, endorsed or promoted by STOXX Limited or Dow Jones & Company,
Inc.
"The Dow Jones EURO STOXX® Select Dividend 30 Index, Dow Jones EURO STOXX Large Cap Value Index and Dow Jones EURO STOXX Large Cap Growth Index (the
"Indices") are proprietary and copyrighted material. The Indices and the related trademarks have been licensed for certain purposes by Barclays Global Investors Limited.
iShares DJ Euro STOXX Select Dividend, iShares DJ Euro STOXX Growth and iShares DJ Euro STOXX Value are not sponsored, sold, endorsed or promoted by STOXX
Limited or Dow Jones & Company, Inc.
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26
European iShares index disclaimers
continued
"FTSE®" is a trade mark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited under licence. "NAREIT®" is the trade mark of the
National Association of Real Estate Investment Trusts and "EPRA" is the trade mark of the European Public Real Estate Association. The FTSE EPRA/NAREIT Europe ex UK Dividend
+ Index is calculated by FTSE International Limited. FTSE International Limited, Euronext N.V., National Association of Real Estate Investment Trusts and the European Public Real
Estate Association do not sponsor, endorse or promote this product and do not accept any liability in relation to its issue, operation and trading.
"Barclays Capital" is a trade mark of Barclays Capital, the investment banking division of Barclays Bank PLC ("Barclays Capital") and is used by Barclays Global Investors under licence. With a
distinctive business model, Barclays Capital provides corporates, financial institutions, governments and supranational organisations with solutions to their financing and risk
management needs. Barclays Capital compiles, maintains and owns rights in and to the Barclays Euro Government Inflation-Linked Bond Index. The iShares € Inflation Linked Bond is
not sponsored, endorsed, sold or promoted by Barclays Capital and Barclays Capital makes no representation regarding the advisability of the iShares € Inflation Linked Bond or use of
either the Barclays Euro Government Inflation-Linked Bond Index or any data included therein.
Barclays Global Investors Limited has been licensed by FTSE International Limited to use the name “FTSEurofirst 80”. ”FTSE™”, is a trade mark jointly owned by the London Stock Exchange
Plc and The Financial Times Limited and is used by FTSE International Limited under licence. “Eurofirst” is a trade mark jointly owned by FTSE and Euronext. The iShares Funds are
not sponsored, endorsed, sold or promoted by FTSE International Limited or Euronext and FTSE International Limited and Euronext make no representation by warranty, express or
implied, to the owners of the iShares Funds or any member of the public regarding the advisability of trading or investing the iShares Funds.
Barclays Global Investors Limited has been licensed by FTSE International Limited to use the name “FTSEurofirst 100”. ”FTSE™”, is a trade mark jointly owned by the London Stock Exchange
Plc and The Financial Times Limited and is used by FTSE International Limited under licence. “Eurofirst” is a trade mark jointly owned by FTSE and Euronext. The iShares Funds are
not sponsored, endorsed, sold or promoted by FTSE International Limited or Euronext and FTSE International Limited and Euronext make no representation by warranty, express or
implied, to the owners of the iShares Funds or any member of the public regarding the advisability of trading or investing the iShares Funds.
“Barclays Capital” is a trade mark of Barclays Capital, the investment banking division of Barclays Bank PLC (“Barclays Capital”) and is used by Barclays Global Investors under licence. With a
distinctive business model, Barclays Capital provides corporates, financial institutions, governments and supranational organisations with solutions to their financing and risk
management needs. Barclays Capital compiles, maintains and owns rights in and to the [Barclays Euro Govt Bond 1-3yr Term Index and/or Barclays US Treasury 1-3yr Term Index ].
The fund/s [iShares $ Treasury Bond 1-3 and iShares € Government Bond 1-3] is/are not sponsored, endorsed, sold or promoted by Barclays Capital and Barclays Capital makes no
representation regarding the advisability of the [fund/s] or use of either the [Barclays Euro Govt Bond 1-3yr Term Index and/or Barclays US Treasury 1-3yr Term Index ] or any data
included therein.
“Dow Jones and Dow Jones Asia/Pacific Select Dividend 30 Index are service marks of Dow Jones & Company, Inc. and have been licensed for use for certain purposes by Barclays Global
Investors, N.A.. The iShares DJ Asia/Pacific Select Dividend is not sponsored, endorsed, sold or promoted by Dow Jones and Dow Jones makes no representation regarding the
advisability of investing in the Product”.
‘iShares’ is a trademark owned by Barclays Global Investors N.A.
© 2006 Barclays Global Investors Limited. All rights reserved.
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27