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Parametric equity portfolio management taking advantage of market capitalisation methodology of index construction.

Gene Fama and Ken French probably introduced the first pseudo systematic style of equity investing by introducing two risk premiums which were different than the traditional CAPM model. The two risk premiums were related to the market cap risk premium and the value risk premium. They argued that an investor should be systematically rewarded, over a long term for taking risk to invest in small cap stocks and also those stocks which are going through a period of distress or out of favour period and are perceived value on a book value per share basis. Simply put, the Fama and French model is represented as Re - Rf = (1 x MRP) + (2 x SCRP) + (3 x VRP) + Where, Re= Expected return Rf= Risk free rate MRP = Market risk premium SCRP = Small cap risk premium VRP = Value risk premium If we take the S&P Small Cap 600 Value TR as the representative of the Fama and French Model and compare it with S&P 500 TR, a proxy for the market in the US, we get the following statistics, Data from June 1995- June 2012 ( monthly data) Annualised return Annualised Risk Sharpe Ratio S&P 500 TR 7.5% 16.1% 0.47 S&P Small Cap 600 Value TR 10.0% 19.7% 0.51

This goes to prove that the market rewards an investor for taking in business risk. The point I am trying to make is that if we dissect the market into the nine boxes formulated by Morningstar and hold all the stocks appearing in the bottom left corner, we can expect to outperform the broad market over a long time horizon.

The above process can be carried out quite parametrically classifying the market into the various style boxes as above by quantitatively filtering out fundamental and market data of the stocks in the equity market. Recent innovations relating to the parametric style of equity portfolio management has been quite impressive, especially quick to address a better way of investing money for clients which have a mandate of beating a broad market index. One method tries to create a parametrically constructed diversified portfolio than the market index with low correlation with its constituent holdings and therefore aims to diversify by allocating risk among all available risk factors. Diversification empirically have been found to increase Sharpe ratios which tend to be more than the market cap weighted index while reducing relative volatility and increasing relative return in the long run. Basically, by having stocks less correlated with each other, the portfolio captures a higher variation of risk premiums to perform better than the market cap index. The concerns I have with this parametric system is whether the risk premiums represented in the portfolio remain less correlated itself through time. Do the risk factors become highly correlated in certain market stress conditions? I would argue, in which case, the portfolio might have a bigger drawdown than the market index. Another method tries to run a parametrically constructed minimum variance portfolio i.e. the lowest point portfolio in the efficient frontier, universe being the stock constituents of a broad market index. Given that the portfolio will have a low variance or volatility, the portfolio will most probably lag on the upside and outperform on the downside in short creating a low beta portfolio. The thing to consider is that individual stocks may change characteristics and to maintain a minimum variance portfolio, it may require a high turnover of stocks in the portfolio.

There is one more group of parametrically driven portfolio construction methodology. This methodology tries to weight the stocks of a market benchmark with fundamental statistics instead of market cap used for index construction. Numerous ways have been found to do the same but I guess all methods will have positives and negatives relative to the market cap index construction methodology. For institutional investors and also for a private investor trying to get access to equity markets, it may be quite advantageous to have access to the market through portfolios constructed parametrically because, in any case, all methods try to negate the inherent bias of market cap weighting methodology which weights successful stocks more as markets go up. It is quite obvious that this weighting increase of a successful stock will be a bigger detriment to the market index portfolio performance in case of a reversal or downturn. On the downside, buying a tracker may also be appropriate as we dont take tracking risk relative to the benchmark. What we use is our choice and is dependent upon our tracking risk objective. The proliferation of these methodologies has been more profound given the consistent bear equity markets in the current or the recent past environment. However, once trending markets presume, it will be interesting to see how these parametrically driven portfolios perform because in trending markets, market cap methodology may well turn out to be the winner in the short to medium term. In the long run, however, parametric portfolios do seem to have some advantage.

Data from June 1995- June 2012 ( monthly data) Annualised return Annualised Risk Sharpe Ratio

S&P 500 TR 7.5% 16.1% 0.47

S&P Small Cap 600 Value TR 10.0% 19.7% 0.51

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