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Amundi Discussion Papers Series

DP-04-2014
May 2014
For professional investors only
UNDERSTANDING SMART BETA:
BEYOND DIVERSIFICATION AND LOW RISK INVESTING
Alessandro RUSSO, Quantitative Research
research-center.amundi.com
Amundi Discussion Papers Series - DP-04-2014
3
Abstract
S
mart Beta is the answer of asset management industry to some well
know drawbacks of market capitalization-based equity indices as price
noise, overrepresentation of large caps, absence of auto-corrective
mean reversion mechanism. Some of these features may result in high volatility
and massive drawdowns, thus potentially compromising the risk return payoff of
traditional equities, at least when the investment horizon is shorter than 8-10 years.
In this study we provide a formal description of three popular risk-based smart beta
strategies (the minimum variance portfolio, the portfolio maximizing the diversifcation
ratio, and the risk parity portfolio), providing some insights in terms of composition.
Specifcally we point out that all of them provide some interesting diversifcation
enhancement relative to standard indices, and all of them contain low systematic
risk characteristics. But still they exhibit different features that can be exploited in a
diversifed alternative beta allocation, as well as in some timing or rotation strategy.
We show that low market beta and the low risk anomaly explain a relevant portion
of the variability of the active returns of the minimum variance strategies, with some
variance explained by sector reversal and dividend yield. Yet the unexplained
variability corresponds to some non-negligible positive contribution to performance,
while fltering the universe for some quality criteria provides additional value. As for the
diversifcation-based strategies, low market beta and low risk anomaly are still the
more signifcant factors, with the addition of small cap and sector reversal. Small
cap and sector reversal are the most relevant factors for risk parity strategies,
while low beta and low risk anomaly are less explanatory.
If the investors relevant risk measure is absolute risk, smart beta may become a
new equity core. In this case, however, liquidity of smart beta strategies must be
consistent with the amount of assets the investor holds.
We fnally discuss whether these strategies should be considered as passive or
rather active strategies.
Key words: smart beta, portfolio diversifcation, minimum variance, risk parity, entropy
Amundi Discussion Papers Series - DP-04-2014
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Amundi Discussion Papers Series - DP-04-2014
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Introduction
Equity markets have been very challenging during the last 25 years: international
indices often shifted from extraordinary bull market conditions to prolonged
drawdowns with high realized volatility. During the frst decade of the new century
equity investors faced a major and unfavorable change in traditional risk-return
payoffs. Such a background stimulated discussions over traditional market cap
weighted index and growing evidence of their ineffciency had been pointed out.
Market cap weighted indexes rely on stocks prices only and, as markets are
not in equilibrium all the times, market value weights may suffer price noise. In
extreme circumstances where bubbles arise, since market cap weighted indices
mimic a buy and hold strategy (with no auto-corrective mean reverting mechanism
embedded), overvalued stocks as telecom before 2000 or fnancials before 2008
become over-weighted.
In addition, in market cap weighted index large cap are over represented, and small
cap almost neglected.

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Weight of Information Technology and Telecom
Source: Amundi Research
TMT bubble RISK PARITY INDEX MKT CAP INDEX (MSCI WORLD)
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UNDERSTANDING SMART BETA:
BEYOND DIVERSIFICATION AND
LOW RISK INVESTING
Amundi Discussion Papers Series - DP-04-2014
6
The asset management industry has been proposing several alternative ways of
building equity indices and portfolios, aiming to mitigate the ineffciency embedded
in price-based index construction rules. These alternative indices or portfolios are
known as smart beta equities and they generally belong to absolute risk-returns
strategies: away from the notion of tracking error or information ratio, they focus on
Sharpe ratio or risk adjusted return, and absolute volatility metrics. They can ideally
be grouped into two categories: fundamental-based and risk-based portfolios. In
the frst family, as in the case of the RAFI index, stocks weights are proportional to
some fundamental metrics, as revenues, income, cash fows, or dividends. In the
second family, stocks may be weighted according to some risk metrics such as
volatility, correlation and contribution to volatility, or may maximize some risk-based
utility function (minimize volatility or maximize diversifcation). Within this category,
risk-based weighting schemes may be applied to a restricted investment universe,
according to the exposure of the stocks to some fundamental, technical, and style
measures (also known as risk factors like value, momentum, volatility, or size).
In the last few years, Amundi has deeply investigated smart beta equities,
developing its own range of solutions aiming to Sharpe ratio improvement. They
are based either on the use of instruments providing favorable asymmetry (options
and other derivatives), or they belong to the risk-based family of alternative beta
portfolios as minimum variance, optimal diversifcation, and risk parity.
I - Smart Beta Strategies
1. 1 The minimum variance portfolio
Amundi claims several years of experience in minimum variance equity management,
with two Europe portfolios (since 2007 and 2009 respectively) and some more
recent portfolios on world developed markets, Japan, emerging markets, Pacifc
ex Japan, and other customized universes.
The effcient frontier and the minimum variance portfolio
The effcient frontier represents the set of portfolios that earn the maximum rate of
return for every given level of risk. The minimum variance portfolio is the one sitting on
the very edge of the effcient frontier. In building such a portfolio, expected returns are
not needed as the only requirement is to minimize volatility, while being fully invested.
The simple objective function is thus:
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w

where w is the vector of the optimal portfolio weights, V is the variance-covariance


matrix, and e
T
is a vector of ones.
Amundi Discussion Papers Series - DP-04-2014
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We will show in the next section that the minimization of variance is achieved
though both the selection of low risk stocks (low systematic and low specifc risk
stocks), and the selection of those stocks that are exposed to uncorrelated even
negatively correlated factors. In other words, we will prove that the minimum
variance portfolio contains both a low risk story, and a diversifcation story.
An enhanced process
Although we recognize the advantage of such a process being transparent and
intuitive, we are conscious of some typical drawbacks that may arise from minimum
variance portfolios: as shown in Clarke, de Silva and Thorley (2011), minimum
variance portfolios may be quite concentrated on a few low volatility stocks, may
exhibit rather high turnover, may be exposed to valuerelated factors such as
dividend yield, may be invested in small capitalization stocks (with some relevant
implications on liquidity), and may have some volatile exposure to momentum.
Similarly, Thomas and Shapiro (2007) highlight the risk of the minimum variance
portfolio being excessively concentrated on a few low risk sectors, and the lack
of control for involuntary factor exposures. They also express their preference for
tilting portfolios toward some successful stock ranking criteria.
These are all relevant issues in portfolio construction. In order to take them into
account, the best practice of the industry is to implement an enhanced portfolio
construction process, employing flters to the investment universe, applying
optimisation constraints, and allowing discretionary interventions by the fund
managers. We will briefy describe Amundis investment process in the annex.
However, in the next section of this study, except where it is explicitly mentioned,
we will ignore any aspect that is beyond the pure smart beta portfolio construction,
as we want to focus on the impact that the unconstrained minimum variance
process has on portfolio composition.
1.2 The portfolio maximizing the diversifcation ratio
Several reasonable diversifcation measures exist, and maximizing each of them
would lead each time to a different portfolio. One of the most popular measures of
diversifcation is the so called diversifcation ratio, which is the ratio () of average
stocks volatility on portfolio volatility, as it was originally introduced by Choueifaty
and Coignard in 2008.
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w

Since correlations among any pairs of assets are lower than one, the denominator
is lower than the numerator and the ratio is always higher than one. Maximizing this
Amundi Discussion Papers Series - DP-04-2014
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ratio is thus equivalent to minimizing the average correlation across all the stocks
in the portfolio.
Better diversifcation and lower correlations explain why the risk of the portfolio
maximizing the diversifcation ratio is always lower than the risk of a standard
market index. In addition to that, the optimisation contains a pseudo-minimization
of the denominator that is satisfed via the selection of low systematic risk stocks.
On the other hand, at the numerator, the optimisation results in the selection of high
specifc risk stocks since they increase average volatility, while having little impact
on the denominator: specifc risk doesnt matter at the denominator as it is easily
diversifed away.
As a result, the portfolio maximizing the diversifcation ratio may show an average
total volatility that is not statistically different from that of a standard market index,
but will necessarily result in below average systematic risk stocks (the denominator
effect), and above average specifc risk stocks (the numerator effect).
Very often the portfolio maximizing the diversifcation ratio is presented as a
portfolio belonging to the effcient frontier, or even being the tangency portfolio
(the portfolio maximizing the Sharpe ratio). Actually, this portfolio corresponds to
the maximum Sharpe ratio portfolio only in the hypothesis that expected returns
are strictly proportional to their total volatility. If this hypothesis does not hold, still
being the portfolio that maximizes our specifc defnition of diversifcation (), such
a portfolio is below the effcient frontier and does not correspond to the tangency
portfolio. Neither can we state that the portfolio maximizing the diversifcation
ratio corresponds to the market portfolio, as we would assume that such a market
portfolio is completely insensitive to expected returns.
Maximizing diversifcation is an intuitive and transparent process, but as for the
minimum variance process it may contain the typical drawbacks of optimisation-
based portfolios, such as overconcentration, lack of liquidity, (involuntary) style
exposures, turnover, low fundamental quality.
For these reasons, when dealing with diversifcation-based strategies, we believe
that an enhanced process similar to the minimum variance one may be sound.
However from now on, we will ignore any aspect that is beyond the pure smart
beta portfolio construction, as we want to focus on the impact that the risk-based
process alone has on portfolio composition.
1.3 The risk parity portfolio
Risk parity means that each asset (asset class, equity sector, single stock) has an
equal contribution to the total risk of the portfolio.
Amundi Discussion Papers Series - DP-04-2014
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In order to come out with full risk parity, the following relationship must hold:
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w

Where RC
i
is the risk contribution of the i
th
asset, and MC
i
is its marginal
contribution to risk, defined as follows
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w

In other words, the risk contribution should be the same for any asset or asset
class and the weight of each asset or asset class should be proportional to the
inverse of its marginal contribution to risk:
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w

Actually, marginal contributions to risk are both function of volatilities and


correlations of any asset with the rest of the portfolio, with correlations depending
on portfolio composition itself. In other words, weights are the unknowns and
should be proportional to the inverse of marginal contributions that depend
on weights themselves: the problem is clearly recursive, and the solution is
endogenous.
As Maillard, Roncalli, and Teiletche (2009) have pointed out, full risk parity cannot
be obtained in a closed formula unless some unrealistic hypotheses (such as
equal correlation among all the assets in the investment universe) are made, and
may not be achieved through optimisation either, if the number of assets involved
is very high, and correlations are very heterogeneous. For this reason the asset
management industry proposes several proxies.
By far, the easiest but probably the most nave proxy for risk parity is the equally
weighted portfolio: no estimation is made on volatility and correlation and assets
are equally weighted. It would correspond to the true risk parity portfolio assuming
that all stocks have the same volatility, and all the pairs of stocks have identical
correlation. With no risk estimation, the equally weighted scheme only removes
the risk concentration driven by market capitalization: since sectors, countries,
or whatever groups of stocks (based on some style criteria, for instance) are not
equally populated, equally weighting stocks would result in higher concentration
of risk over those sectors, countries, or styles that are over-represented.
Another proxy for risk parity would be the risk weighted scheme where stocks are
weighted proportionally to the inverse of their volatility. This weighting scheme
removes the risk concentration driven by market cap and adjusts for volatility,
but the resulting portfolio is a true risk parity solution only in the hypothesis of
Amundi Discussion Papers Series - DP-04-2014
10
equal correlation across all pairs of assets. However, when correlations are quite
homogenous, although every stock has a similar risk contribution, we would still
have concentration over those families of stocks that are overrepresented.
In order to smooth the risk concentration over such an overrepresented group
of stocks, a two-step risk weighting scheme may be used: risk-weighted sector
baskets should be created first, and the overall portfolio should be created
afterwards by weighting those baskets for the inverse of their volatility.
We can check for the accuracy of each of these solutions computing the
percentage contribution (PC
i
), for any basket of stocks:
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w

In a test over the constituents of the MSCI Emu, we have built risk parity portfolios
according to the three methodologies discussed above, at any quarter-end from
2003 to 2012. In the chart below, we show the average contribution of any GICS
sector, computed over these quarterly observations.
0%
10%
20%
TELECOM
ENERGY
FINANCIALS
INF. TECH
MATERIALS
CONS. STAPLES
HEALTH CARE
CONS. DISCRET
UTILITIES
INDUSTRIALS
Percentage Risk Contributions by Sectors
MSCI EMU Eq. Weighted Risk Weighted (1 Step) Risk Weighted (2 Steps)
Source: Amundi Research
Amundi Discussion Papers Series - DP-04-2014
11
The MSCI index is extremely concentrated on Financial stocks (black line).
Removing the market cap bias we reduce risk concentration on Financials, but
we introduce the same problem on some other over-represented sectors such
as Consumer Discretionary and Industrials (dotted black line). After correcting for
volatility at stock level only, risk distribution only marginally improves (red line).
For a better solution two steps are needed: risk parity should frst be achieved
within each sector, and then at a portfolio level (light brown line). In any case, this
two-step risk weighting scheme still generates some deviations from a 10% target
contribution to total risk.
In order to further improve the precision of our risk parity, we have tested an additional
method where correlations are taken into account at least across the sectors, in the
second step. We account for correlations using the marginal contribution to total
risk of any risk parity sector. We observe marginal contributions of any sector, in the
most neutral portfolio composition: the equally weighted composition. Equal weights
as a starting point have the advantage of not being too far from the (still unknown)
optimal solution. In this way the marginal contributions that we use for target weight
calculation are a very good proxy for the marginal contribution that we will observe
after weight calculation, thus ensuring a well-balanced risk contribution. We then
weight sector baskets proportionally to the inverse of these measures.
TELECOM
ENERGY
FINANCIALS
INF. TECH
MATERIALS
CONS. STAPLES
HEALTH CARE
CONS. DISCRET
UTILITIES
INDUSTRIALS
Percentage Risk Contributions by Sectors
Source: Amundi Research
Risk Weighted (2 Steps) Risk Weighted (2 Steps with Correlations)
10% Target
Amundi Discussion Papers Series - DP-04-2014
12
Taking into account correlations at least across sectors reduces the dispersion
of risk contributions, and the deviations from a 10% target become negligible.
In any case, whatever the precision of our risk parity (with the exception of the
equally weighted approximation), in order to contribute the same to portfolio risk,
high risk stocks must have lower weight relative to stocks with lower risk. This is
the main reason why risk parity portfolios are generally exposed to the low risk
anomaly, as we will show hereafter.
In addition, risk parity strategies have an embedded mean reverting mechanism,
as stocks and sectors with positive performance and increasing weights will be
reduced in order to be aligned back to a risk parity weight. Reversal at a sector
level is a successful risk control strategy, and a two-step approach accounts for
it more effectively.
II - Low Risk Anomaly and Diversifcation
2.1 The Low Risk Anomaly
Financial theory assumes that higher risk is remunerated on average by higher
returns. However, the outperformance of low volatility stocks during the last 50
years has been among the most puzzling anomalies in equity markets. At the
same time, low risk investing has recently gained a remarkable interest, due to its
documented performance coupled with the unprecedented volatility experienced
during the last two global financial crises.
In our previous work, we showed how researchers have been documenting
such anomaly since the early nineties: Fama and French (1992) show a rather
negative relationship between risk and returns, and Baker and Haugen (1991)
find significant reduction in volatility with no reduction in returns, for US minimum
variance portfolios. We find that most of the relevant empirical studies focus on
systematic risk; some of them state that the low risk anomaly holds regardless of
which dimension of risk systematic or total is used for stock selection. Only few
exceptions instead (Ang et al, 2006) rather refer to idiosyncratic volatility.
In this section we show with a practical example that all of the three smart beta
strategies discussed so far are exposed to the low risk anomaly.
We build three portfolios (in Barra One, at the model date of 12/31/2012),
restricting the investment universe to the constituents of the MSCI World Index.
We impose that no stock can exceed a 5% weight. We then group stocks into
three equally populated families, according to their risk: low risk, average risk
and high risk stocks. Finally we observe the percentage allocated to each family
of stocks, for each of the three portfolios as well as for the MSCI World.
Amundi Discussion Papers Series - DP-04-2014
13

Source: Amundi Research
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Diversification Minvar Risk Parity Msci
Weight Distribution: Total Risk
High Risk
Average Risk
Low Risk
In the chart above we see that while the minimum variance portfolio is exclusively
invested in stocks with below average risk, the risk parity portfolio has only a slight tilt
toward low risk stocks, compared to the standard index. The portfolio maximizing the
diversifcation ratio is apparently well balanced in absolute terms toward low or high risk
stocks, while it clearly underweights average risk stocks. As a conclusion, using total
risk as a grouping criterion, we see a clear and intuitive exposure to low risk anomaly
for the minimum variance, a slight but intuitive exposure for the risk parity portfolio,
and no exposure at all but rather a barbell allocation for the portfolio maximizing the
diversifcation ratio.
However we traditionally distinguish two components of risk: the systematic
component (or common factor component according to Barra One terminology) and
the specifc component. This distinction is needed because, as we have documented,
the systematic risk is the most relevant measure when addressing the low risk anomaly
and, if we restrict our analysis to this component only, the picture changes.

Source: Amundi Research
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Diversification Minvar Risk Parity Msci
Weight Distribution: Common Factor (Systematic) Risk
High Common Factor Risk
Average Common Factor Risk
Low Common Factor Risk
The portfolio maximizing the diversifcation ratio now exhibits a much more
signifcant percentage invested in low risk stocks. The low risk feature of the risk
Amundi Discussion Papers Series - DP-04-2014
14
parity portfolio is somehow more signifcant as well, while unsurprisingly, the
minimum variance portfolio is still exclusively invested in low risk stocks.
Interestingly we observe some different effects while investigating specifc risk.

Source: Amundi Research
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Diversification Minvar Risk Parity Msci
Weight Distribution: Specific Risk
High Specific Risk
Average Specific Risk
Low Specific Risk
This time, the portfolio maximizing the diversifcation ratio exhibits almost 50% of
the weight invested in high specifc risk stocks, and only marginal weight in low
specifc risk stocks.
We have explained in section 1 that the maximization of the diversifcation ratio
contains a pseudo-minimization of the denominator that is satisfed via the
selection of low systematic risk stocks. On the other hand, at the numerator, the
optimisation results in the selection of high specifc risk stocks since the latter
increase the numerator, while having little impact on the denominator: specifc risk
doesnt matter at the denominator as it is easily diversifed away.
As a result, the portfolio maximizing the diversifcation ratio may show an average
total volatility that is not statistically different from that of a standard market index,
but will necessarily result in below average systematic risk stocks (the denominator
effect), and above average specifc risk stocks (the numerator effect).
2.2 Diversifcation
Diversifcation according to the risk model
We now move to investigate how the three investment processes behave in terms
of diversifcation. In addition to the portfolio maximizing the diversifcation ratio, we
expect the minimum variance optimisation to exploit uncorrelated stocks as well
as low risk stocks; in the same way, we have seen that the two-step risk parity
process also somewhat relies on low correlations (at least across sectors) and
volatilities. In other words we are supposed to fnd some diversifcation evidence in
the minimum variance and in the risk parity portfolios as well.
In order to check for diversifcation we compute the diversifcation ratio frst.
Amundi Discussion Papers Series - DP-04-2014
15

Source: Amundi Research
1
1,2
1,4
1,6
1,8
2
2,2
2,4
2,6
2,8
3
Diversification Ratio Total Risk Diversification Ratio Common
Factor Risk
Diversification Ratio
Diversification
Minvar
Risk Parity
Msci
Unsurprisingly, we fnd that the minimum variance portfolio is well diversifed indeed,
while the risk parity portfolio also provides some diversifcation improvement,
relative to the standard market index.
We compute the same measure excluding the specific risk component both at
the numerator and at the denominator and, while finding the same hierarchy,
we confirm that the specific risk inflates diversification measures, and better
explains why a process maximizing diversification is tilted toward high specific
risk stocks.
We than compute the average correlation of stocks, according to the CBOE
methodology:
Min (w
T
Vw)
Such that e
T
w = 1
=
w
w w
,


= = =
=
~
1

=

= >
= =

=
1
1
1
2 2
1 ,
2
N
i
N
i j
j i j i
n
i
i i
N
j i
ij j i j i
avg
w w
w w w


Source: Amundi Research
0%
10%
20%
30%
40%
50%
60%
70%
Average Correlation Total Risk Average Correlation Common Factors
Average Correlation
Diversification
Minvar
Risk Parity
Msci
Amundi Discussion Papers Series - DP-04-2014
16
Average correlations do not change the picture: the portfolio maximizing the
diversification ratio is the best diversified across risk factors, but once again we
find some evidence of diversification in the minimum variance and in the risk parity
portfolios. Again, the specific risk component reduces measured correlation.
Capital diversifcation
Risk-based measures of diversifcation like diversifcation ratio and average
correlation show that smart beta are better diversifed than a standard index,
while within smart beta, optimized portfolios are better diversifed than risk parity
portfolios. This is because while the optimisation mainly selects a limited number of
highly uncorrelated stocks, a risk weighting scheme still invests in all the stocks in the
investment universe, regardless of their true diversifying properties. Optimisation-
based portfolios are thus quite concentrated on a few low-risk, low-correlation
stocks and investors are comfortable with such a portfolio when the confdence in
the risk model is very high. In contrast, investors may be concerned by the effect
of using a risk model that is not properly specifed, where a relevant risk factor is
neglected, or where the optimisation relies on incorrectly estimated correlations.
In these cases, investors may correctly believe that the ultimate insurance against
unexpected risks is capital diversifcation.
In order to address the capital diversifcation of the three portfolios, we employ the
entropy measure on the weights of their constituents. The entropy of a portfolio may be
read as the equivalent number of assets held, if those assets were equally weighted.
As shown in the chart below, optimisation-based portfolios that typically invest in
70-80 assets have an entropy measure of roughly 40-45, meaning that they have
a capital diversifcation equivalent to an equally weighted portfolio of 40-45 assets.
The risk parity portfolio is obviously much better diversifed in terms of capital
allocation, with an entropy measure of roughly 1300, out of a maximum possible
of 1600 (the number of investment universe constituents, if equally weighted). Also
the risk parity portfolio has almost double the entropy of the standard market index,
even investing in the same number of stocks.

Source: Amundi Research
47
39
1 276
740
1
10
100
1000
10000
Diversification Minvar Risk Parity Msci
L
O
G

S
c
a
l
e

Entropy
Amundi Discussion Papers Series - DP-04-2014
17
We believe that risk parity is more suitable for investors that are not completely
confdent about the estimation of the full variance covariance matrix, thus favoring
capital diversifcation over risk-model diversifcation.
However, in order to improve capital diversifcation of the optimisation-based
portfolios, some more prudent constraints may be used on the maximum weight of
any holdings (compared to the 5% that we use in this example).
III - Smart Beta in asset allocation
Since their introduction into the industries, many questions have been raised about
the use of smart beta in asset allocation: investors wonder about the implication of
introducing smart beta equities in traditional equity-bond allocation.
Another point of growing interest is whether smart beta should replace traditional
equity as an alternative equity core, or whether they should constitute a new
satellite. A similar issue is whether smart beta equities should be used to improve
active returns relative to a traditional benchmark, or whether they should rather
be used by investors seeking absolute returns, and thus replace the traditional
benchmark.
Crucial to all these questions is the detection of the drivers behind the risk-return
profles of smart beta equities, as investors must be comfortable with them before
introducing them into a strategic asset allocation (will these drivers keep on
delivering low risk outperformance in the long run?).
Also, we need to investigate if smart beta equities exhibit some evidence of different
and hopefully more favorable correlations with bonds.
Finally, investors should monitor liquidity as any equity strategy deviating from
free float adjusted market cap is by definition less liquid than the latter. Is
liquidity enough to allow for such a radical switch from traditional equities to
smart beta?
3.1 Performance drivers
Smart beta strategies have proven to be more effcient than market cap indices from
a risk-return standpoint. Their returns over the last decade are at least equal to and
very often higher than those of standard indices, while volatility and drawdowns are
systematically lower.
We try to explain the sources of these favorable deviations from market cap indices,
for some well-known global equity smart beta benchmarks, as well as for some
Amundi smart investment processes.
As for the diversification family, we have analyzed two well-known indices the
FTSE Tobam Maximum Diversification, and the FTSE Edhec Risk Efficient
Amundi Discussion Papers Series - DP-04-2014
18
together with an Amundi process aiming to enhance diversification by minimizing
average correlations (it should be noted that the Amundi process is applied to a
restricted list of high dividend stocks in the global developed markets). As for the
risk parity family, we investigate the MSCI World Risk Weighted together with an
Amundi risk parity process, as explained in section 1 (the biggest difference with
MSCI being the two-step sector-company approach for the Amundi process).
In the minimum variance family we study the MSCI Minimum Volatility, and two
Amundi processes: the first is a minimum variance with some liquidity constraints,
while the second is a very similar process applied to a restricted list of high
quality stocks according to the Piotroski score.
In the Table below we show the correlation matrix of active returns relative to the
corresponding benchmark for each strategy.
CORRELATION
FTSE
EDHEC-
R.E.
Amundi
Diversif.
FTSE
TOBAM
M.D.
MSCI
World
RW
Amundi
Risk
Parity
MSCI
World
MinVol
Amundi
MinVar
Amundi
MinVar -
Piot
FTSE EDHEC-R.E. 14% 29% 61% 35% 20% 14% 10%
Amundi Diversifcation 14% 78% 62% 61% 83% 84% 86%
FTSE TOBAM M.D. 29% 78% 66% 64% 82% 85% 84%
MSCI World RW 61% 62% 66% 79% 65% 59% 54%
Amundi Risk Parity 35% 61% 64% 79% 48% 48% 48%
MSCI World MinVol 20% 83% 82% 65% 48% 91.4% 91.2%
Amundi MinVar 14% 84% 85% 59% 48% 91.4% 95.4%
Amundi MinVar - Piot 10% 86% 84% 54% 48% 91.2% 95.4%
We can easily recognize the three family blocs with the FTSE Edhec Risk Effcient
somehow being an outlier among its family as well as among the full sample of
strategies. This is due to the specifc constraints that affect holdings on each stock:
any constituent cannot be weighted less than one-third of an equal weighting
schemes, neither more than 3 times such a quantity. Though these constraints are
sound, they make this index half way between a market weighted and an equally
weighted portfolio, and not that close to an unconstrained portfolio maximizing
diversifcation. Not surprisingly, this index is well correlated to the MSCI World Risk
Weighted index that applies similar constraints. Interestingly we notice that the
diversifcation bloc is highly correlated with the minimum variance block, while the
risk parity block stays somewhere in the middle.
In any case, the correlation matrix suggests that there is some common behavior
behind the active returns of each strategy and this intuition is confrmed by the principal
component analysis (always on active returns), summarized in the chart below.
Amundi Discussion Papers Series - DP-04-2014
19

0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
PC 1 PC 2 PC 3 PC 4 PC 5 PC 6 PC 7 PC 8
Explained Variance
Cumulative Percentage Variance (LS) Variance of Each Component
Source: Amundi Research
The common behavior is confrmed by the 85% variance explained by the frst factor,
and by the 91% variance explained by the frst two factors alone. One can argue
that we have such a high percentage explained as we use redundant information,
since many strategies in our analysis (almost all the strategies within each family
bloc) are very similar to each other, thus resulting in overlapping behaviors. For this
reason we run a simplifed PCA on a restricted sample of one strategy per family
(FTSE Tobam Maximum Diversifcation, Amundi Risk Parity, Amundi Minimum
Variance).

0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
PC 1 PC 2 PC 3
Explained Variance
Cumulative Variance By Strategy Cumulative Variance By PC
Source: Amundi Research
With no common factor in place (that is, with perfectly uncorrelated strategies) any
principal component would coincide with a stand-alone strategy, while we can see
that the frst component of our simplifed sample explains as much variance as the
two most volatile strategies. There is defnitely some common behavior underlying
the active returns of smart beta strategies and the true challenge is to identify such
a common performance drivers.
In order to detect those drivers, we regress the frst two principal components of
the complete sample of eight strategies, over the explanatory variables listed below.
Amundi Discussion Papers Series - DP-04-2014
20
Variables Description Note
Equity Market The standard market index
Sector Reversal
Long-short of equally weighted
basket of GICS sectors versus the
MSCI World
Residual returns of linear regression
on MSCI World
Momentum MSCI World Momentum
Small Cap MSCI World Equally Weighted
Value MSCI World Value
Dividend Msci World High Dividend
Residual returns of multiple linear
regression on MSCI World and the
Value factor
Low (Systematic) Risk
Anomaly
Beta-neutral long-short of low
systematic risk stocks (L) versus high
systematic risk stocks (S)
Residual returns of multiple linear
regression over all the other
explanatory variables
All variables are adjusted for market beta in order to avoid double counting for
the market beta effect and to limit multicollinearity. The dividend yield factor
has been simultaneously regressed over the market index and the value factor,
to delete positive correlation between value and dividend. As for the low risk
anomaly, we have built a long basket of stocks belonging to the lowest quintile
according to systematic risk (cf. common factor risk, estimated by Barra One),
and a short basket with stocks belonging to the highest quintile; baskets are then
weighted inversely proportional to their ex ante Beta in order make the long-short
beta-neutral, and residual (ex-post) market exposures as well as any involuntary
exposure to other factors are canceled out via a multiple regression over all
explanatory variables.

0,7
1
1,3
1,6
1,9
2,2
2,5
0,8
1
1,2
1,4
1,6
1,8
2
01/06/03 01/04/04 01/02/05 01/12/05 01/10/06 01/08/07 01/06/08 01/04/09 01/02/10 01/12/10 01/10/11 01/08/12 01/06/13
Cumulative Factors Performance
Low Syst. Risk Sector Reversal Moment. Small Cap Value Dividend Msci World
Source: Amundi Research
The sample period has been characterized by strong equity markets despite
the massive drawdown of 2008, a strong low risk anomaly effect (except during
the rebound of 2009), positive momentum, positive sector reversal (the latter is
interesting as it exhibits very low volatility), and small caps. Value and dividend yield
have been fat.
Amundi Discussion Papers Series - DP-04-2014
21
CORRELATIONS Mkt Beta
Low Syst.
Risk
Sector
Reversal
Moment. Small Cap Value Dividend
Mkt Beta 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Low Syst. Risk 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Sector Reversal 0.0% 0.0% 39.5% -1.4% -18.0% 32.9%
Moment. 0.0% 0.0% 39.5% -5.1% -36.8% 8.8%
Small Cap 0.0% 0.0% -1.4% -5.1% 9.1% -19.0%
Value 0.0% 0.0% -18.0% -36.8% 9.1% 0.0%
Dividend 0.0% 0.0% 32.9% 8.8% -19.0% 0.0%
Correlation of all the explanatory variables with the market factor and the low
volatility factor (as well as between value and dividend yield) are equal to zero by
construction, while other correlations are suffciently low to exclude muticollinearity
problems.
As mentioned, we regress the frst two principal components of smart beta
strategies, over the full set of explanatory variables, and we analyze their exposures
and their explained variance.

-
0,5
1,0
1,5
2,0
MKT (negative)
LMHbeta
Sector Reversal
Momentum Small Cap
Value
Dividend
Exposures
PC 1 PC 2
0,0%
0,0%
0,0%
0,2%
0,8%
3,1%
12,5%
50,0%
MKT (negative)
LMHbeta
Sector Reversal
Momentum Small Cap
Value
Dividend
Variance Explained (Log Scale)
PC 1 PC 2 Source: Amundi Research
The frst principal component has a very signifcant negative market beta, and
signifcant exposures to all the other explanatory variables with the exception of
momentum (positive but not signifcant). The variance explained is 60% for market
beta, 15% for the low risk anomaly, 5% for the dividend factor, and about 1% for
value, small caps and sector reversal.
The second component has small cap and sector reversal exposure, both of them
signifcant, but with small caps only explaining a non-negligible portion of variance (5%).
Overall we would argue that the active performance of smart beta strategies is
fnally due to low market beta, low risk anomaly, small caps, and sector reversal.
However we recognize that each strategy may have different exposure to these
Amundi Discussion Papers Series - DP-04-2014
22
explanatory variables, and we need to estimate them separately. We thus run seven
multiple linear regressions, and once regression parameters are estimated, we run
performance attribution in order to quantify the impact that any of these drivers have on
the cumulative active return of the eight strategies. We show cumulative effect over the
period from the end of June 2003 to the end of December 2013 in the following Chart.

-150%
-100%
-50%
0%
50%
100%
150%
200%
250%
FTSE EDHEC-R.E. Amundi Diversif. FTSE TOBAM MD MSCI World RW Amundi Risk Parity MSCI World MinVol Amundi MinVar Amundi MinVar -
Piot
Cumulative Active Returns vs. Standard Index: 2003 - 2013
Unexpl. + Interact. MKT Low Syst. Risk Sector Reversal Momentum Small Cap value Dividend Total
Source: Amundi Research
The following chart instead shows the contribution to ex-post tracking error
(computed as the percentage explained variance times the realized tracking error)
for each of them.

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
FTSE EDHEC-R.E. Amundi Diversif. FTSE TOBAM MD MSCI World RW Amundi Risk Parity MSCI World MinVol Amundi MinVar Amundi MinVar -
Piot
Explained Variability of Active Returns by Components
Unexpl. + Interact. MKT Low Syst. Risk Sector Reversal Momentum Small Cap value Dividend
Source: Amundi Research
With the exception of the FTSE Edhec Risk Effcient, the regression model explains
80% to 90% of the variance of active returns and its F-test is signifcant for all the
strategies investigated. The model is thus overall well specifed.
Intuitively the low market beta has a negative effect during upward markets, and
it explains a big percentage of the variance of active returns. Interestingly, those
strategies exhibiting the lowest market beta offset much of this negative effect with
a positive contribution by the low risk anomaly.
Amundi Discussion Papers Series - DP-04-2014
23
All strategies beneft from sector reversal, with the Amundi Risk Parity benefting
the most. In this case, the variance explained is particularly high as the construction
process of this portfolio is based on a systematic sector rebalancing (cf. section 1
about the two-step company-sector methodology).
Small cap effect explains both performance and variance for diversifcation-based
portfolios and risk parity portfolios, while it is basically absent on minimum variance
portfolios, because small caps bring some additional volatility, and because
Amundi portfolios apply some liquidity flters as well.
The dividend factor explains some variance, but has little impact on returns, as it
is quite fat over the period.
In the same way, the value factor is basically absent in the performance chart and
is also negligible in terms of explained variability.
Unexplained component of returns is positive in the case of Amundi minimum
variance, and it is even higher in the portfolio with a quality (Piotroski) flter: we
can argue that there is some more room for investigation about minimum variance
drivers, especially when the construction process is less constrained than the
MSCI World Minimum Volatility. The quality flter delivers additional value.
Finally, we confrm the outlier behavior for the FTSE Edhec Risk Effcient Index.
We have said about the constraints applied in its construction process and,
unsurprisingly, its deviations from a market weighted index are quite low in terms
of cumulative active returns, and realized tracking error. The only visible source of
active return is the small cap exposure.
3.2 Smart Beta for active or absolute returns, a new equity core?
The choice whether smart beta should be used in an absolute or in an active risk-
return framework, depends on the utility function of the investor (or the mandate of
the fund manager in the case of delegated asset management), and the governance
of the investment process.
While a fund manager with the objective of maximizing information ratio -under
a limited tracking error constraint- may fnd it diffcult to massively move toward
smart beta equities, an institutional investor aiming to maximize wealth under
some absolute risk constraint, could use smart beta equity to make up the bulk
(or the new equity core) of its equity investments. In an investment process that
is based on top-down strategic asset allocation by the investment board, and
equity allocation by the equity department thereafter, if the board allocates wealth
based on traditional benchmarks allowing limited tracking error deviations, the
equity department is likely to exploit the enhanced risk-return profle of smart beta
equities only in some satellites of the global equity allocation, since smart beta
equities bring high tracking error relative to a standard market index. On the other
Amundi Discussion Papers Series - DP-04-2014
24
hand, if the investment board accepts to change its strategic benchmark into a
smart beta benchmark, smart beta equities can effectively become the new equity
core. However such a radical choice implies that several conditions are met.
First, the investor must be confdent that the performance drivers identifed above
are going to deliver positive performance, just as we have seen in the recent past.
The lower this confdence, the lower the likelihood that the investor will be willing
to allocate a relevant portion of its equity to low beta stocks. As we have seen in
performance attribution, low beta itself penalizes proftability as long as it is not
offset by some other positive effects. With no positive contribution from low risk
anomaly, size, sector reversal and so on, investing in low beta stocks is not effcient
in a classical Markowitz framework either (cf. next section).
Second, the investor should be sure that smart beta strategies provide suffcient
liquidity. If the market can absorb the volumes needed for monthly or quarterly
rebalancing, but cannot quickly absorb the program trades resulting from strategic
asset allocation or tactical asset allocation decisions, the investor should rather
prefer to allocate smart beta equities to the satellite bucket of the portfolio. On the
other hand, if liquidity is not an issue, investors may switch their core equity allocation
to smart beta, but should be ready to change the equity benchmark, since smart
beta equities bring high tracking error relative to a standard market index.
Lets consider the case of a big sovereign investor that is going to implement a big
change in its strategic asset allocation, buying (selling) a relevant amount of global
equity. Lets assume the investor wants to complete the program trade in 10 days,
using up to 20% of the daily average volumes, each day (the daily average volumes
are estimated over the last three months as of end of December 2013). We test
three program trades of USD 10, 25 and 50 billion respectively, times four equity
index hypotheses: the MSCI World, the MSCI World Minimum Volatility, the MSCI
World Risk Weighted, and a risk weighted allocation of the latter two indices (43%
MSCI World Risk Weighted and 57% MSCI World Minimum Volatility, according to
a long-term estimation of volatility).

0%
20%
40%
60%
80%
100%
d1 d2 d3 d4 d5 d6 d7 d8 d9 d10 d11 d12 d13 d14 d15 d16 d17 d18 d19 d20
Program Trade - MSCI World
10 Bln Usd Prog. Trade 25 Bln Usd Prog. Trade 50 Bln Usd Prog. Trade
0%
20%
40%
60%
80%
100%
d1 d2 d3 d4 d5 d6 d7 d8 d9 d10 d11 d12 d13 d14 d15 d16 d17 d18 d19 d20
Program Trade - MSCI Risk Weighted
Source: Amundi Research
Amundi Discussion Papers Series - DP-04-2014
25

0%
20%
40%
60%
80%
100%
d1 d2 d3 d4 d5 d6 d7 d8 d9 d10 d11 d12 d13 d14 d15 d16 d17 d18 d19 d20
10 Bln Usd Prog. Trade 25 Bln Usd Prog. Trade 50 Bln Usd Prog. Trade
0%
20%
40%
60%
80%
100%
d1 d2 d3 d4 d5 d6 d7 d8 d9 d10 d11 d12 d13 d14 d15 d16 d17 d18 d19 d20
Source: Amundi Research
Program Trade - MSCI Minimum Vol Program Trade - RW(43)MV(57)
The most liquid index is unsurprisingly the maker weighted index: a huge program
trade of 50 billion may be completed in five days. The Minimum Volatility index is
the least liquid, not really because it is more exposed to small caps, but rather
because it is concentrated over a lower number of stocks (248), than the Risk
Weighted Index (1600).
As for smart beta in general, only a USD 10 billion program trade allows a relevant,
though not exhaustive, completion after 10 days. In detail, this is the percentage
completion after 10 days.

Source: Amundi Research
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
10 BLN USD 25 BLN USD 50 BLN USD
Percentage Completion of Program Trade after 10 days
In order to effectively complete the program trades in 10 days, the investor cannot
hold 100% of equity in smart beta and should dilute his holding with traditional
and more liquid equity investments. In the table below, we show the maximum
allocation in smart beta that the investor can afford, in order to complete each
program trade in 10 days.
Amundi Discussion Papers Series - DP-04-2014
26

Source: Amundi Research
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
10 BLN USD 25 BLN USD 50 BLN USD
Maximum Allocation in Smart Beta
Smart Beta weight MSCI World weight
If the investor is not likely to incur program trades bigger than USD 10 billion, risk
weighted, minimum volatility (to a lesser extent), and a mix of the two indices may
all become a new equity core, as the investor can hold up to 100% of total equity
in smart beta. For higher sizes of program trades, smart beta allocation should be
kept residual with respect to market weighted equity, thus smart beta would be
more suited to being a satellite bucket of the portfolio.
However, if comfortable with the USD 10 billion hypothesis, the investor that
goes for smart beta as a new equity core, should seriously consider changing its
strategic benchmark.
In the next chart, we show the tracking error relative to the MSCI World Index
of all equity allocations from the example above, and the tracking error of an
allocation with 40% in the smart beta above and 60% in global bonds, relative
to a classic balanced benchmark (40% MSCI World Index, and 60% JPM Global
Bond Index).

Source: Amundi Research
Tracking Error Relative to Standard Benchmarks
tracking error vs CW Equity tracking error vs 60-40
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
Risk Weighted 43%R.W.
57%M.V.
Minimum
Volatility
10 BLN USD 25 BLN USD 50 BLN USD
0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
The lower the impact of liquidity issues, the easier the move toward smart beta
equities as a new equity core. But massive investments in smart beta equities
Amundi Discussion Papers Series - DP-04-2014
27
bring high relative risk and it is very unlikely that the investment committee and
fund managers are comfortable with tracking error as high as 2% relative to a
traditional bond-equity composite benchmark, and 5% relative to a traditional
equity benchmark. As a consequence, such a big move toward smart beta
equities increases the likelihood that these traditional benchmarks are replaced by
opportune and maybe customized smart beta indices.
3.3 Bond-Equity Allocation
As historical returns may suggest, as far as the risk is lower while returns are
higher, the risk-return profle of some traditional bond-equity allocation is improved
by simply switching from market weighted equities to smart beta. In the chart
below, we trace two simplifed effcient frontiers using the JP Morgan Global Bond
index for fxed income, and the MSCI World Index or the MSCI World Minimum
Volatility for equities. The chart is based on historical data only (returns, variance
and covariance).
Historical
Returns
Historical
Volatility
Correlations
with bonds
MSCI World 9.48% 15.72% 20.09%
MSCI World MinVol 9.58% 11.41% 31.90%
JPM GBI 4.75% 6.86%
Despite a slightly higher correlation with bonds, and thanks to the far better risk
return profle of the MSCI Minimum Volatility Index, the improvement in the effcient
frontier is straightforward:

Source: Amundi Research
4%
5%
6%
7%
8%
9%
10%
11%
12%
4% 6% 8% 10% 12% 14% 16% 18%
Efficient Frontiers - Historical Data
------- MSCI Min Vol: historical data ------- MSCI World: historical data
We can state that, for the same level of risk of a traditional bond-equity allocation,
we can increase the relative weight of smart beta equities in the allocation (as
smart beta equities are more conservative than traditional equities), thus improving
performance, via both the higher percentage of equity and the higher return of
Amundi Discussion Papers Series - DP-04-2014
28
smart beta. In the same way, introducing smart beta while keeping the weight of
equity unchanged, we improve the expected return of the portfolio, while reducing
its risk.
These statements are formally correct, have proven to hold up over the last decade,
and may be confrmed in the future. However they imply a precise hypothesis: the
performance drivers discussed above will deliver performance in line with those
we have seen in the recent past. On the contrary, if we apply an alternative and
less favorable scenario where sector reversal, low risk anomaly, small caps, and
all other residual factors are not going to deliver any additional return, investing
in smart beta would be simply equivalent to investing in low beta equity. This
is the reason why we believe that clearly identifying performance drivers (even
demystifying some beliefs about these strategies) and being confdent with them is
a required condition for investors to buy smart beta.
To formalize this unfavorable scenario into our simplifed effcient frontier, we may
set the expected return of the MSCI Minimum Volatility Index to a level that equalizes
the risk-adjusted return of the MSCI World Index.
Historical
Returns
Historical
Volatility
Risk Adjusted
returns
MSCI World 9.48% 15.72% 0.60
MSCI World MinVol 6.88% 11.41% 0.60
JPM GBI 4.75% 6.86% 0.69
This is equivalent to the hypothesis that the MSCI Minimum Volatility Index is simply
a low beta index, as it was a combination of cash and a traditional index. Thus,
investing in low beta equity with the same risk adjusted return of traditional equity
would be equivalent to imposing the constraint of a minimum holding in cash, thus
making the frontier less attractive than using unconstrained equity.

Source: Amundi Research
4%
5%
6%
7%
8%
9%
10%
11%
12%
4% 6% 8% 10% 12% 14% 16% 18%
------- MSCI Min Vol: historical data ------- MSCI Min Vol: historical data
- - - - MSCI Min Vol: same risk adjusted return and correlation of MSCI World
Efficient Frontiers - Historical Data and Risk Adjusted Returns
Amundi Discussion Papers Series - DP-04-2014
29
Actually, in a balanced asset allocation with smart beta, we still have to investigate
if some additional beneft could come from lower correlation with bonds: if so,
smart beta equities would be more diversifying. Unfortunately this is not the case
as bonds correlation with the MSCI Minimum Volatility Index is 32%, while its only
20% with the MSCI Index (cf. previous table).
Taking true correlation into account we have an even less interesting profle:

Source: Amundi Research
4%
5%
6%
7%
8%
9%
10%
11%
12%
4% 6% 8% 10% 12% 14% 16% 18%
------- MSCI Min Vol: historical data ------- MSCI World: historical data
- - - - MSCI Min Vol: same risk adjusted return and correlation of MSCI World
- - - - MSCI Min Vol: same risk adjusted return and correlation of MSCI World historical correlation
Efficient Frontiers - Historical Data and Risk Adjusted Returns
We may wonder if this evidence is limited to the MSCI World Minimum Volatility
Index, or correlation with bonds is higher for any smart beta. Actually this is rather
generalized evidence, with the exception of the FTSE EDHC Risk Effcient Index
that is close to traditional equity, even from a correlation standpoint.

0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
FTSE EDHEC
-Risk Efficient
Amundi
Diversif.
FTSE
TOBAM MD
MSCI
World RW
Amundi Risk
Parity
MSCI World
MinVol
Amundi
MinVar
Amundi
MinVar - Piot
Correlations with Bonds
Smart Beta MSCI World
Source: Amundi Research
3.4 Diversifying and timing smart beta strategies
As we have seen in previous sections, there are several factors behind the
performance of smart beta equities. Though we may identify some signifcant
common behavior across them, the relevant factors explaining such performance
deviations from a standard index are not the same for every smart beta strategy.
Amundi Discussion Papers Series - DP-04-2014
30
Furthermore we observe that smart beta strategies perform differently according
to the conditions of the equity market as a whole (bear or bull market, trading
range, high or low volatility, high or low average correlation).
These are all strong arguments for diversifying across smart beta strategies, and
not holding just one of them.
3.4.1 Diversifying across smart beta strategies
There are several ways to diversify across smart beta strategies, and diversifcation
is possible even if the number of strategies involved is very limited. Diversifying
across smart beta may also be useful in addressing the issue of building a
reasonable multi-strategy smart beta benchmark.
We provide several cases of multi smart beta allocation and for illustrative purposes
we stay within the MSCI family (MSCI World Minimum Volatility, and MSCI Risk
Weighted). We frst consider the case of an investor within an absolute risk-return
framework. If the investor wants to achieve diversifcation by equalizing the two
indices contribution to absolute risk, according to a long term (10 years) covariance
matrix, he would allocate 57% of his assets to the minimum variance and 43% to
the risk weighted indices respectively.

Source: Amundi Research
Equal Active Risk Contribution by Strategy
MSCI World RW MSCI World MinVol
43%
50,0%
23%
57%
50,0%
77%
0%
20%
40%
60%
80%
100%
Weights Total Risk Contribution Active Risk Contribution
As requested, each strategy has an equal contribution to absolute risk but it is
interesting to notice that risk relative to a standard index is concentrated on the
minimum variance strategy.
We can translate the analysis on performance drivers, using the estimated
parameters of linear regressions and their covariance matrix, from section 3.1.
From an absolute risk perspective, the market factor explains roughly 90% of the
absolute variance, with no surprise as we are dealing with equity portfolios. From
an active risk perspective, risk is rather concentrated over low beta (obvious as
minimum variance has very low beta), low risk anomaly, and dividend yield; 10% of
active variance is unexplained.
Amundi Discussion Papers Series - DP-04-2014
31

92,08%
0%
20%
40%
60%
80%
100%
Factor Contributions
Contributions to Absolute Risk
Unexplained
Momentum
Sector Reversal
Value
Dividend
Low Syst. Risk
Small Cap
MKT Beta
48,67%
15,43%
12,96%
10,06%
0%
20%
40%
60%
80%
100%
Factor Contributions
Contributions to Active Risk
Source: Amundi Research
In a second example, we assume that another investor prefers to diversify from
an active risk perspective. He still diversifies on the two indices, and does not
yet control for factor exposures directly. In this case he would rather invest 73%
in the risk-weighted index and 27% in the minimum variance index respectively.

67%
73.3%
50%
50% 33% 26.7%
0%
20%
40%
60%
80%
100%
Weights Total Risk
Contribution
Active Risk
Contribution
Equal Active Risk Contribution
by Strategy
MSCI World RW MSCI World MinVol
37.47%
17.19%
16.69%
12.37%
5.61%
8.13%
0%
20%
40%
60%
80%
100%
Factor Contributions
Unexplained
Momentum
Sector Reversal
Value
Dividend
Low Syst. Risk
Small Cap
MKT Beta
Contributions
to Active Risk
Source: Amundi Research
By doing so, active risk would be balanced across the two strategies and, as a
side effect, diversification across the performance drivers would improve as well,
while the percentage of active risk with an unknown source would be reduced.
However, the investor might be much more sensitive to diversification across
the factors than across the two indices themselves. In this third example, we
assume that the investor is willing to maximize the diversification of the sources
of active risk. We thus maximize the measure of entropy as defined in section 2.2,
computed over the active risk contributions by factors, or performance drivers.
Amundi Discussion Papers Series - DP-04-2014
32

0%
20%
40%
60%
80%
100%
Weights Total Risk
Contribution
Active Risk
Contribution
MSCI World RW MSCI World MinVol
0%
20%
40%
60%
80%
100%
Factor Contributions
Unexplained
Momentum
Sector Reversal
Value
Dividend
Low Syst. Risk
Small Cap
MKT Beta
Source: Amundi Research
79%
83.9%
68%
21%
16.1%
32%
29%
27%
17%
11%
6%
7,36%
Maximum Entropy Over
Factor Contributions to Active Risk
Contributions
to Active Risk
In this case, in order to reduce the still dominant contribution of low market beta,
the allocation in the risk-weighted index would increase. Contrarily, small cap,
dividend yield, and low risk anomaly contributions are increased. The change in
the latter, however, is mainly due to a base effect: portfolio exposure to the low
risk factor decreases, but as the active risk decreases as well (risk weighted index
has a much lower tracking error than minimum volatility, relative to the standard
index), its risk contribution as a percentage marginally increases. As a side effect,
unexplained active variance is further reduced.
As a fourth and last case, we now consider an investor that is comfortable with an
objective of diversifcation across factors in an active management framework, but
that is willing to introduce into his allocation some exposure to the sector reversal
factor, because of its regular and low-volatility historical contribution to performance.
The exposure to this factor is negligible in the three previous allocations.
The smart beta portfolio that is most exposed to sector reversal is the Amundi Risk
Parity, because of the two-step stock-sector construction process. We thus repeat
the last case study, adding Amundi Risk Parity to the set of available strategies.

0%
20%
40%
60%
80%
100%
Weights Total Risk
Contribution
Active Risk
Contribution
MSCI World RW MSCI World MinVol
0%
20%
40%
60%
80%
100%
Factor Contributions
Unexplained
Momentum
Sector Reversal
Value
Dividend
Low Syst. Risk
Small Cap
MKT Beta
Source: Amundi Research
Maximum Entropy Over
Factor Contributions to Active Risk
Contributions
to Active Risk
37%
40,9%
34%
41%
42,9%
34%
21%
16,3%
32%
Amundi Risk Parity
32%
28%
16%
7%
4%
7%
5%
Amundi Discussion Papers Series - DP-04-2014
33
The overall allocation to the risk parity strategies is basically unchanged, but split
into the MSCI Index and the Amundi process. This latter now accounts for 37%
of the assets, 41% of absolute risk, and 34% of active risk. Sector reversal would
be introduced as a source of active risk with a 7% contribution, while the entropy
measure on the risk factor would increase to 5.02 from 4.89. Unexplained risk
would be further reduced to 5%.
3.4.2 Timing smart beta strategies
As several factors drive smart beta performance, the most straightforward way to
implement some timing over the different indices or strategies, should be to time
the underlying factors and consistently allocate strategies.
Investors may develop a reliable style rotation model, and may apply some allocation
where risk contributions match return expectations, rather than maximizing some
diversifcation measure as we have done in previous case studies.
Another way to time smart beta strategies might be to investigate their behavior
according to different market conditions. The following chart exhibits the 12-month
cumulative outperformance of each of the three Amundi strategies relative to the
standard index, with a quarterly frequency, from June 2003 to December 2013.
Results are interesting and often intuitive as well.

Rolling 12-Month Outperformance (LS) Relative to MSCI World (RS)
1.0
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Amundi Minvar Amundi Diversification Amundi Risk Parity MSCI World
1
2
3
4 5
Source: Amundi Research
In long and steady bull markets as was the case from 2003 to mid-2007, the
risk parity portfolio often exhibits the best returns, while during market crashes
minimum variance is by far the winning strategy.
When the impressive rebound of March 2009 starts, minimum variance starts
lagging the two other strategies, while diversifcation and especially risk parity react
well since they keep on delivering some positive outperformance.
When the market is suffering some higher volatility without exhibiting a clear trend
as in the period between mid-2011 and mid-2012, minimum variance is the winning
strategy with some nice resistance by the diversifcation strategy as well.
Amundi Discussion Papers Series - DP-04-2014
34
During the recent low volatility bull market period, smart beta strategies are slightly
lagging overall (with better risk adjusted returns than the market index, however),
but the risk parity strategy still captures the trend fairly well.
We are conscious that forecasting the market conditions of the future is not an
easy task, and actually this is not our goal. On the other hand, we recognize that
volatility, correlation and turbulence, may be behind each of the fve states of
the world described above. In this section, we describe the dynamic allocation
model that Amundi implements on a real money multi-smart beta fund on Eurozone
equities. The model is based on three stand-alone dynamic strategies: each of
them is based on a market signal, has an equally weighted target allocation on the
three smart beta, and assigns an overweight and an underweight of 5% to the most
and least proftable strategy, according to the market signal.
The frst model is based on market implied volatility, and works as a typical risk
off risk on model. When the average level of the VIX Index, computed over the
last 10 days, is higher than the average computed over the last 25 days (increasing
VIX), we overweight the minimum variance portfolio and we underweight risk parity,
according to the conditional next-month average returns that we have computed
historically. When the 10-day average is lower than the 25-day average (decreasing
VIX) we overweight risk parity and we underweight minimum variance. According to
the VIX model, the weight of the diversifcation-based smart beta is always neutral.
When the relative difference between the two averages is less than 5% we do not
apply any under/over weights as we allow the model to be in a neutral position,
in order to reduce turnover and avoid false signals. The chart below exhibits the
next-month average annualized returns, conditional to the VIX confguration, as
estimated from beginning 2003 to mid-2012 (our sample period).

-20.0%
-15.0%
-10.0%
-5.0%
0.0%
Risk Parity Diversif. Minvar MSCI
Average Returns Increasing Vix
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
Risk Parity Diversif. Minvar MSCI
Average Returns Decreasing Vix
Source: Amundi Research
The second model is based on average market correlation. We have computed
average correlation according to the CBOE methodology, on single country indices,
as well as on the GICS industry group indices of the MSCI World.
Amundi Discussion Papers Series - DP-04-2014
35
As for the case of the VIX, in the charts below we report the average annualized
returns computed over months following an average two-week correlation higher
than the 104-week average (low correlation), and months following an average two-
week correlation higher than the 104-week average (high correlation). Again, the
5% threshold for neutral signals applies, and the sample period ends in mid-2012.

0.0%
5.0%
10.0%
15.0%
Risk Parity Diversif. Minvar MSCI
Average Returns High Correlation
-10.0%
-5.0%
0.0%
5.0%
10.0%
Risk Parity Diversif. Minvar MSCI
Average Returns Low Correlation
Source: Amundi Research
The intuition behind this is that when correlation is very high (left chart), there is
less beneft in searching for diversifcation over risk factors, while searching for
diversifcation across assets directly is probably more effective. When average
correlation is lower (right chart), strategies based on diversifcation across risk
factors beneft more than those diversifed on stocks directly, since the former
favor those stocks exposed to uncorrelated factors. Overall, returns on the right-
hand chart are lower, as the low correlation across sectors and countries includes
a typical pre-crisis situation (October 2008 and July 2011). English Version
Average Correlation and Returns in the Eurozone
Estimation Period: 01/2003 - 06/2012
Performance
Title Arial 9 Bold (1 or 2 lines maxi)
Title Arial 9 Bold (1 or 2 lines maxi)
Title Arial 9 Bold (1 or 2 lines maxi)
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High Corr Low Corr Neutral Delta 2W - 2Y Av Corr
Source: Amundi Research
0.99
1.00
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Strategy with Timing (LS) Const. Mix (LS)
Mkt W Index (LS) Cum. Active (RS)
Source: Amundi Research
Our third indicator is a turbulence index. We defne market turbulence as the cross-
section dispersion of returns, computed over the GICS industry group indices. As this
indicator is closely correlated with the VIX index, we normalize by the VIX itself, as we want
to capture the turbulence that is not already explained by the market implied volatility.
Amundi Discussion Papers Series - DP-04-2014
36
As for the correlation indicator, we compute rolling averages on two weeks and 104
weeks, we apply the neutrality threshold at 5%, and we fnally compute next-month
annualized average returns.

0.0%
5.0%
10.0%
15.0%
Risk Parity Diversif. Minvar MSCI Risk Parity Diversif. Minvar MSCI
Source: Amundi Research
Average Returns
High Turbulence
Average Returns
Low Turbulence
0.0%
2.0%
4.0%
6.0%
8.0%
Results are less intuitive than in the two previous cases, but the turbulence
indicator is uncorrelated with the implied volatility and average correlation signals.
As mentioned, our fnal dynamic strategy consists in the portfolio that averages
the three model portfolios based on the three market signals above. Each model
portfolio overweights the best performing strategy according to the observed
signal at the end of the previous month.
The chart below shows the gross total return performance of the market-weighted
index, an equally weighted basket of the three smart beta strategies, and the
dynamic strategy described so far. Starting mid-September 2012 data are out-of
sample, while starting from June 2013 the strategy feeds a real money portfolio.
Turnover 72.06% IR 1.27
Mkt Wght Constant Mix Dynamic Strategy
Sharpe Ratio 0.29 0.64 0.67
Return / Conditional Var (5%) 0.53 1.01 1.08
Return 6.1% 9.4% 9.9%
Conditional Var (5%) -12.6% -9.3% -9.1%
Drawdowns -56.2% -50.1% -49.3%
Volatility 17.5% 13.2% 13.2%
Compared to an equally weighted composite of smart beta strategies, the
dynamic model outperforms by more than 40 basis points per year. There is no
significant impact on the absolute volatility, even though the drawdown of 2008
is reduced. The Sharpe ratio rises to 0.67 from 0.64 , and the ratio of returns to
Conditional Var improves too (1.08 versus 1.01).
Amundi Discussion Papers Series - DP-04-2014
37
English Version
Average Correlation and Returns in the Eurozone
Estimation Period: 01/2003 - 06/2012
Performance
Title Arial 9 Bold (1 or 2 lines maxi)
Title Arial 9 Bold (1 or 2 lines maxi)
Title Arial 9 Bold (1 or 2 lines maxi)
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High Corr Low Corr Neutral Delta 2W - 2Y Av Corr
Source: Amundi Research
0.99
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Strategy with Timing (LS) Const. Mix (LS)
Mkt W Index (LS) Cum. Active (RS)
Source: Amundi Research
IV - Are smart beta passive or active strategies?
Defning an investment strategy as active or passive is usually not an easy task.
Of course there are some extreme circumstances where such a defnition is
obvious: lets consider an ETF benchmarked to the S&P 500 and the investment
fund Berkshire Hathaway run by Warren Buffett: it would be hard not to classify
them as passive and active respectively.
However, there are some frequent intermediate situations where we can distinguish
different levels or intensities in being active or passive.
A classic condition for a passive strategy is that we clearly identify the systematic
replication of a widely recognized, transparent and investable benchmark.
According to our defnition, we must recognize both the elements in order to match
the passive condition:
1. Benchmark characteristics: widely recognized (generally accepted),
transparent and investable;
2. Systematic replication.
On the other hand, we defne as active whatever strategy exhibits pronounced
deviations (both in terms of holdings and in terms of returns) from a benchmark
index.
Widely recognized and transparent Benchmark
Prior to this point, we need to clarify whether the market cap index should be
considered as the benchmark of a smart beta strategy. We believe this should not
be the case, as the main argument for smart beta investing is the well-documented
ineffciency of market capitalization benchmarks. As a consequence, smart beta
strategies should not be benchmarked to market weighted indices, nor is their
impressive tracking error a valuable argument for defning them as active.
Amundi Discussion Papers Series - DP-04-2014
38
However, market weighted indices offer an interesting reference point for
comparison to our discussion. Together with their composition, index providers
disclose the rules applied for companies inclusion or exclusion from the index
(typically: geographical belonging, sector classifcation, free foat, and size), as
well as the rules for index weighting. All of them rely on continuously and publicly
available information as market capitalization. To some extent, market cap weighted
benchmarks may be replicated even without knowing their composition directly: in
order to derive it, investors could combine construction rules with publicly available
information, at the cost of a negligible margin of error.
The case for smart beta benchmark is different. Lets have an example focusing on
some minimum variance benchmarks (such as the MSCI Minimum Volatility index),
or on some diversifcation benchmarks (such as the FTSE EDHEC Risk Effcient
Index, or the FTSE TOBAM Maximum Diversifcation).
These indices do not rely on some objective and easily measurable metrics, as in
the case for market capitalization: rather, all of them depend on:
1. Some risk measure estimation (the variance covariance matrix of stocks)
2. An optimizer, and its numerical algorithms
3. The objective function that is maximized: portfolio variance is minimized
(or some diversification measure maximized), subject to some constraints
(minimum stocks threshold, stocks upper bounds, sector concentration
constraints, etc.)
All the points mentioned above contain provider-specifc features (risk model,
optimizer), while some of them (the set of constraints) are also very discretionary
and better shaped to design an investment strategy than to build a traditional
investment benchmark.
Smart beta benchmarks require the estimation of a variance covariance matrix. A
simple historical data approach is almost impossible: a statistical and parsimonious
method (such as principal component analysis, or fundamental factor models) is
usually needed, as a covariance matrix may ideally contain millions of parameters.
Such benchmarks are thus dependent on some necessarily complex risk model.
Furthermore, smart beta composition is defnitely infuenced by the numerical
algorithm (often very complex too) of the optimizer. This point is rather critical
as we often observe some better consistency among risk forecasts provided by
different risk models, than among portfolios optimized by different optimizers: little
differences in risk and correlation estimates may determine huge differences in
optimal stock weights, and differences in numerical algorithms across optimizers
magnify those discrepancies in portfolio composition.
Furthermore, in order to prevent some typical drawbacks of some optimisation-
based smart benchmarks (as excessive concentration on a few sectors or a few
Amundi Discussion Papers Series - DP-04-2014
39
and sometimes illiquid- stocks, involuntary exposure toward styles such as small
caps or momentum) some prudent constraints may be needed:
minimum holding thresholds;
general upper bound on each stock (in absolute terms or as a function of the
daily liquidity);
sector and country holdings may be constrained in a range around their
weights in a traditional index;
the index may be prevented to have major exposure to some style factors.
Although reasonable, realistic, and prudent, these rules are discretionary and lead
to a benchmark that is provider-specifc, rather than universally recognized, as it
would be required instead.
As a consequence, for instance, the minimum variance indices so far available in
the market exhibit reciprocal (historical) tracking errors ranging from 4% to 6%.
Defnitely more than the tracking errors among market weighted indices, which are
usually lower than 1%.
In conclusion, while the disclosure of parameters and models may satisfy the
transparency condition, the dependency on different risk models and optimizers,
and the common practice of applying various and sometimes heterogeneous
constraints prevent the benchmark to be easily recognized and universally
representative.
We might argue that, as far as there is no universally representative smart beta
benchmark for any of the three categories, passive management is basically
precluded for smart beta: many alternative benchmarks exist and all are very
different from each other.
We think this conclusion is too radical, it is highly infuenced by a traditional defnition
of benchmark, and it does not recognize some signifcant trends in the passive asset
management industry. Nowadays passive management is experiencing spectacular
growth thanks to a highly comprehensive product offer. These products are not
limited to those asset classes with a universally recognized benchmark available. In
contrast, every asset class or strategy, even the more exotic or customized, may be
packaged in an ETF. The only requirements are the mere existence of a benchmark
(and very often we would better say the existence of an underlying asset), and the
concrete possibility for the fund manager to replicate its payoff.
We believe that the universal recognition of the benchmark should rather be
replaced by some less stringent requirement such as the mere existence of the
benchmark itself, its transparency and its investability. If several and different
minimum variance, or risk parity, or diversifcation benchmarks exist, we may
potentially have several passive mandates replicating them, each with a very
different payoff, but all mimicking the payoff of their own benchmark.
Amundi Discussion Papers Series - DP-04-2014
40
Of course, a smart beta fund manager that is formally benchmarked to a traditional
market cap index, would concretely be a passive manager if he actually tracks an
existing smart beta benchmark, regardless of the decision of declaring the true
benchmark.
On the other hand, a highly innovative or customized smart beta solution could
be packaged in a passive product by asking an index provider to produce a tailor-
made benchmark. We think that disclosing a benchmark is a not a pure formality,
neither is it a trivial decision by the fund manager. A formal benchmark implies
the involvement of an index provider that provides objective calculation and
transparency, and also implies a formal commitment by the fund manager of never
deviating from the benchmark itself. Furthermore having an offcial benchmark
would be a costly decision as smart beta benchmarks are far more expensive than
traditional ones.
As a conclusion, once we have verifed that a pertinent benchmark exists, is
transparent, investable and computed by a third party (the index provider), the
only criterion that we need to apply in order to categorize a smart beta product
as active or passive, is whether or not the fund manager implements a systematic
replication of it.
Systematic replication
Once the benchmark is built and made available, the goal of a passive fund
manager is to systematically apply and comply with it, rebalancing at a pre-
specifed frequency with no room left for incorporating (time varying) views on
market and stocks. In other words, stock picking is not contemplated, and tracking
error relative to the benchmark or relative to the reference strategy must be ideally
equal to zero.
On the other hand, for a strategy to be defined as active, deviation from
the benchmark must be relevant, and the main drivers of such deviations are
investment decisions. The latter depend on time-varying forecasts of the future
profitability of stocks.
According to this criterion, smart beta investments may fall in both the active
and the passive category. The easiest example of an active strategy is some
optimisation-based smart beta strategy (minimum variance or diversification),
where the process is applied to a restricted list of stocks, based on some
qualitative and judgmental criteria (the best investment ideas of the buy-side
analysts, for instance). Similarly, a smart beta portfolio is actively managed where
the investment universe is filtered by some quantitative or systematic criteria, if
this filtering is specific to the fund manager, and generates some non-negligible
tracking error relative to any of the existing benchmarks available. In the same
way, portfolios where risk factors exposures are managed according to market
views are active portfolios. Finally, any risk parity portfolio that systematically
Amundi Discussion Papers Series - DP-04-2014
41
applies some unique weighting schemes (as the two-step approach discussed in
previous sections) is actively managed, if those weighting rules differ from those
applied by the available benchmarks.
As an opposite example, any replication of an index is passive, even if the index
is built by maximizing a highly innovative utility function, through a sophisticated
numerical algorithm, employing highly specifc sector and country constraints, and
investment universe restrictions. The requirements are that the index is produced
by an independent index provider that discloses calculation methodology, and that
the fund manager assures very low tracking error.
Conclusion
Smart Beta equities are the asset management industrys answer to some well-
known drawbacks of market capitalization-based equity indices such as price
noise, overrepresentation of large caps, absence of an auto-corrective mean-
reversion mechanism. Some of these features may result in high volatility and
massive drawdowns, thus potentially compromising the risk-return payoff of
traditional equities, at least when the investment horizon is shorter than 8-10 years.
In this study we provide a formal description of three popular risk-based smart beta
strategies minimum variance, diversifcation, and risk parity.
We show that low market beta and the low risk anomaly explain a relevant
portion of the variability of the active returns of the minimum variance strategies,
with some variance explained by sector reversal and dividend yield. Yet the
unexplained variability corresponds to some non-negligible positive contribution to
performance (thus further investigation is needed), while fltering the universe for
some quality criteria proves to provide additional value.
As for the diversifcation-based strategies (portfolio maximizing the diversifcation
ratio, risk effcient portfolio, etc.), low market beta and low risk anomaly are still
the most signifcant factors, with the addition of small cap and sector reversal.
Performance drivers behind the risk parity strategies are basically the same, but
we notice that the low beta and low risk anomaly are less explanatory than
small cap and sector reversal. Sector reversal as a source of outperformance
is more relevant for risk parity than for any other smart beta, especially where (as
is the case in Amundis process) risk parity is achieved through a two-step stock-
sector construction process.
Smart beta may become a new equity core if the investors relevant risk measure
is absolute risk. In this case, however, the liquidity of those strategies must be
consistent with the amount of assets the investor holds. If the investors relevant
risk measure is relative risk, smart beta might still become a new equity core,
Amundi Discussion Papers Series - DP-04-2014
42
but some more pertinent benchmarks should be designed, because smart beta
investing generates high tracking error relative to standard indices.
A clever benchmark, as well as a clever multi-smart allocation should exploit the
circumstance that the exposures to performance drivers are not identical for all
smart beta equities, and thus there is room for diversifcation. Another argument
for diversifying across smart beta is the different behavior they exhibit in some
typical market conditions. In addition to diversifcation, investors can translate
these different behaviors into some proftable timing strategies.
Finally, we discuss whether smart beta should be considered as passive or rather
active strategies. According to the pure replication criterion, most smart beta
strategies should fall into the passive category, with the exception of those (such
as for the Amundi minimum variance) where the portfolio construction processes
are combined with discretionary and judgmental investment decisions by the fund
manager. The second traditional criterion of transparency and wide recognition of
the benchmark should be replaced by the less stringent requirement of the mere
existence of a benchmark. If the fund manager replicates an existing smart beta
benchmark, the answer is obvious if he designs his own smart beta process,
then the asset manager himself determines the active or the passive nature of his
product by requiring or not that a tailor-made benchmark is created and maintained
by an index provider.
Amundi Discussion Papers Series - DP-04-2014
43
Appendix
Optimisation-based smart beta portfolios at Amundi
Quality Stocks
We believe that fundamental equity selection can provide some valuable
enhancement in the risk return profle of equity portfolios, at least in the long run.
At the same time we do not want to renounce an optimisation process which is
completely independent from expected returns. Expected returns are very noisy in
forecast and thus responsible for well known error maximization problems. For this
reason, we apply a qualitative flter to our investment universe, excluding the lowest
quality stocks from the optimisation. Basically, each quarter we rank the constituents
of the MSCI World Developed Markets according to a Piotroski (2000) score and
we exclude the two bottom quintiles. Keeping 60% of constituents available for
investments, the optimizer is left with a high degree of freedom and it tilts the optimal
portfolio toward good quality stocks, without using explicit expected returns.
Turnover and liquidity
High turnover is a critical issue in many systematic investment strategies like
Minimum Variance and other optimisation-based strategies. In our case, turnover
in the investment universe is limited as the Piotroski score is based on balance
sheet data that varies very little during one quarter. Furthermore we also rebalance
our portfolio quarterly, as suggested by Baker and Haugen (1991).
Nevertheless, more than turnover itself, our concern is indeed liquidity: we aim to
avoid small illiquid companies as we want to be able to liquidate our portfolio in a
reasonable time lag, without incurring signifcant market impact costs.
To address this requirement, we limited the amount held in any stock to the
following percentage:
where UB
i
is the upper bound on the ith stock, D is the number of days that we
accept to liquidate the fund, ADV
i
is the average daily volume over the last quarter,
and NOT is a notional amount of assets under management of USD 1 billion: quite
conservative as it is still far above the current size of our fund.
Sector, country, and stock concentration
As mentioned above, Minimum Variance and Diversifcation portfolios provide
excellent diversifcation across risk factors, but may tend to be poorly diversifed
across sectors, countries or single stocks. We have thus applied some constraints
at these levels, without preventing the optimizer from choosing solutions that are
far enough from a market index.
Amundi Discussion Papers Series - DP-04-2014
44
On countries and sectors we accept deviations from the market index of 5% to 10%,
while for single stocks we apply a general upper bound (GUB), thus modifying the actual
upper bound as follows:
Management of asymmetries in factor returns
Furthermore, we are conscious that optimisation-based smart beta portfolios may
be systematically or incidentally exposed to fundamental factors such as size,
value or momentum.
We observe that much of our size exposure is corrected away by the liquidity
constraints. As for other factor exposures, we have decided not to manage them
systematically as again we do not want to excessively restrict the optimisation
process.
On the other hand, we regularly monitor the behavior of all the risk factors of
the BARRA model (size, value, growth, momentum, leverage). The goal of this
monitoring is to detect bubbles or suspicious asymmetries like excessive positive
skewness in recent performance: in the case of signifcant alerts, from time to
time the fund manager hedges the risk of an exploding bubble, imposing a neutral
exposure to the suspected factor.
Amundi Discussion Papers Series - DP-04-2014
45
Acknowledgements
I would like to thank Sylvie de Laguiche for discussions, suggestions, and
comments that improved the quality of the manuscript.
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Chief Editors:
Pascal BLANQU
Deputy Chief Executive Offcer
Head of Institutional Investors and Third Party Distributors
Group Chief Investment Offce
Philippe ITHURBIDE
Global Head of Research, Strategy and Analysis
Pia BERGER, Assistant Editor Research, Strategy and Analysis
Benoit PONCET, Graphic Designer - Research, Strategy and Analysis
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This document neither constitutes an of fer to buy nor a solicitation to sell a product, and shall not be
considered as an unlawful solicitation or an investment advice.
The portfolios mentioned in this document, Amundi Di versification, Amundi Risk Parity and Amundi
Minimum Variance, are back test portfolios gi ven for illustrati ve purposes onl y.
Past performance and simulations shown in this document do not guarantee future results, nor are
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May 2014

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