PubServlet 1

Asia Pacific Equity Research
23 June 2009
Quant Concepts
Lower Volatility for Better Returns
This report explores the impact of volatility on portfolio returns. Australian Quantitative Analysis
AC
Thomas Reif
• We demonstrate that high volatility is destructive to portfolio return. (61-2) 9220 1473
thomas.w.reif@jpmorgan.com
• Via simulations we show that portfolios constrained to have volatility J.P. Morgan Securities Australia Limited
below the benchmark outperform portfolios constructed to have higher
Berowne Hlavaty
volatility than the benchmark. (61-2) 9220 1591
berowne.d.hlavaty@jpmorgan.com
• When portfolios are constructed to take active positions relative to
J.P. Morgan Securities Australia Limited
benchmark, one needs to strike a compromise between avoiding the
negative effect of volatility on return and the positive effect of biasing a Asia/GEM Quantitative Analysis
portfolio toward alpha. We measure portfolio effectiveness positioning Steve Malin
(852) 2800 8568
towards alpha via the Transfer Coefficient.
steven.j.malin@jpmorgan.com
Figure 1: Summary of Outperformance and Transfer Coefficient J.P. Morgan Securities (Asia Pacific) Limited
Transfer Robert Smith

Coefficient (852) 2800 8569
Simulation Avg Annual Alpha
robert.z.smith@jpmorgan.com
Sub Low Vol 5.01% 33%
J.P. Morgan Securities (Asia Pacific) Limited
Low Vol Sim 3.82% 34%
Sub Med Vol 3.82% 26% European Quantitative Analysis
Med Vol Sim 2.43% 30% Marco Dion
Sub High Vol 2.36% 3% (44-20) 7325-8647
marco.x.dion@jpmorgan.com
High Vol Sim -0.77% 9%
Source: BARRA, J.P.Morgan J.P. Morgan Securities Ltd.
Matthew Burgess
(44-20) 7325-1496
Figure 2: Annualized Outperformance, ranking in Ascending Risk matthew.j.burgess@jpmorgan.com
J.P. Morgan Securities Ltd.

6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%
-2.00%
Sub High Vol Sub Med Vol Sub Low Vol Low Vol Sim Med Vol Sim High Vol Sim
Benchmark Volatility
Source: BARRA, J.P.Morgan
See page 22 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Thomas Reif Asia Pacific Equity Research
(61-2) 9220 1473 23 June 2009
Introduction
Preferring Lower Volatility
In this paper we present our empirical findings concerning the optimal level of
volatility allowed during the portfolio construction process, where ‘optimal’ is
viewed in the context of maximizing outperformance.
Generally, low volatility is preferred to higher volatility when seeking to maximize

return. We demonstrate this point by a discussion of the impact of beta on return.
However, if a portfolio is simultaneously seeking to generate alpha while controlling

Lower volatility is preferred to
volatility, there is a compromise between the risk and return objectives for the
higher volatility when maximizing portfolio. For portfolios constructed to generate alpha, we find portfolios with a tilt
return towards lower volatility than benchmark outperform matching pairs targeted towards
higher volatility.
We also observe a decay in outperformance as the volatility objective is moved

further away from benchmark. The competition between the risk and return
objectives is observed by the drop in the Transfer Coefficient as the volatility target
is moved further away from benchmark.
Buying Beta
In early June 2009 ‘the market', as heard via the JPMorgan trading desk, was ‘buying
beta’. The ASX 200 had rallied 20% over the preceding quarter, and the cynics
among us suggested ‘the market’ has already bought beta, and were now talking their
own book.
Meanwhile our academic side was wondering whether buying beta had actually
worked as an investment strategy during bull and bear markets. We published a note
on this in JP Morgan’s Australian ‘First to Market’ pack on 06 June 2009,
reproduced (and augmented) here, which addresses ‘Buying Beta’.
We found buying beta is generally a risky portfolio strategy. High-Beta can

essentially be considered as leverage, and one with uncertain leverage to market
return at that.
We found the hit rate of ‘high’ and ‘low’ beta portfolios was in the order of what
reasonable quant strategies might earn, circa 60-70%. This means high beta
portfolios outperform during market rallies about 60-70% of the time. A 60-70% hit
rate is acceptable if an investor had multiple opportunities to take positions. Under a
repeatable scenario the realized outcome would approach the theoretical distribution,
given enough iterations.
However, positioning a portfolio for a rally over the ‘next period’ amounts to market
timing. Furthermore, we noted high beta had underperformed low beta over a 14
year period where the market had rallied 200%!
This paper begins with a discussion of beta and return. We then move on to the
portfolio context, exploring the tradeoff between risk and return. We end with an
article review: Ang, A., inter ali, “The Cross Section of Volatility and Expected
Returns”, Journal of Finance, Vol 61, 2006.
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Not-so-subtle Impact of Beta

In a Flat, Volatile market
In conjunction with our Asian colleagues, we tested whether buying high beta stocks,
while shorting low beta stocks (or just a high beta portfolio) had added alpha over
time.
The market generally goes up, so one might expect that the high beta portfolio would
outperform the low beta portfolio. The theory that high beta outperforms low beta
over a rising market came unstuck when faced with reality, the high beta portfolio
underperformed the low beta portfolio. We attributed this outcome to more volatility
than sector bias.
Beta and volatility are not the same (but have a high correlation). Beta is
proportional to the covariance of the portfolio’s return and the market return. The
return for a portfolio can be expressed relative to market return as follows:
Rp = βRm + error1
Where:
Rp and Rm represent the portfolio and market return respectively.
β represents the beta of the portfolio.

The problem with beta is
the volatility of returns.
To flesh out the effect of volatility (we’ll get to the market going up shortly), note an
X% down month hurts more than an X% up month helps a portfolio value.
Let’s use some extreme returns to illustrate the point of beta. Say a portfolio rallies
50% over a period, then falls -50% over the next period.
The loss following the 50% path (a

The portfolio starts with $100, earns 50% so goes to $150. The portfolio then loses
loss of $25) is more than 2.5 times 50%, half the original investment and half the incremental return earned in the
the $4 loss following the 20% path. previous period, so ends up with $75. The Volatility has cost the investor $25/25%.
That's compounding - apologies
for stating the obvious. If over the same time the market earned 20%, and lost 20%, then an investor who had
bought the market has $96 left at the end of both periods, giving a total loss of $4/-
This observation leads to the
refining of portfolio construction–
4%.
biasing towards lower volatility.
That’s beta in a nutshell. The market return was 20%, but the stock/portfolio had a
beta of 2.5, so earned 50%. Then the market gave back 20%, and the portfolio 50%.
The high beta portfolio ends up down 25%, whilst the market is down 4%.
The portfolio with a 2.5 beta lost 25%, which is more than 2.5 the 4% the market
lost.
1
Grinhold and Kahn, “Active Portfolio Management”, McGraw Hill
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Rising, but Volatile market

Consider a rising, but volatile market. If the market goes up 30% then loses 20%, a
$100 market portfolio (with a beta of 1) is worth $104 at the end of both periods.
If a portfolio’s beta was 2.5, the markets’ +30% becomes +75%, and the
markets’ -20% down becomes -50% down.
Following through each period then, the 2.5 beta portfolio of $100 earns 75% to
$175 in the first period, then halves to $87.50 during the second period.
Meanwhile, the beta 1 market remains (ends) in positive territory during both
periods, whilst after both periods the $100 portfolio with beta 2.5 is worth only
$87.50.
That’s the effect of volatility, and by definition beta.
Over long periods of time, high

So, for a long period of time, where ‘long’ is long enough to ride through some
beta will underperform low beta. volatility, volatility in return will mean a high beta portfolio will underperform a low
beta portfolio. Even though the market generally goes up.
In Figure 3 we present the return indices for equally weighted high and low beta
portfolios. These portfolios are rebalanced every month to be the top and bottom
20% of the ASX200, sorted by beta.
The period we studied was 31 Dec 1995 to 31 May 2009. Over this period the
ASX200 index returned 201.7%, (86% for an equally weighted ASX 200 index).
The high beta portfolio returned -60.9%! While the low beta portfolio 207%.
As at 31 May 2009 the high beta quintile ASX 200 portfolio (top 40 stocks by beta),
had a beta of 1.86, the bottom 40 stocks had an average beta of 0.72
Figure 3: High Beta, Low beta and equally weighted benchmark

Equal Wt Benchmark High Beta Low Beta
600
500
400
300
200
100
0
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
source: BARRA, JPMorgan
In Figure 4 we show the return to a market neutral long short portfolio. This strategy
is long the top quintile by beta of the ASX 200, short the low beta stocks. These
portfolios are rebalanced every month to be the top and bottom 20% of stocks by
beta. The strategy starts off with $100, and fairly consistently loses money until the
strategy has $13.40 at the end of the test period. Of course this would not be the
experience of a real portfolio, as the manager would never keep the mandate that
long.
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Figure 4: Market Neutral: Long High Beta, Short low beta. Value of $100 through time
120
100
80
60
40
20
0 Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Thomas and Shapiro2 investigated the returns vs Beta for equally weighted portfolios
“CAPM beta does a good job of (a univariate backtest) for the Russell 3000 Universe and found:
explaining risk but a poor job of
explaining returns. In other
1. Returns are not linearly related to beta
words, high beta means high
risk but low returns” (Thomas,
2. Low beta stocks performed much better than expected
Shapiro, 2006) 3. High Beta stocks performed much worse than expected
Data from Thomas and Shapiro demonstrate a neatly monotonic drop off in average
annual return from beta 0.8 ranging to 1.8 (with no greater observations of beta).
The average annual returns for the lower ranges of beta, 0.3 to 0.8, were
monotonically increasing, peaking with a beta of 0.8. Returns decayed with beta
greater than 0.8.
Thomas and Shapiro leverage off the historical outperformance of value over growth
and “notice a general negative relationship between the value/growth profile of a
portfolio and the beta of that portfolio... since value orientated portfolios are
associated with low beta it follows that low beta portfolios perform better over time.”
In the conclusion of their paper, Thomas and Shapiro observe ‘high beta portfolios
do tend to exhibit high volatility. Because of this dynamic investors should consider
adopting low-beta strategies.”
2
Thomas, R, Shaprio, R., ‘Managed Volatility: A New Approach to Equity Investing’, The
Journal of Investing, Spring 2009
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Improving Portfolio Construction
The implication that higher volatility and high beta can be destructive to returns
draws attention to Volatility as a tool to bias the portfolio to outperformance.
We used a BARRA portfolio optimizer as a generic tool to test the sensitivity of

returns to ‘Volatility’ (as defined by BARRA), though the implication is universal
across systematic definitions of volatility.
The BARRA volatility factor is comprised of:
• Historical Beta
• Cumulative Range
• Ratio of High Price to Low Price
• Relative Price Volatility
To our knowledge BARRA do not publish the exact composition of the B3 Volatility
factor across these inputs. We calculated the correlation between B3 Volatility and
B3 Beta, and found it to be above 80% over the last decade.
Pulling the Volatility Lever

Given the destructive impact of volatility on return, we ran a series of simulations
testing the sensitivity of our model returns to portfolios constructed with low,
medium and high levels of systematic volatility.
We targeted volatility greater and lower than the market in three stages. What we are
really referring to with low, medium or high is the deviation from benchmark
volatility.
1. 'Low' volatility was constrained between 0.0 and 0.3 standard deviations
above the market. ‘Sub Low’ volatility was constrained to be between -0.3
and 0.0 standard deviations below the market.
2. Medium: 0.3 to 1.0 standard deviations above market, sub-medium being
the same volatility band below market (-1.0 to -0.3).
3. High: 0.666 to 2 s.d above benchmark volatility. Sub High Vol was -2
to -0.666 s.d below market.
The outcome of these constraints was that portfolio volatility was 0.2%, 1% and
2-3% higher or lower than benchmark (13% on average), for low, medium and high
volatility bands. The bands operate on ‘standard deviations’ of the standard
deviation, which we think is best avoided discussing further for sake of simplicity.
Suffice to say the impact on portfolio volatility is fairly clear, and the goal of this
study. The constraint levels are presented in Figure 5.
Figure 5: B3 Volatility Constraints

Constraint levels
Simulation Name Minimum Maximum
Low Vol 0.000 0.300
Med Vol 0.300 1.000
High Vol Sim 0.666 2.000
Sub Low Vol -0.300 0.000
Sub Med Vol -1.000 -0.300
High Vol Sim -2.000 -0.666
Source: JPMorgan
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To isolate the impact of ‘risk’ as much as possible, we kept the remaining portfolio
construction parameters constant.
General Simulation Parameters

The following present an overview of the remaining parameters that drive the JP
Morgan’s Quantitative simulation process.
• Simulation Period: 31-May-1995 to 30-Jun-2009

• Benchmark: S&P/ASX200
• Ex-ante Risk Target: 4%
• Turnover: 7.5% one way per month
• BARRA risk factors: +/- 1 s.d: Momentum, size, trading activity, value, growth,
leverage, foreign exposure. Volatility was adjusted as required.
• GIC Sector Positions: +/- 5%, except property +/- 1%
• Stock Positions, capitalization banded
Top 20: +/- 5%
21-50: +/- 3%
51-100: +/- 2%
101-200: +/- 0.25%
Thomas and Shapiro (2009) noted a “general negative relationship between the
value/growth profile of a portfolio and the beta of that portfolio.” This suggests
some caution is required when modifying portfolio beta or volatility profile, so as not
to inadvertently introduce a Value bias into the portfolio. We discuss this and other
portfolio features in the Results section.
The Alpha Model

The alpha model we used was the ‘standard’ JPMorgan Quantitative Model. The
JPM model portfolio is constructed from the following Factor Families:
• Price Momentum Family: 20%
• Earnings Momentum Family: 30%
• Value Family: 20%
• Shareholder Value: 30%

We present the full suite of factors in the JPM Quantitative Model in the appendix.
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Results
Simulations constraining Volatility to be lower than the benchmark perform better
than their higher volatility pairings.
Outperformance peaks when Outperformance peaks when volatility is in the -0.3 – 0.0 range, which forces overall
volatility is in the -0.3 – 0.0 range volatility slightly below the benchmark.
As volatility is forced further away from the benchmark level, either high or lower,
performance deteriorates monotonically. The relationship between volatility and
alpha can be considered to have a ‘normal’ distribution shape, with left skew (Figure
7)
Figure 6: Summary of Simulation Outperformance
Simulation Avg Annual Alpha
Sub Low Vol 5.01%
Low Vol Sim 3.82%
Sub Med Vol 3.82%
Med Vol Sim 2.43%
Sub High Vol 2.36%
High Vol Sim -0.77%
Source: JPMorgan, BARRA
Figure 7: Annualized Outperformance, ranking in Ascending Risk

6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%
-2.00%
Benchmark Volatility
Source: JPMorgan, BARRA
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General Discussion
The path to better returns through managing volatility is clearly not linear. There is a
trade off between the ‘other attributes’ the portfolio is trying to achieve, and the
volatility target.
The main reason for the high volatility simulations performing poorly relative to the
low volatility simulations is the sacrifice of positioning the portfolio towards
volatility rather than alpha as the volatility target becomes more aggressive. We can
see this from the reduction in Transfer Coefficient3 in Figure 8.
Figure 8: Summary of Outperformance and Transfer Coefficient

Transfer
Simulation Avg Annual Alpha Coefficient
We note the portfolios targeting Sub Low Vol 5.01% 33%
volatility above 0 had generally Low Vol Sim 3.82% 34%
higher transfer coefficients than Sub Med Vol 3.82% 26%
their ‘sub 0’ pairings, yet lower
Med Vol Sim 2.43% 30%
outperformance.
Sub High Vol 2.36% 3%
High Vol Sim -0.77% 9%
Comparing Figure 9 and Figure 10 one can see how the high volatility portfolio
struggled to get the portfolio position for alpha. The charts represent the alphas of
the portfolio weighted by their active position.
The transfer coefficient of the low volatility portfolio was 33%, whereas the high
volatility portfolio only achieves 3%. This was fairly consistent whether the
volatility target was banded above or below zero. The medium volatility simulations
achieved transfer coefficients in the order of 25-30%. We note the portfolios
targeting volatility above 0 had generally higher transfer coefficients than their ‘sub
0’ pairings, yet lower outperformance.
Figure 9: ‘Sub’ Low Portfolio Alpha

Alpha
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
-0.1
-0.2
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
source: BARRA, JP Morgan
3
Transfer Coefficient is the correlation between active positions taken in stocks and their
alpha from the alpha model.
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Figure 10: ‘Sub’ High Portfolio Alpha

Alpha
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
-0.1
-0.2
ay-95
ay-96
ay-97
ay-98
ay-99
ay-00
ay-01
ay-02
ay-03
ay-04
ay-05
ay-06
ay-07
ay-08
M
M
source: BARRA, JP Morgan
Risk Profile
Volatility
In Figure 12 and Figure 13 we present the average profile of the simulated portfolios
with regards to total risk and beta.
The targeted variable of interest was total volatility, Figure 12 shows the
effectiveness and magnitude of the bias induced with the Target Volatility ranges.
A negligible reduction in terms Recall Figure 11, presented in ‘Pulling the Volatility Lever’, and represented below.
of total risk, but quite effective in The implication of a volatility band bounded at 0, extending 0.3 lower (or higher), is
its impact on performance! to reduce (increase) average total volatility -0.11% (+.16%), over a base of 13.3%
(average benchmark total volatility).
Figure 11: B3 Volatility Constraints

Constraint levels
Simulation Name Minimum Maximum
Low Vol 0.000 0.300
Med Vol 0.300 1.000
High Vol Sim 0.666 2.000
Sub Low Vol -0.300 0.000
Sub Med Vol -1.000 -0.300
High Vol Sim -2.000 -0.666
Source: JPMorgan
As the target volatility bands widened, more specifically, the lower tolerance of the
bands was moved further from neutral, total volatility increased monotonically as
expected. Total volatility moved from 11.5% at the lower range, through the
benchmark at 13.3% then to 14.3% at the ‘medium’ range. (The high volatility
example can be ignored for this purpose, pragmatically, as it shot though to 16.4%,
even after removing an outlier)
The outcome of these constraints was that portfolio volatility was 0.2%, 1% and
2%-3% higher or lower than benchmark volatility (13% on average), for low,
medium and high volatility bands.
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Figure 12: Average Total Risk of Simulated portfolios
20.0
18.0
16.0
14.0
12.0
10.0
Sub High
High Vol
Bench
Med Vol
Sub Med
Low Vol
Sub Low
Sim
Sim
Sim
Vol
Vol
Vol
Source: BARRA, JPMorgan
Beta
Beta was an outcome rather than input of the simulation. But we mentioned that the
correlation between beta and volatility was in the order of 0.8, so it was no surprise
to see the beta move in concert with the induced volatility bias. Beta range from 0.8
to 1.2.
The two portfolios with the most subtle bias to volatility (low and sub-low
simulations), had betas statistically indistinguishable from 1.0.
Figure 13: Average Beta of simulated portfolios

1.3
1.2
1.1
1.0
0.9
0.8
0.7
0.6
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Volatility range, Value Bias and Tracking error
Low and Sub low Volatility Simulations

• BARRA Volatility oscillated between the limit and zero for both simulations.
• Circa 4% ex-ante tracking error was achieved consistently.
• Value Bias: The portfolios generally had a slight (0.0 - 0.3 s.d) Value bias from
1995 to 2003, swinging between immaterial -0.1 and 0.1 Value from 2003 to
2008.
• The portfolios were similarly biased against BARRA (B3) growth.
Figure 14: ‘Sub’ Low Realized Volatility Figure 15: Low Realized Volatility
VOLAT IL
0.3 VOLAT IL
0.3 0.3
0.2 0.3
0.2 0.2
0.1 0.2
0.1
0.1
0.1
0.0
0.0
-0.1
-0.1
-0.1
-0.1
-0.2 -0.2
-0.2 -0.2
-0.3 -0.3
-0.3 -0.3
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
Source: BARRA
Mid and Sub Mid Volatility Simulations

• The simulation effectively capped Volatility at the lower end of the limit in
either simulation, highlighting the BARRA optimizer preference for reducing
risk relative to the benchmark.
• The Mid vol simulation Value bias oscillated between insignificant -0.3 - 0.3 s.d,
although allowed to range to 1 s.d by these simulation parameters. The sub mid
vol portfolio was reasonably consistently biased towards Value, though between
0.0 and 0.3. The portfolios were similarly biased against BARRA (B3) growth.
Figure 16: ‘Sub’ Medium Realized Volatility Figure 17: Medium Realized Volatility
VOLAT IL VOLAT IL
0.40 0.40
0.35 0.35
0.30 0.30
0.25 0.25
0.20 0.20
0.15 0.15
0.10 0.10
0.05 0.05
0.00 0.00
-0.05 -0.05
-0.10 -0.10
-0.15 -0.15
-0.20 -0.20
-0.25 -0.25
-0.30 -0.30
-0.35 -0.35
-0.40 -0.40
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
Source: BARRA
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High Volatility Simulations

• The simulation effectively capped Volatility at the lower end of the limit in
either simulation, highlighting the BARRA optimizer preference for reducing
risk relative to the benchmark. For the sub-high simulation, the processes could
not always achieve the minimum volatility, and often went as high as -0.6
to -0.4.
• Value: The ‘sub’ high simulation oscillated between a value bias of 0.0 to 0.3,
whilst the high volatility simulation generally had a value bias of -0.2 to 0.
Figure 18: ‘Sub’ High Realized Volatility Figure 19: High Realized Volatility
VOLAT IL
0.2 VOLAT IL
0.8
0.1
0.7
0.0
0.6
-0.1
0.5
-0.2
0.4
-0.3
0.3
-0.4 0.2
-0.5 0.1
-0.6 0.0
-0.7 -0.1
-0.8 -0.2
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
May-95
May-96
May-97
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
May-07
May-08
Sector Biases?
We looked at the two portfolios with volatility closest to the benchmark, being 0-0.3
s.d above and below benchmark, which had the effect of changing total risk within
0.3% of the benchmark.
The sector positions between the two simulations were reasonably consistent,
expected when using the same alpha model.
However we were conscious of bias induced by the volatility skew of the portfolios.
The sector differences between the two simulations were marginal, though in the
direction you’d expected when biasing a portfolio towards lower or higher beta
sectors. However recall that beta was not significantly different to one, so it seems
unlikely that sector biases account for the differences.
Note that decay in outperformance was symmetric with volatility bias – the further
away the portfolios moved from benchmark volatility the more alpha decay, either
volatility up or down. If outperformance was due to sector bias we would expect
asymmetric alpha decay.
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Conclusion
Volatility in returns is detrimental to portfolio performance.
The bias of a portfolio towards or away from volatility can be used as a tool to
position the portfolio for higher returns.
A bias where volatility is below the benchmark in the order of -0.3 to 0.0 standard
deviations maximises outperformance.
This is in spite of this portfolio having a (slightly) lower transfer coefficient than a
pairing portfolio constructed with similar (but higher than benchmark) volatility
target.
There was no statistically significant impact on beta for simulations targeting

volatility within 0.3 s.d of the benchmark.
A target volatility greater than +/- 0.7 standard deviations from benchmark sacrifices
positioning the portfolio for alpha, in preference to the volatility constraint. We
noticed a significant drop in the transfer coefficient as the volatility bias was
increased.
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Appendix I: Volatility Simulation Summary

Statistic Sub Low Vol Low Vol Sim Sub Med Vol Med Vol Sim Sub High Vol High Vol Sim
Risk & Return
Annual Total Return 13.9% 12.7% 12.7% 11.3% 11.2% 8.1%
Annual Benchmark Return 8.9% 8.9% 8.9% 8.9% 8.9% 8.9%
Annual Active Return 5.0% 3.8% 3.8% 2.4% 2.4% -0.8%
Annual Active Risk 4.3% 4.2% 4.7% 4.3% 5.7% 5.7%
Ex-Ante Tracking Error Limit 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%
Information Ratio (IR) 1.16 0.91 0.81 0.56 0.41 - 0.13
Transfer Coefficient 33% 34% 26% 30% 3% 9%
Assets
Average Annual Turnover 101% 107% 111% 103% 192% 187%
Minimum Holdings 40 40 41 40 27 10
Maximum Holdings 82 111 89 110 107 111
Exposures (Mandates)
Average Active Industry Exposure 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Maximum Active Industry 5.0% 5.0% 5.0% 5.0% 5.0% 16.1%
Minimum Active Industry -5.0% -5.0% -5.0% -5.0% -8.4% -7.9%
Average Factor Exposure 0.02 0.04 -0.03 0.06 -0.11 0.08

Maximum Active Factor 0.73 0.73 0.64 0.68 0.56 0.83
Minimum Active Factor -0.44 -0.49 -0.42 -0.47 -0.81 -0.74
Portfolio Construction
Description Sub Low Vol Low Vol Sim Sub Med Vol Med Vol Sim Sub HighVol HighVolSim
Alpha C_JPM_ASX_Model C_JPM_ASX_Model C_JPM_ASX_ModelC_JPM_ASX_Model C_JPM_ASX_Model C_JPM_ASX_Model
Asset Level Bounds BMK_Tight BMK_Tight BMK_Tight BMK_Tight BMK_Tight BMK_Tight
Industry Level Bounds b ± 5% b ± 5% b ± 5% b ± 5% b ± 5% b ± 5%
Risk Index Bounds SubLowVol LowVol SubMedVol MidVol SubMedHighVol MedHighVol
Benchmark SAP200 SAP200 SAP200 SAP200 SAP200 SAP200
Portfolio Turnover Limit 7.5% 7.5% 7.5% 7.5% 7.5% 7.5%
Asset Turnover Limit (%ADV) 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Transaction Cost Function 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Fund Size
Initial Fund Size $ 99,999,993 $ 99,999,992 $ 99,999,987 $ 99,999,987 $ 99,999,996 $ 99,999,988
Final Fund Size $ 611,999,514 $ 528,870,062 $ 529,054,368 $ 445,258,095 $ 441,307,975 $ 296,588,085
Source: BARRA , JP Morgan Quantitative Research
15
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Appendix II: The JPM Alpha Model

The alpha model we used was the ‘standard’ JPMorgan Quantitative Model. The
JPM model portfolio is constructed from the following Factor Families:
• Price Momentum Family: 20%
• Earnings Momentum Family: 30%
• Value Family: 20%
• Shareholder Value: 30%
Price Momentum Family

• 60% 52 Week High
• 30% True Market Surprise
• 10% Price Mom (avg 1, 3, 6, 12 mth performance)
Earnings Momentum Family

• 40% Earnings Potential
• 20% One Year Forward Earnings (70% 1 mth, 30% three mth)
• 40% One year fwd earnings / Co-efficient variation 1 yr fwd Earnings
Value Family
• 50% Forward PE relative to Sector
• 12.5% Value to Growth
• 12.5% Forward PE relative to History
• 25% one year forward PE
Shareholder Value Family

• 60% Fundamental Scorecard
• 30% ROE
• 10% ROE Growth
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Appendix III: Using Beta Skillfully

Beta as leverage
Varying portfolio beta is one way to ‘time’ the market. A beta greater than market
beta (typically defined as 1) may be considered leverage, without the cost of borrow.
To labour the theory, (because it comes unstuck when faced with the practice) if the
market rallies 5% in a month, and the beta of a portfolio is 1.5, the portfolio should
rally 7.5%. If there is an expectation of a market rally, then a high beta would be an
attractive portfolio characteristic, likewise low beta in times of a falling market.
We also looked at ASX200 highest and lowest beta quintiles for all months where
the market returned more than 5%. Since 31 Dec 1995 there have been 15 months
with a greater than 5% return. When the return was greater than 5%, then average
return was 6.06%.
Successfully timed, beta adds to During these bull months the top quintile (high beta) portfolios outperform the
return market by 5.35%, outperforming in 10 of the 15 months (hit rate of 66%). The low
beta portfolio underperforms the market during a 5% bull month by -3.42%, which is
what you’d expect, outperforming once, giving a comfortably low hit rate of 7%.
On the flip side, during Bear months which returned less than -5% (the average Bear
month was -8.36%, demonstrating the negative skew to market returns when
compared against the average bull of 6.06%), the high beta portfolio underperforms
the market by -8.46%, whilst the low beta portfolio outperforms 1.88% on average.
The high beta portfolio outperforms bull months by 5.35%, but underperforms in the
(less frequent) bear months by -8.36%. So not only is there a skew to extreme
market returns, there is also a skew to beta outperformance/underperformance.
Technically we should allow for return in excess of the risk free rate, however this
exacerbates the result, so our approach can be considered conservative in its
exposition.
There were ‘bear’ 10 such months over the test period, high beta outperforming in 1
of them, the low beta outperforming in 9 of them. We present these results in Figure
20.
Figure 20: High and Low Beta Portfolios during 5% Bull and Bear months
5.0% Bull Month -5.0% Bear Month
High Beta Low Beta High Beta Low Beta
Average Outperf 5.35% -3.42% -8.46% 1.88%
St dev 11% 2% 9% 3%
T-stat 1.95 - 5.47 - 2.85 1.90
Outperf Hit Rate 67% 7% 10% 90%
Source: JP Morgan
We reduced the bull/bear hurdle from 5% to 2% to stress the sensitivity of our

numbers to the cutoff, and also to increase the statistical validity (a lower hurdle
giving us more observations, thus greater comfort in the conclusions). We present
these results in Figure 21. They are consistent with the higher bull/bear definitions.
17
(61-2) 9220 1473 23 June 2009
Figure 21: High and Low Beta Portfolios during 2% Bull and Bear months
2.0% Bull Month -2.0% Bear Month
High Beta Low Beta High Beta Low Beta
Average Outperf 1.62% -1.60% -5.10% 1.85%
St dev 6% 2% 7% 3%
T-stat 2.08 - 5.64 - 3.99 3.28
Outperf Hit Rate 67% 21% 13% 83%
Source: JP Morgan
18
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Appendix IV: Article Reviews
The Cross-Section of Volatility and

Expected Returns
Subject: The interaction of Volatility and realized return
Author: Ang, A., Hodrick, R., Xing, Y., Zhang, X.
Publication: Journal of Finance, Vol 61, No 1
Date: 2006
JPM Comments
The authors find a strong and robust negative relationship between systematic
volatility and returns. After finding the relationship between return and volatility is
robust to a variety of possible alternate factors, they suggest investors “priced with a
negative sign by risk averse agents, who reduce consumption to increase
precautionary savings in the presence of higher uncertainty about future market
movements.” We agree with their findings, and have found that our simulation work
varying portfolio exposure to barra volatility supports the broad thrust of their
conclusion
The authors report a similar negative relationship for idiosyncratic volatility, which
we would caution against applying too liberally. We note the negative relationship
between Q1 less Q5 certainly is statistically significant, however there is little
dispersion between Q1 to Q4, suggesting that the results may be driven by the poor
return of Q5, stocks with high idiosyncratic volatility.
Abstract
The authors examine the pricing of aggregate volatility risk in the cross-section of
stock returns. Consistent with theory, they find that stocks with high sensitivities to
innovations in aggregate volatility have low average returns. In addition, they find
that stocks with high idiosyncratic volatility relative to the Fama and French (1993)
model have abysmally low average returns. This phenomenon cannot be explained
by exposure to aggregate volatility risk. Size, book-to-market, momentum, and
liquidity effects cannot account for either the low average returns earned by stocks
with high exposure to systematic volatility risk or for the low average returns of
stocks with high idiosyncratic volatility.
19
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Introduction
The authors investigate how the market prices stock sensitivities to changes in
aggregate volatility. They put forth a number of theories that suggest price of risk of
innovations in volatility should be negative - implying stocks which have high
sensitivities to changes in volatility, a desirable characteristic, should trade at a
premium.
Idiosyncratic volatility on the other hand, is undiversifiable and investors should

demand compensation for holding stocks with high idiosyncratic volatility. The
authors, however, find that stocks with high idiosyncratic have statistically
significant low average returns, which presents simultaneously a puzzle and an
opportunity.
The authors suggest that previous studies finding a positive relationship (or
statistically insignificant relationship) between idiosyncratic volatility and returns did
not allow for firm level idiosyncratic volatility, or did not sort on this metric.
Pricing Systematic Volatility
The Usual Suspects are Influential, not Dominant
Size
Investigating the interaction between size and volatility is particularly important due
to the high anecdotal relationship (and correlation) between volatility and firm size.
The authors note that small firms may be considered as containing a put option that
would do well when volatility increases.
The authors find that small stocks do influence the results, particularly small growth
stocks, however their return does not completely drive the differentials. After
allowing for size the return differentials of their univariate tests are still statistically
significant – the authors show in Figure 22 that whilst the average return reduces
when allowing for small growth firms, statistical significance increases.
Figure 22: Characteristic Controls for Portfolios sorted in Aggregate Volatility Risk
Exclusing Small
All Firms Growth Firms
Rank Mean Std Dev Mean Std Dev
1 0.32 2.11 0.36 1.9
2 0.04 1.25 0.02 0.94
3 0.04 0.94 0.05 0.89
4 -0.11 1.04 -0.1 1.02
5 -0.58 3.39 -0.29 2.17
(5 - 1) (-0.9) (-0.64)
T-stat [-3.59] [-3.75]
source: Ang, A. inter ali, (2006)
Robustness Checks
The authors find their negative relationship between idiosyncratic risk is robust after
controlling for value, size, liquidity, volume, dispersion of analysts’ forecasts and
momentum effects. The finding is persistent in both bull and bear markets.
20
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We direct the interested reader to the paper for a further discussion of their
robustness checks.
Pricing Idiosyncratic Volatility

Idiosyncratic risk presents an interesting return profile. The authors control for size,
book-to-market, leverage, liquidity, volume, turnover, bid-ask spreads, coskewness,
dispersion of analysts’ forecasts and momentum effect.
Q1 less Q5 certainly is statistically The curious feature of their findings (across all metrics controlled for) is the Q1 less
significant, however there is little Q5 certainly is statistically significant, however there is little dispersion between Q1
dispersion between Q1 to Q4. to Q4. Arguably then any statistical significance can be attributed to the poor
performance of Q5 (the high idiosyncratic volatility quintile).
Size: The authors control for size by limiting the universe from AMEX, NASDAQ
and NYSE to NYSE only, which only particularly resolves the issue. Secondarily
the authors for quintiles across the capitalisation range, then resort these quintiles
into further quintiles (25 groups in total) based on idiosyncratic volatility. The
authors find their results are robust across these reformed size quintiles. Scanning
the returns across the 25 size/volatility groupings one sees that, while Q1-Q5 is
statistically significant, their certainly is not a nice linear monotonicity across the
second order (idiosyncratic) quintile groupings. This is probably just a warning that
the (poor) returns to idiosyncratic risk are driven by stocks with the highest
idiosyncratic risk.
The reduction in returns across the idiosyncratic sort is sketchy, or concentrated in

Q4 and Q5 of idiosyncratic risk.
Economic Recessions and Expansions

The authors hypothesize that the idiosyncratic volatility effect may be caused by
asymmetric return distribution across business cycles, perhaps being driven largely
by recessions in the sample. The authors note that volatility is asymmetric (and large
with downward moves), and test is stocks with high idiosyncratic volatility may have
normal returns during expansions.
The authors find low returns from high idiosyncratic volatility exists during both
recessions and expansions.
Conclusion
The authors find a negative return to increasing volatility across their sample. This
suggests aggregate volatility risk is “priced with a negative sign by risk averse
agents, who reduce consumption to increase precautionary savings in the presence of
higher uncertainty about future market movements.”
21
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Asia Pacific Equity Research

Transfer Robert Smith

J.P. Morgan Securities Ltd.

Generally, low volatility is preferred to higher volatility when seeking to maximize

However, if a portfolio is simultaneously seeking to generate alpha while controlling

We also observe a decay in outperformance as the volatility objective is moved

We found buying beta is generally a risky portfolio strategy. High-Beta can

Not-so-subtle Impact of Beta

Rp and Rm represent the portfolio and market return respectively.

β represents the beta of the portfolio.

The loss following the 50% path (a

Rising, but Volatile market

That’s the effect of volatility, and by definition beta.

Over long periods of time, high

Figure 3: High Beta, Low beta and equally weighted benchmark

source: BARRA, JPMorgan

Improving Portfolio Construction

We used a BARRA portfolio optimizer as a generic tool to test the sensitivity of

The BARRA volatility factor is comprised of:

Pulling the Volatility Lever

Figure 5: B3 Volatility Constraints

General Simulation Parameters

• Simulation Period: 31-May-1995 to 30-Jun-2009

The Alpha Model

• Price Momentum Family: 20%

• Earnings Momentum Family: 30%

• Value Family: 20%

• Shareholder Value: 30%

Figure 7: Annualized Outperformance, ranking in Ascending Risk

Figure 8: Summary of Outperformance and Transfer Coefficient

Figure 9: ‘Sub’ Low Portfolio Alpha

source: BARRA, JP Morgan

Figure 10: ‘Sub’ High Portfolio Alpha

Figure 11: B3 Volatility Constraints

Figure 12: Average Total Risk of Simulated portfolios

Figure 13: Average Beta of simulated portfolios

Source: BARRA, JPMorgan

Volatility range, Value Bias and Tracking error

Low and Sub low Volatility Simulations

Mid and Sub Mid Volatility Simulations

High Volatility Simulations

There was no statistically significant impact on beta for simulations targeting

Appendix I: Volatility Simulation Summary

Average Factor Exposure 0.02 0.04 -0.03 0.06 -0.11 0.08

Source: BARRA , JP Morgan Quantitative Research

Appendix II: The JPM Alpha Model

• Price Momentum Family: 20%

• Earnings Momentum Family: 30%

• Value Family: 20%

• Shareholder Value: 30%

Price Momentum Family

• 10% Price Mom (avg 1, 3, 6, 12 mth performance)

Earnings Momentum Family

• 40% One year fwd earnings / Co-efficient variation 1 yr fwd Earnings

• 12.5% Value to Growth

• 12.5% Forward PE relative to History

• 25% one year forward PE

Shareholder Value Family

• 10% ROE Growth

Appendix III: Using Beta Skillfully

We reduced the bull/bear hurdle from 5% to 2% to stress the sensitivity of our

Appendix IV: Article Reviews