1Capital IQ, A Standard & Poor’s Business Variations on Minimum Variance March 2011 Ruben Falk, Capital IQ Quantitative Research

2Capital IQ, A Standard & Poor’s Business Agenda Quick overview of the tools employed in constructing the Minimum Variance (MinVar) Portfolio Features of a basic unconstrained MinVar Portfolio and comparative performance against the main benchmarks Impact on performance of imposing constraints such as style or sector neutrality Alternative methods for imposing style tilts within the minimum variance framework

3Capital IQ, A Standard & Poor’s Business The Tools Capital IQ US Fundamental Risk Model ›140 Alphaworks factors aggregated into 8 style factors: Value, Momentum, Earnings Quality, Analyst Expectations, Historical Growth, Capital Efficiency, Volatility, Size ›Other factors: Market factor and 24 industry factors based on GICS ›Responsiveness: Based on daily returns with serial correlation adjustment Capital IQ ClariFI Mean-Variance Optimizer ›State of the art solver for Mixed Integer Quadratically Constrained Quadratic Programming problems Capital IQ ClariFI Portfolio Attribution Framework: Classic side-by-side factor based risk and return attribution

4Capital IQ, A Standard & Poor’s Business Historical Evidence Early work from HAUGEN/BAKER (1991). For the period covering the years 1972 to 1989 the authors found that a MinVar portfolio would outperform the Wilshire 5000 at lower risk Many studies followed the original paper. For the US stock market CHAN/KARCESKI/LAKONISHOK (1999), SCHWARTZ (2000) and JAGANNATHAN/MA (2003) and CLARKE/SILVA/THORLEY (2006) found both higher returns and lower realized risks for the MinVar portfolio versus a capitalization weighted benchmark For global equity markets GEIGER/PLAGGE (2007), POULLAOUEC (2008) and NIELSEN/AYLURSUBRAMANIAN (2008) all find similar results SCHERER (2010) shows that 79% of the variation of the MinVar portfolio’s excess return can be attributed to exposure to low market beta and low stock specific risk. Value and size are other characteristics noted

5Capital IQ, A Standard & Poor’s Business The Anomaly Risk Return Efficient Frontier Security Market Line Market Portfolio Empirical MinVar Portfolio Theoretical MinVar Portfolio

6Capital IQ, A Standard & Poor’s Business Base Case Minimum Variance Portfolio Portfolio size $1.5BN (initial), long only Monthly rebalancing, Apr to Oct Objective: Minimum Variance at each rebalancing Risk Model: Capital IQ US Fundamental Medium Term Universe: S&P 1500 Max 100 Holdings (not always binding) Max trade size: 10% of ADV Trade costs: 25bps Max holding size: 3% of portfolio per name Threshold holding and trade size: $50k

7Capital IQ, A Standard & Poor’s Business Base Case MinVar Performance

8Capital IQ, A Standard & Poor’s Business Base Case MinVar Performance Note: The annualized risk numbers in this presentation are based on monthly returns. Using daily returns, the risk of the Base Case MinVar portfolio is 13.4% and the S&P 500 is 21.8%

9Capital IQ, A Standard & Poor’s Business Base Case MinVar Portfolio Factor Attribution Apr – Oct Portfolio Exposure Annualized Portfolio Return Forecast Contribution to Portfolio Risk Forecast Percent of Portfolio Risk Realized Contribution to Portfolio Risk Realized Percent of Portfolio Risk Realized Return/Risk Ratio Factor1.96%10.16%89.67%9.63%72.09%0.20 Market %9.09%70.37%8.44%55.35%0.25 Styles-0.58%3.04%9.21%3.11%7.49%-0.19 Valuation %-0.58%-0.79%-0.98%-0.74%-0.84 Size %0.41%-0.30%1.04%0.84%0.17 Analyst Expectation %0.58%0.35%0.94%0.68%-0.30 Historical Growth %0.94%1.24%-0.46%-0.16%-0.15 Capital Efficiency %1.15%0.81%2.27%4.01%-0.08 Price Momentum %-0.30%-0.24%2.03%3.19%0.23 Earnings Quality %2.27%5.11%0.85%0.56%-1.11 Volatility %1.34%3.03%-1.07%-0.89%0.66 Industries %3.36%10.10%3.45%9.25%0.12 Stock Specific %3.06%10.33%5.99%27.91%0.68 Grand Total6.02%10.61%100.00%11.35%100.00%0.53 The Base Case MinVar portfolio has a low average beta of 0.48 and derives most of its return from stock specific sources

10Capital IQ, A Standard & Poor’s Business Base Case MinVar Sector Attribution against S&P 1500 The Base Case MinVar portfolio on average overweights traditionally defensive sectors such as Consumer Staples and Utilities while underweighting IT and Financials

11Capital IQ, A Standard & Poor’s Business Base Case MinVar Cap. Group Attribution against S&P 1500 The unconstrained MinVar portfolio heavily underweights the top market cap. decile while, on average, overweighting decile 2-5 and staying neutral to the bottom half market cap names in the S&P However on average, the top Market cap. decile still represents 34% of the MinVar portfolio by value

12Capital IQ, A Standard & Poor’s Business Base Case MinVar v. Fama-French 3 Factor Model Returns Dependent Variable BetaStd ErrorP-value Constant Market Excess Return 0.500*** SMB (Size) HML (Value)0.215*** R-squared0.597 Market and Value (but not Size) loadings were statistically significant at the 95% level in explaining the returns of the Base Case MinVar portfolio. The Market beta was about the same as when using the CIQ risk model at 0.5 while the exposure to Value was positive which is consistent with the results of Scherer (2010)

13Capital IQ, A Standard & Poor’s Business Optimal Turnover & Holding Period (Base Case)

14Capital IQ, A Standard & Poor’s Business Implementing Sector & Style Neutrality & Style Tilts Imposing sector neutrality on the Base Case with respect to the S&P 1500 (+/-2%) has the effect of pushing up the market exposure which increases risk while return suffers as we can’t achieve a defensive sector allocation Imposing strict style neutrality on the Base Case shows some promise in terms of providing higher returns and return/risk ratio but the problem often isn’t feasible Three scenarios for style neutrality with flexible tilts (lower bound of the style exposure is zero but no upper bound) ›Earnings Quality tilt ›Value Tilt ›Both Value & Price Momentum Tilt

15Capital IQ, A Standard & Poor’s Business Performance of MinVar Portfolios with Value Style Tilts ›The tilted MinVar portfolios generally outperform both on absolute and risk adjusted return ›The sources of outperformance are: more efficient market exposure, higher stock and industry specific returns, and the fact the style contributions to return are mostly negative when not constrained Factor Contribution to Ann. Return Apr – Oct Base Case MinVar Earnings Quality Tilt MinVar Value Tilt MinVar Value & Price Momentum Tilt MinVar Market2.1%2.9%2.8%2.6% Market Exposure Return/Risk Ratio Value0.8%0.2%-0.2% Earnings Quality-0.9%-0.7%-0.1% Price Momentum0.5%0.1% 0.3% Other Styles-1.0%-0.3%-0.2% Industries0.4%0.7%1.0%0.6% Stock Specific4.1%4.5%4.6%4.5% TOTAL (Pre-Tcosts)6.0%7.4%8.0%7.5% Total Return/Risk Ratio TOTAL (Post-Tcosts)5.1%6.3%6.9%6.3% Total Return/Risk Ratio

16Capital IQ, A Standard & Poor’s Business Market & Style Exposures: Base Case v. Single Tilts

17Capital IQ, A Standard & Poor’s Business Style Exposures: Price Momentum & Value Tilt The style factor exposures have ICs of 0.08 and 0.13 with respect to 1-month forward factor returns of Price Momentum and Value respectively. The Value exposure IC is statistically significant at the 95% while the Price Momentum exposure IC is only statistically significant at the 84% level

18Capital IQ, A Standard & Poor’s Business MinVar with Flexible Style Tilts Spreads Cumulative Active Return vs. S&P 500

19Capital IQ, A Standard & Poor’s Business Global MinVar Performance *Pre transaction costs. Transaction costs impact annual returns by 0.7% in the Base Case **Capitalization weighted Note: Returns are compounded Apr – Oct Ann ReturnAnn Risk Return/Risk Ratio Global Base Case*6.2%9.8%0.63 Global Value Tilt*6.9%10.7%0.65 S&P 1200**4.2%18.7%0.22 Base Case and Value tilted global MinVar portfolios constructed using the same parameters as for the US portfolios except drawn from the S&P 1200 universe

20Capital IQ, A Standard & Poor’s Business Base Case Global MinVar Country Attribution vs. S&P 1200

21Capital IQ, A Standard & Poor’s Business Summary From Apr to Oct. 2010, our MinVar portfolio without sector or style constraints easily outperforms the S&P 500 and S&P 1500 with much lower risk Portfolio construction with a minimum variance objective naturally lends itself to a large cap. but not mega-cap. bias During this period, the minimum variance objective has the effect of over allocating to traditionally defensive sectors such as Consumer Staple and Utilities while under allocating to Financials and Technology Imposing sector constraints has the effect of lowering returns and increasing risk Style constraints, however, when combined with certain specific style tilts, enhance the performance of the MinVar portfolio As a side effect, the style factor exposures that are generated from minimum variance portfolio construction provide useful input for factor switching strategies, at least in the case of Value and Price Momentum The results are quite robust for different style tilts which suggests that many existing strategies could use minimum variance as a performance enhancing overlay Initial results appear generally consistent for global portfolios