For professional investors - March 2014

Insights
BNPP IPs newsletter for institutional investors

Food for thought 2014

W
elcome to the third edition of Insights, BNP Paribas Investment Partners
newsletter for the institutional investors. The focus of this quarterly newsletter
is to share with you our views on relevant market trends, update you on our
Thought Leadership key investment capabilities and bring you ideas and insights from the investment teams,
Inter-temporal risk parity 2 strategists and researchers at BNP Paribas Investment Partners.

Capability insights This quarters Thought Leadership piece summarises a forthcoming white paper titled
European equities are back on track Inter-temporal risk parity: A constant volatility framework for equities and other asset
and their outlook remains positive 6 classes`. The paper, produced by our Thought Leadership Group, highlights the importance
Senior secured loans: an attractive of risk management in asset allocation portfolios. The fact that volatility is not constant
addition to fixed income portfolios 11
over time and tends to show volatility clustering is of great importance; investors should
think in terms of risk budget allocation. Inter-temporal risk parity strategies dynamically
Experts View adapt the asset class weights so as to target a desired risk budget quite successfully, and
The revolution of smart beta can show better risk-adjusted returns.
& factor investing 15 In our Capability Insights, Daniel Hemmant, Senior Portfolio Manager in our European equity
team, explains the main factors that have contributed to the strong rally for European equity
Key capabilities since the summer of 2012. He also explains why he believes that from now on good future
Quarterly reports 22 absolute and relative performance will be driven by focusing on the companies themselves
and their ability to deliver earnings.
Our second Capability Insights looks at the investment case for bank loans. Heather Knox,
Credit Analyst in our global loans team, presents the key characteristics of the asset class,
BNPP IP is the source for all data in this the differences between the US and Europe, our outlook for 2014 and why bank loans make
document as at end of December 2013, a strong addition to a traditional fixed income portfolio.
unless otherwise specified For our Experts view we hosted a roundtable discussion in our Amsterdam offices on the
subject of smart beta and factor investing. On 23 January we invited a select number of
high profile institutional investors and an investment consultant to discuss their views and
thoughts on smart beta with our key investment professionals; Raul Leote de Carvalho and
Etienne Vincent. Participants had a dynamic discussion on the topic exchanging opinions,
sharing experiences and individual findings in a very transparent and direct way.

We hope this edition is interesting and relevant to you, please do contact your local
relationship manager with any questions or feedback.

Written on 28 February 2014

INSIGHTS #003 - March 2014 I 2 I

Thought Leadership

Inter-temporal risk parity:

Inter-temporal A constant volatility framework for
risk parity is a
systematic strategy
equities and other asset classes1
that invests in
In a world where asset returns follow a normal distribution pattern, the
both a risky asset
volatility of those returns is constant over time. Hence, in such a world,
and the risk-free
allocating weights to assets in a portfolio is equivalent to determining a
asset, rebalancing
risk budget; they are two sides of the same coin. However, the real world
the portfolio in
is more complex. The returns of financial assets do not follow normal
such way that the
distributions and volatility is not directly observable. In this summary of
portfolio risk is kept
our most recent white paper, Romain Perchet of the Financial Engineering
at a constant pre-
team explains why this is, and how targeting a constant risk budget over
defined target level.
time improves the risk-return trade off in a number of key asset classes.

T
here is evidence that managing equities to target constant volatility adds value
compared to buy-and-hold strategies. Managing equities to target constant volatility
means buying more equities when volatility is low and selling equities and investing
in cash when volatility is high, in such a way that portfolio volatility remains constant; in
other words, targeting inter-temporal risk parity.

Inter-temporal risk parity is a systematic strategy that invests in both a risky asset and
the risk-free asset, rebalancing the portfolio in such way that the portfolio risk is kept at
a constant pre-defined target level. The weight of the risky asset in the portfolio is always
positive and can be leveraged if necessary. The weight of the risk-free asset can be positive
or negative, depending on whether the risky asset must be deleveraged or leveraged so as to
attain the constant target risk. To explain the benefit of this strategy, we used Monte Carlo
simulations based on a number of time-series parametric models from different volatility
models, which allowed us to model a number of effects.

In our first simulation, we simply demonstrated that in a world where the returns of risky
assets are normally distributed and the volatility is constant over time, the application of
the strategy using a rolling historical standard deviation of returns as a model for volatility
neither adds nor destroys value. It simply generates a higher average exposure to the risky
assets, which explains the higher excess return and greater volatility of the strategy. But
the final Sharpe ratio of the strategy is, in the end, comparable to that of a buy-and-hold
strategy.

The fact that the volatility of financial asset returns tends to show positive auto-correlation
over several days is known as volatility clustering, meaning that high-volatility events tend
to cluster over time. When volatility clustering is introduced in the time series of risky asset
returns, we find in simulations that the inter-temporal risk parity strategy delivers a higher
Sharpe ratio than a buy-and-hold strategy does. The volatility clustering effect is in essence
a market timing effect. If the volatility changes over time and returns remain constant, then
the Sharpe ratio is higher in lower volatility regimes. Increasing the weight of the risky assets
in such periods will result in better risk-adjusted performances.

1 The full white paper, by Romain Perchet, Raul Leote de Carvalho, Thomas Heckel and Pierre Moulin, is available for
For professional investors download from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2384583
 INSIGHTS #003 - March 2014 I 3 I
Romain Perchet Raul Leote de Carvalho
Quantitative Analyst, Head of Quantitative Research
Financial Engineering and Investment Solutions,
BNPP IP Financial Engineering BNPP IP

The inter-temporal
risk parity strategy
The inter-temporal risk parity strategy can add even more value when the returns of the can add even more
risky assets not only show volatility clustering but also include fat tails. Then, not only do
we find a larger improvement in the Sharpe ratio, we also see a clear reduction in the largest value when the
drawdowns. Compared to buy-andhold, we find higher returns and lower volatility. The
strategy requires leveraging the risky asset in low volatility regimes but still achieves lower returns of the risky
volatility than a buy-and-hold strategy.
assets not only show
Improvement of Sharpe ratio according to clustering effects & fat tails effects
Improvement in Improvement in volatility clustering
Sharpe ratio Sharpe ratio
0.45% 0.160%
but also include
0.40% 0.150%
0.35% 0.140% fat tails.
0.30% 0.130%
0.25% 0.120%
0.20% 0.110%
0.15% 0.100%
0.10% 0.090%
0.05% 0.080%
0.00% 0.070%
56% 48% 40% 32% 24% 16% 8% 0% 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Clustering impact ()

Impact of the clustering effect and fat tails in the Sharpe ratio of an inter-temporal risk parity strategy. Left chart:
clustering impact changes from 60% (high effect) to 2% (small effect). Right chart: fat tails events changes from 3
(frequent fat tails events) to 30 (low frequency of fat tails events). The clustering impact, at 7%, is in line with historical
estimates for the S&P 500. In both charts, the target risk budget is chosen so as to target 18.8% of volatility for the risky
assets, the target Sharpe ratio = 0.40 and 500 Monte Carlo simulations of 2 600 daily returns were used.
Source: BNP Paribas Investment Partners, January 2014

If returns are not constant over time but instead we observe a negative correlation between
volatility and returns, then an even stronger improvement in the Sharpe ratio should be
expected when compared to a buy-and-hold strategy. For equities and for high yield bonds,
this is typically the case.

We also looked at the impact of the rebalancing frequency. The results of the simulations
at different frequencies show that if the frequency of rebalancing is decreased then the
improvement in the Sharpe ratio becomes less significant. But the results for equities change
little if the frequency is reduced from daily to weekly. This is important because it means
that the turnover of the strategy can actually be largely reduced in practical applications.

Perfect volatility smoothing would require perfect volatility foresight, which is impossible as
volatility is not even observable. The most popular approach to forecasting volatility is to
use time-series models. One reason is because these models only require easily accessible
historical information. To use such models, we must first define the features required when
modelling volatility and then put these into an actual financial distribution. If successful, it
is reasonable to expect that the final model should be successful at forecasting volatility.
The key expected features are volatility clustering and volatility asymmetry. We focused our
attention on four such models in the family of GARCH2 models.

2 Generalised Autoregressive Conditional Heteroskedasticity

For professional investors
INSIGHTS #003 - March 2014 I 4 I

Thought Leadership

We performed simulations to assess which of the four chosen GARCH models generates the
superior volatility forecast when applied to the S&P 500. To assess this, we looked at the ex-
post volatility of the inter-temporal risk parity strategy using daily data within a one-year
rolling window and checked which of these models produces the best control of volatility
ex-post. In the historical back-test, the I-GARCH model clearly demonstrates superior control
of the volatility of the portfolio. The one-year rolling ex-post volatility deviates less from the
target volatility of 10% when the I-GARCH model is used. With other models, the ex-post
volatility falls well below the target between 1991 and 1996 and again between 2003 and
2008. This fall in volatility is mainly due to the long-term volatility parameter, which is the
most difficult to estimate.

I-GARCH best model to target volatility over time

Ex-post rolling
volatility
12.0%

11.5%
I-GARCH
11.0%

10.5%

10.0%

9.5%
NA-GARCH
9.0%
GARCH
8.5%

8.0%

7.5%
GJR-GARCH
7.0%
Jan.91 Jan.93 Jan.95 Jan.97 Jan.99 Jan.01 Jan.03 Jan.05 Jan.07 Jan.09 Jan.11

Comparison of the one-year rolling ex-post volatility of an inter-temporal risk parity strategy applied to the S&P
500. The target volatility is 10% and the forecast volatility is based on four different GARCH models, with parameters
estimated from an expanding window once every year at the start of each year.
Source: Bloomberg, BNP Paribas Investment Partners, January 2014

We also looked at the performance of the strategy over this historical period. When compared
to buying and holding the S&P 500, the inter-temporal risk parity strategy improves the
Sharpe ratio and reduces the maximum drawdown, irrespective of the GARCH model used.
We can say that the S&P 500 shows volatility clustering and we observed some short-term
serial correlation in the returns.

Buy and
Inter-temporal Risk Parity
Hold
S&P 500 GARCH NA-GARCH I-GARCH GJR-GARCH

Average annulalised excess

7.1% 4.5% 4.1% 5.0% 4.2%
return

Average annualised volatility 18.9% 9.9% 9.9% 10.4% 9.7%

Sharpe ratio 0.38 0.45 0.41 0.48 0.43

Maximum drawdown (MDD) -55.3% -30.3% -30.0% -28.6% -30.3%

Average exposure 100.0% 68.2% 69.3% 74.1% 68.2%

Improvement in Sharpe ratio 0.08 0.04 0.11 0.06

Comparison of a buy-and-hold strategy for the S&P 500 with inter-temporal risk parity strategies, with target volatility
at 10% and using forecast volatility from four different GARCH models. The GARCH model parameters are estimated
from an expanding window once every year at the start of each year.
Source: Bloomberg, BNP Paribas Investment Partners, January 2014

2 Generalised Autoregressive Conditional Heteroskedasticity

For professional investors
 INSIGHTS #003 - March 2014 I 5 I

We recommend the use of I-GARCH models in practical implementations of the strategy.

This model for volatility shows the strongest predictive power and manages to keep ex-post Inter-temporal
volatility reasonably close to target. The improvement in the Sharpe ratio and reduction in
drawdowns when compared to buy-and-hold strategies was better than that found using risk parity
other GARCH models.
strategies
Finally, we looked at the application of the inter-temporal risk parity strategy to other equity
indices and asset classes. Assets with stronger volatility clustering and fat tails, e.g. high dynamically adapt
yield bonds, show the most significant improvements, as expected. These effects are also
significant for equities but less so for commodities. For investment-grade corporate bonds the asset class
and government bonds, volatility clustering has not been strong enough in the last 20 years
to generate any significant or visible effects. weights so as to

Russell MSCI S&P GSCI US High US Investment US 10Y target a desired
1000 Emerging Commodity Yield Grade Bonds Government
Markets Bonds Bonds
risk budget quite
Buy and hold strategy
Average annualised excess return 8.0% 6.7% 2.3% 4.8% 3.7% 3.2% successfully, and
Average annualised volatility 19.0% 19.2% 21.6% 4.4% 5.1% 8.0%
Sharpe ratio 0.42 0.35 0.11 1.09 0.73 0.40
can show better
Maximum drawdown (MDD) -55.8% -65.2% -73.4% -29.1% -16.7% -14.1%
risk-adjusted
Ratio MDD / volatility -2.9 -3.4 -3.4 -6.6 -3.3 -1.8
Average exposure 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% returns.
I-GARCH Inter-temporal risk parity strategy
Average annualised excess return 2.9% 3.0% 0.8% 8.5% 3.9% 2.1%
Average annualized volatility 5.2% 5.4% 5.2% 5.5% 5.1% 5.2%
Sharpe ratio 0.56 0.56 0.15 1.55 0.76 0.40
Maximum drawdown (MDD) -10.4% -19.1% -16.7% -28.5% -11.2% -10.2%
Ratio MDD / volatility -2.0 -3.5 -3.2 -5.2 -2.2 -2.0
Average exposure 36.8% 36.5% 28.9% 181.3% 108.9% 70.0%
Turnover 1.3 3.8 2.5 9.2 3.7 2.4
Improvement in Sharpe ratio 0.14 0.21 0.05 0.45 0.04 0.00
Student test 0.66 0.98 0.24 2.12 0.15 0.07

Comparison of a buy-and-hold strategy for different asset classes with an inter-temporal risk parity strategy, with
target volatility at 5% and using forecast volatility from I-GARCH models. The GARCH model parameters are estimated
from an expanding window once every year at the start of each year.
Source: Bloomberg, BNP Paribas Investment Partners, January 2014

This paper highlights the importance of risk management in asset allocation portfolios. The
fact that volatility is not constant over time and tends to show volatility clustering, which
makes it easier to forecast, is of great importance. Investors should think in terms of risk
budget allocation rather than fixed weights. Inter-temporal risk parity strategies dynamically
adapt the asset class weights so as to target a desired risk budget quite successfully, and
can show better risk-adjusted returns. Moreover, since risky asset classes also show fat tails,
inter-temporal risk parity strategies can smooth their impact and reduce drawdowns relative
to buy-and-hold strategies that rebalance. The fact that, in some asset classes, returns
are on average lower in periods of higher volatility brings additional benefits, improving
further the Sharpe ratio for those asset classes when targeting a constant risk. For less risky
asset classes such as government bonds, the strategy shows little added value other than
keeping the risk budget constant. But that may be a consequence of the period used in our
simulations, which was extremely benign for government bonds.

Written 3 February 2014

For professional investors

INSIGHTS #003 - March 2014 I 6 I

Capability Insight

European equities are back on

track and their outlook remains
positive
European equities experienced strong returns in 2013, with the MSCI
Europe NR index up by 19.82%1. In this Capability Insight we talk about
how European equity markets have bounced back since the summer of
2012 on the back of market sentiment. We also explain why we believe
that from now on, good future absolute and relative performance will
be driven by focusing on the companies themselves and their ability to
deliver earnings growth.

European equities are back on track

European equities have regained their attractiveness to investors. They have enjoyed a major
rally, gaining 19.82%1 in calendar 2013 and more than 31%1 over the last 18 months (see
exhibit 1 below).

Exhibit 1: The MSCI Europe index has rallied strongly since the speech by Mario Draghi on
26 July 2012. Valuation of MSCI Europe for the period from June 2011 to January 2014
3300

3100

2900

2700

2500

2300

2100
On July 26 2012 Mario Draghi makes speech
saying the ECB is ready to do whatever it takes
1900
to preserve the euro
1700

1500
Jun.11 Sep.11 Dec.11 Mar.12 Jun.12 Sep.12 Dec.12 Mar.13 Jun.13 Sep.13 Dec.13

Source: Bloomberg, BNP Paribas Investment Partners, February 2014

After all the doom and gloom about the eurozone, European equities have been a much
neglected asset class. In the summer of 2012, Europe was at the height of the euro sovereign
debt crisis. By the second half of 2012, there was talk of Europe being doomed; it was at risk
of becoming the new Japan, beyond rescue from its structural decline. Nonetheless, European
equities have had a fantastic turnaround over the past 18 months.

Impact of the euro crisis

The euro crisis was very damaging for the asset class. It completely obscured the intrinsic
merits of European equities. Investors lost sight of the fact that European companies, or
more precisely companies that happen to be listed in Europe, do not necessarily depend
solely on the health of the European economy to make profits. Certainly, some sectors are

1 The performance of the MSCI Europe index, with dividends reinvested in the index, was +19.82% for the period 01/01/13
For professional investors to 31/12/13. The performance of this index for the period from 26/07/12 to 31/12/13 was +31.2% on a dividends-
reinvested-in-the-index basis Source all data: Bloomberg.
 INSIGHTS #003 - March 2014 I 7 I

Daniel Hemmant
Senior Portfolio Manager,
European Equities BNPP IP

highly domestic in nature. Think about utilities, telecoms, banks. But most listed European
companies are multinationals, true world players that are generally much more diversified
internationally than Japanese or US companies, in sectors such as health care, personal and
household goods and beverages, but also chemical and capital goods.

Renewed focus on healing the economy Most listed European

There may be much disenchantment about what politics can achieve, but in some countries
weve seen forceful action to improve the structure of local economies. For example, the companies are
Spanish government has been working hard to make the labour market more flexible.
Furthermore, the countries with big structural problems have had no choice but to work multinationals, true
them out. Despite all the political uncertainties related to the fact that most of these
remedial measures are by their nature very unpopular, these governments really have been world players that
progressing on making their economies more competitive. Thus, Portugal and Spain are
regaining competiveness at the expense of northern Europe. are generally much
What we are now seeing is a general decline in political risk, such as the relatively limited more diversified
impact of last Septembers political crisis in Italy. Financial markets have shrugged off all
these shenanigans. Theyre more focused on the healing of the economy and improving internationally than
conditions so that companies can thrive and re-establish profitability. That is, at the end of
the day, what matters. Japanese or US
So far we have been facing a profitless recovery companies.
The rally in the European equity market over the last 18 months is often called a jobless
recovery, but the reality is that this has been a profitless recovery. Indeed, as exhibit 2
demonstrates, earnings have actually been falling over the past three years.

Exhibit 2: Change in consensuses growth projections during the last 3 years

15%

12%

9%
2013 2011 EPS Growth, %
6%
2012
3%

0%

-3%

-6%
Jan. Fev. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec.

Source: IBES, Facset, January 2014

Why the current enthusiasm for European equities?

In part this reflects the fact that the market looked cheap relative to history and, given the
relative valuations of many other financial assets, at some point the market was likely to
be re-rated. This is especially the case when you consider how international the market
is. Around 54% of the revenues of the MSCI Europe come from outside Europe and almost
two-thirds of this come from emerging markets. So to the extent to which the market was
trading cheaply due to concerns about the euro or the European growth outlook, such fears
were misplaced.

For professional investors

INSIGHTS #003 - February 2014 I 8 I
Both the market's
margins and return on
equity are currently
around their historical
cyclical lows.
For professional investors
Capability Insight
This was particularly the case for sectors such as IT, food & beverages and health care, which
derive the vast majority of their revenues from outside Europe (see exhibit 3 below).
Exhibit 3: European sector revenues derived from developed Europe
100
90
80
70
Proportion of Revenues from Europe
60
50
40
30
20
10
0
Real Estate
Utilities
Retailing
Consumer Services
Food Retail
Telecommunications
Banks
Transportation
Insurance
Media
Software & Services
Commercial & Prof. Services
Diversified Financials
HealthCare Equip. & Services
Household & Personal Prods.
Capital Goods
Automobiles & Components
Materials
Pharmaceuticals
Consumer Durables & Apparel
Food Bev & Tobacco
Semiconductors & Equip.
Technology Hardware & equip.
Energy
Source: Morgan Stanley, BNPP IP, July 2013
Looking ahead, sustainable gains only can be achieved via earnings growth
With the current market multiple based on 12-month forward earnings more or less in line
with history, the question is where do we go next? Given the extent to which the European
market has re-rated in the absence of earnings growth, and looking at the performance of
other financial markets, not least the bond market, it is hard to escape the conclusion that
the massive expansion of central bank balance sheets has resulted in a liquidity-driven
market. So while it is entirely possible that the European equity market trades higher from
here, for such gains to be sustained, we need to see earnings growth.
The case made for seeing the market as cheap is usually based on a Shiller Price/Earnings
(P/E) ratio which is calculated using ten-year average earnings. Since the conventional
forward P/E is in line with history, what this is telling you is that the current level of earnings
is below average and that the market will appear cheap in the event that they recover.
It is indeed the case that both the markets margins and Return on Equity are currently
around their historical cyclical lows. If you look at the earnings performance of the market,
this should come as no surprise when you consider how far earnings have fallen since a
peak in 2008.
Indeed, as exhibit 4 illustrates, only three sectors have seen earnings growth over the last six
years consumer staples, health care and consumer discretionary (primarily automobiles).
All have been greatly helped by their exposure to emerging markets, but sentiment has
recently swung through one hundred-and-eighty degrees as a combination of slowing growth
and tumbling exchange rates has reversed market optimism.
 INSIGHTS #003 - March 2014 I 9 I

Exhibit 4: Sector EPS MSCI Europe trailing 12m

140

120

100
Cons S taples
Cons D iscr
Health Care
80 Telcos
Industrials
60 Energy
Utilities
Materials
40 IT
Financials
20
We look for
companies that can
0,0
2008 2009 2010 2011 2012 2013

Source: BNPP IP, Bloomberg, January 2014 consistently deliver

Are current earnings growth expectations sustainable? strong returns
At the same time, the market has become much more upbeat about a European recovery,
but as the earlier chart of earnings estimates shows, the experience of the last three years and the key is to
suggests that current expectations of 12.5% earnings growth in 2014 are unlikely to be
sustained throughout the year. understand how
So given the choice between the parts of the market that have actually been able to deliver these are generated
some growth but where the outlook is a lot murkier than it was, or alternatively the parts
of the market that have flattered to deceive on numerous occasions and where optimism is and why they are
now relatively high, where should you look for returns?
sustainable.
Dual focus on both defensive growth and undervalued stocks
Our view is that you need a bit of both. There is definitely a place for defensive growth stocks
that can continue to grow earnings largely independent of the cycle. At the same time, if you
want exposure to European equities because you believe the market is relatively cheap, you
must have exposure to those areas where returns are currently depressed.

Industry sector is the key determination factor

In either event, the starting point should be companies that are not reliant on a highly
favourable economic environment to generate attractive returns and, for us, the key
determinant of this is industry structure. As investors we look for companies that can
consistently deliver strong returns and the key is to understand how these are generated and
why they are sustainable. While there are potentially a variety of answers to this question,
the one we focus on is pricing power, which is typically a function of an oligopolistic market,
on the basis that it is the nature of the industry that is the key determinant of a companys
profitability. So whether we are looking for companies with a good track record of growth or
those where returns are currently depressed due to the cycle, the starting point is always
whether the industry they operate in is concentrated and whether this consolidation is
increasing. By contrast, we actively avoid fragmented or fragmenting industries.

In practice this has meant supplementing our innate preference for quality growth
companies with companies operating in well-structured industries where returns are low.
A quick look at the chart of earnings by sector highlights the financials sector and this does
present good opportunities, especially in retail banking. In particular we like markets where
provisioning levels are high due to aggressive lending prior to the financial crisis and where
we have subsequently seen substantial consolidation. In this respect, Spain and the UK stand out.

Returns are also very low in materials and we have been increasing exposure to construction,
especially non-residential. As exhibit 5 shows, the current level of spending is extremely
low, yet while there was undoubtedly a boom, it was not exceptional when put in a historical
context.

For professional investors

INSIGHTS #003 - March 2014 I 10 I

Capability Insight

Exhibit 5: Eurozone non-residential fixedinvestment as % of GDP

17%

16%
Eurozone non-residential fixed investment % of GDP

15%
average

14%

13%

12%
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Source: JP Morgan, Eurostat, January 2014

Company focus and earnings growth can lead to good absolute and relative performances
Over the past twelve months we have been very much in a macro market where the upward
path of European equities has been characterised by swings in sentiment, but little in the way
of earnings growth. Having gone through phases of enthusiasm for both the international and
domestic aspects of the market, its time to focus once more on the companies themselves
and their ability to deliver earnings growth. We expect this to become once again the primary
determinant of both absolute and relative performance.

Its time to focus

once more on the
companies themselves
and their ability to
deliver earnings
growth.

For professional investors

 INSIGHTS #003 - March 2014 I 11 I

Capability Insight

Senior secured loans: an attractive As of 19 February

2014, loan funds
addition to fixed income portfolios have experienced
88 consecutive
Senior secured leveraged loans have received a lot of attention lately
weeks of inflows.
due to the record inflows into loan mutual funds, the creation of
loan exchange-traded funds (ETFs) and the resurgent collateralised
loan obligation (CLO) market. As of 19 February 2014, loan funds
have experienced 88 consecutive weeks of inflows1. What are senior
secured leveraged loans and why are they an attractive asset class?

The corporate loan universe is broad and includes loans for a variety of purposes including
general corporate purposes, infrastructure, construction, or real estate purchases and
issued by a variety of companies. Different loans have different features they may be
secured or unsecured, revolving or term loans, have amortising or bullet repayment
structures, be guaranteed by government agency, or backed by real estate. This article
will focus on one of the most liquid segments: the broadly syndicated senior secured
leveraged loan market.

Senior secured leveraged loans are debt obligations of companies that have a corporate
rating below Baa3/BBB- and which rank in claim above unsecured high-yield bonds,
mezzanine debt and equity. Senior refers to this superior position in the capital structure,
which allows for repayment before other claimants in the event of bankruptcy. Secured
indicates that companies have pledged assets against the loan, which enhances recovery
in the event of default. Leveraged refers to high, but sustainable, levels of debt, resulting
in below investment-grade ratings.

Highest ranking in the capital structure of a corporate

+ Senior Secured Loans Top seniority

Secured by assets
Floating rate
Reimbursable
Seniority

Bonds/Subordinated Debt Subordinated

Unsecured
Fixed rate (bonds)
Reimbursable

Lowest seniority
Public/Private Equity Unsecured
No fixed income stream
Non reimbursable

- Strong recoveries in case of default (around 70% for loans

vs approximately 40% for bonds)
For professional investors
1 Source: S & P LCD
INSIGHTS #003 - March 2014 I 12 I

Capability Insight

Leveraged loan market evolution and characteristics

The European market
still has a conspicuous
The US leveraged loan market did not become an institutional market until the late 1980s.
Before then, banks were the typical providers of large, often syndicated, corporate loans. In
the late 1980s, mutual funds became involved, followed by other institutional investors. The
European market still has a conspicuous bank presence, but disintermediation and regulatory
changes are leading to a more prominent role for institutional investors.

bank presence, but
disintermediation and
regulatory changes
are leading to a more
prominent role for
institutional investors.
Leveraged loans are floating-rate instruments: the coupon consists of LIBOR (EURIBOR for
European loans) plus a margin, paid quarterly. The margin is set at the time of issuance and
represents compensation for the credit risk of the issuer. The margin does not vary during
the life of the loan. In the US, a minimum level of LIBOR, known as a floor, is often used
instead of the current historically low LIBOR rate. The floor is in effect until LIBOR exceeds this
minimum level, after which LIBOR is reset every three months at the then prevailing market
rate. Most institutional loans have maturities of five to seven years, with 1% amortisation of
the principal per year and the remainder upon maturity.
Covenants are another feature of leveraged loans. Although maintenance covenants are becoming
less common in the US, incurrence covenants remain standard. These limit an issuers ability to
issue more debt, thereby protecting existing creditors. Maintenance covenants proscribe specific
limits which must be measured quarterly such as a maximum leverage ratio (debt relative to
profitability) and/or a minimum interest coverage ratio (profitability versus interest expense).
Although maintenance covenants may provide investors with comfort, empirical evidence in the
US shows there is no difference in performance between loans with maintenance covenants and
those without (cov-lite loans). About 60% of new loans in the US is cov-lite. Full covenant
packages remain far more common in the European market.

As said, companies issue loans for a variety of reasons. The proceeds may be used to expand
operations, buy other entities, replace previously issued bonds or pay dividends. Private
equity companies frequently include leveraged loans as part of the financing package when
they buy companies for their funds. Companies in every sector of the economy issue loans,
including energy, industrials, services and health care.

A compelling case for loans

Leveraged loans can benefit fixed income portfolios in many ways. They provide diversification
and exposure to issuers who do not participate in the high-yield bond market. Loans can
add a floating-rate component to a portfolio, which can reduce interest-rate risk. As senior
secured instruments, loans typically have lower default and higher recovery rates, enhancing
capital preservation, even in adverse economic conditions. Lower exposure to interest-rate
risk and a higher position in the capital structure have contributed to the lower volatility
of loan returns over time, as measured by the standard deviation of monthly returns. This
stability of returns should be especially attractive in the context of the US Federal Reserve
reducing quantitative easing, which may cause market uncertainty.

Standard deviation of monthly returns: S&P/LSTA leveraged loans index vs. other asset
classesJ - Jan 1997 Dec 2013
5.0% 4.6%

4.0%
2.8% 2.7%
3.0%
2.2% 2.2% 2.2%
1.8% 1.9%
2.0%
1.6% 1.6%

1.0%

0.0%
x

)
A0

PX

A1

A2
10
de

de

de
de

0A

(J0
0

(J0
A

(S
In

In

In

In

(C
(H

(G
an
A

an

an

ds

B
P
ST

50
S
D

R
Lo

Lo

L
Lo

EA

n
EL

M
CO
/L

Bo
P
TR
YI
rf.
BB

B
P

&
S&

BB
Pe

GH

YR

AD
S

L
10
HI

GR

M
L

HI
M

L
M

Source: S& P Capital IQ, December 2013

For professional investors

 INSIGHTS #003 - March 2014 I 13 I

Heather Knox
Credit Analyst
Global Loans BNPP IP

New issuance in the leveraged loan market totalled USD 144 billion in Q4 2013, with USD 127
billion coming from the US. As of December 31, 2013, there was USD 1,336 billion outstanding
in the US leveraged loan market, which compares with USD 1,326 billion outstanding in the
high-yield bond market. Comparable figures for Europe are EUR 372 billion and EUR 369
billion, respectively.3 It is fair to say that the broadly syndicated leveraged loan market can
generally be considered to be as liquid as the high-yield bond market, particularly for high-
volume issuers.

Given the size and scale of the loan market in both the US and Europe, it can be advantageous
for investors to have access to both regions. The US market tends to be larger and more
liquid, but the European market frequently offers higher yields, partially due to the smaller
investor base. Although some issuers do issue cross-border deals, many issuers issue only in Best-in-class asset
their own market, therefore a manager who is present in both the US and Europe can have
access to a broader pool of issuers. selection is based
Loans and high-yield bonds constitute different parts of the capital structure, but can be on dedicated credit
looked upon as complementary products. Since bonds and loans trade in different markets,
it may be possible to assign relative value to two instruments from the same issuer. Given analysis, taking
the relative seniority of leveraged loans, one can express a credit view by investing in loans
instead of bonds. Additionally, there are diversification benefits from participating in both into account the
asset classes since there is a roughly only 50% overlap between the high-yield bond and loan
universes, so each asset class will contain unique issuers. macroeconomic
Currently the US loan market has favourable fundamentals and technicals. Technical factors environment as well
include significant demand from mutual funds, ETFs and CLOs. The market also benefits from
a surplus of funds seeking returns in the wake of the global easing of monetary policy. While as the specific credit
demand has driven prices up and yields down, returns are still attractive in our view. As of
December 2013, the average yield of loans rated B+ or B was 4.5%4 in the primary market, profile of a given
offering a pick-up versus many other fixed income asset classes. The positive fundamental
factors include moderate leverage, increased cash balances, lower interest costs, reduced issuer.
commodity and labour expenses and better cost discipline at companies. These factors can
help to offset weak consumer demand due to a modest recovery in the US economy.

The CLO market is an important source of demand for leveraged loans. CLOs are structured
vehicles which issue liability tranches, differentiated by risk and return, against a pool of
loans selected by a manager, who has a limited ability to trade. During the financial crisis,
CLO tranches dropped in price, in concert with other asset backed securities such as subprime
RMBS (Residential Mortgage Backed Securities), but have since recovered as fundamental
performance has prevailed. The CLO asset class has made a comeback in the US, with USD
56 billion in issuance in 2012 and USD 87 billion in 2013. The European CLO market is just
starting to return and this trend is expected to continue in 2014.

CLOs account for about 45% of leveraged loan demand and the specific requirements of CLOs
have helped shape the leverage loan market. CLOs are required to have a diverse portfolio
of loans across issuers and industries which create a very receptive audience for first time
issuers. CLOs are not meant as trading vehicles (there is a limited ability to do so) nor are
the loans in the portfolio marked to market, which helps avoid panic selling in the face of
adverse conditions.

Leveraged loans are below investment-grade instruments and hence do involve an element
of risk. The default outlook in the US for speculative-grade issuers is currently benign, at
1%-4% (2%-4% for the European market) over the next 12 months5. Although loans do offer
superior recoveries in the event of default due to their senior position in the capital structure,
asset selection is important, as the goal is to avoid defaults in the first place. Best-in-class
asset selection is based on dedicated credit analysis, taking into account the macroeconomic
environment as well as the specific credit profile of a given issuer.

3 Source: Credit Suisse.

4 Source: S & P LCD For professional investors
5 Source: Credit Suisse
INSIGHTS #003 - March 2014 I 14 I

Capability Insight

As mentioned, leveraged loans are floating-rate instruments. This feature allows for
Leveraged loans protection against inflation in a rising rate environment. Given that the LIBOR base adjusts
every three months, coupons adjust quickly to changes in rates, which can help price stability.
provide access to
2014 outlook and conclusions
a broad variety For 2014, leveraged issuance in the US is expected to be strong. Moodys is predicting USD
600 billion in issuance across all leveraged loan types, up 3% on 2013. However, demand
of issuers in a should be strong as the CLO pipeline is still robust and regulatory uncertainty was resolved in
2013. Leverage loan retail mutual funds currently have USD 154 billion6 under management,
liquid market at an providing another source of demand. While demand can continue to pressure yields, loans
should still provide investors with attractive total returns.
appealing yield.
Leveraged loans provide access to a broad variety of issuers in a liquid market at an appealing
yield. They can offer stable cash flows due to their floating-rate nature as well as their senior
position in the capital structure. These characteristics can make them an attractive addition
to any fixed income portfolio.

6 Source: Citibank
For professional investors
 INSIGHTS #003 - March 2014 I 15 I

Experts View

The revolution of smart beta

& factor investing
On 23 January, BNP Paribas Investment Partners hosted a roundtable
discussion at its Amsterdam offices on the subject of smart beta
and factor investing. We invited a select number of high-profile
institutional investors and an investment consultant to discuss
their views and thoughts on smart beta with our key investment
professionals Raul Leote de Carvalho and Etienne Vincent.
Participants:

Etienne Vincent, BNPP IP

THEAM, head of systematic
portfolio management

Raul Leote de Carvalho,

BNPP IP, head of quantitative
research and investment
solutions

Ramon Tol, Blue Sky Group,

fund manager equities

Karin Roeloffs, Mercer

Investments Benelux,
business leader

Olivier Rousseau, French

Pension Reserve Fund (FRR),
executive director

Raul Leote de Carvalho: On the research side at BNP Paribas, we have been working on Rogier Van Harten, BNPP IP,
smart beta and factor investing for a number of years. We published a paper in the Journal head of institutional sales
of Portfolio Management in the spring of 2012, where we found quite a strong link between Netherlands
a number of smart beta approaches, showing that indeed drivers of risk and performance
seem to be factors which are known to investors from a number of academic papers which Mark Voermans, PGGM,
have been published throughout years. We highlighted that we liked smart beta, but we senior investment strategist
also identified issues which we liked less. Namely the fact that sometimes in smart beta
approaches, which use explicit formulas, you can have unnecessary hidden complexity and Alex Neve, Univest,
the fact that the risk exposures that drive the performance of smart beta are usually not director of equities
properly controlled.

In 2014, we will publish a paper in the Journal of Asset Management, which is really focused
on factor investing and shows investors how they can actually build long-only portfolios,
which do not need derivatives or any complex financial instruments, to implement exposures
to the factors they may want to have in their allocation. We also show in this paper how
investors can actually control for the risk of their factor exposures and build the portfolios
in a robust way.

For professional investors

INSIGHTS #003 - March 2014 I 16 I
Smart beta and risk
factor investing are
related
For professional investors
Experts View
We understand that it is not yet well known whether factor performance is coming from
gaining additional risk exposures or that we are talking just about anomalies. However, we
are seeing more and more evidence that the factor performance tends to be derived from
anomalies and mis-pricings.
We will also have a paper published in the Journal of Fixed Income soon discussing the
factor low risk and also highlighting that low risk global fixed income appears able to deliver
abnormally high excess returns, just like in equities.
Etienne Vincent: On the (fund) management side, we are trying to keep up with the research,
which is a tough job, because at the same time, we have the development of the low volatility
strategies. The flagship fund has reached USD 700 million now. We also launched a pure low
volatility fund last year and the emerging (market) version is switching to Parvest, which
is our flagship sicav, at the end of January. The emerging (market) version is raising quite a
lot of interest because it is more complex to access emerging equities than developed ones,
and therefore more interesting to have a pooled fund. The combination of emerging (market
equities) and low volatility is meeting a lot of interest.
We have funds that are running on the multi-factor process targeted in risk. These are rather
in incubation mode, but we do have some running. And to make the link with the fixed income
part, we are actually merging with the fixed income quantitative team.
What do you consider to be smart beta?
Ramon Tol: Smart beta and risk factor investing are often used interchangeably. Both are
broad concepts. Smart beta is often used in the context of the applied weighting scheme:
anything but a market-cap weighting scheme, whereas risk factor investing is much more
about what factor premia to look for. Low volatility is a risk factor as well. Broadening this
to include other risk factors is a natural extension to a low vol allocation. Smart beta and
risk factor investing are related. If you decide to go for risk factor investing, you have to
eventually decide what weighting scheme to apply. You can apply all kinds of weighting
schemes to a risk factor allocation such as minimum variance, equal risk contribution or
maximum diversification.
Mark Voermans: Smart beta is probably the general name for systematic strategies in the
equity world. We used to call it quantitative equity, which was alpha and active management.
After the crisis, we started calling it smart beta. I am more or less doing the same thing that
I used to do 10 years ago, but the name has changed.
Alex Neve: Smart beta in my view is anything but market-cap weighting.
Vincent: The definition of smart beta by James Montier actually was that smart beta equals
smart marketing plus dumb beta. It shows how difficult it is to define that. I tend to like the
idea that smart beta is a premium factor which does add a risk aspect. But it is not just any
risk. It is a strategic risk or long-term risk that should pay off in the end.
Tol: To some extent, it is a little bit enhanced indexing in disguise with the most important
difference being that most asset managers are now starting to admit it is beta they offer
instead of alpha. It will be interesting to see whether the fees will go down as well.
Vincent: What is really new in smart beta is accepting the fact that there is no strong link
at least to the market cap index. That is why it is clearer than enhanced indexing, because in
enhanced indexing you are not saying that a part of the problem is the market cap reference
that you are using at first. In many of the smart beta products, at least they start by explaining
where the problems of market cap are and then choosing another way of weighting.
Do we think it is pure quant management or judgmental overlays also?
Karin Roeloffs: We see pure quant managers, but also managers taking a quantitative
approach and adding qualitative or judgmental overlays. We do not have a strong preference
 INSIGHTS #003 - March 2014 I 17 I

Experts View

for either one of these categories. There is the issue though of predictability and for our clients
to get a grip on the approach including a judgmental overlay.

Leote de Carvalho: We have a number of managers that have been actually implementing
factors in their approaches with judgmental overlays. How to actually combine both approaches
offers a lot of challenges; this is also a very interesting research topic.

Vincent: We now see more and more top-down allocation processes that are rather
systematic, where the human part is one of the signals, whereas what we saw before was
usually quantitative help to a human manager who was overlooking the whole thing. The
problem is, if you have the human at the top, there is this layer of uncertainty about the
stability through time. So you might be in the end going against what were your original factors.
We know for instance that some styles are fairly prone to human adjustments because they
are essentially well understood by humans and so on. We know that low vol goes with low
glamour, low popularity.

Do you have an opinion on that?

Olivier Rousseau: Smart beta is all non-cap-weighted indexing. It is certainly a smarter

marketing name than alternative indexing, especially in countries such as France where
everything which starts with alternative or hedge is problematic. It is also some sort of new
quant. We at the FRR (Fonds de Rserve des Retraites) are more up-to-date than you Dutch
institutions in playing with smart beta. The first time we did so was in 2009 when we decided to The question is open:
go for RAFI fundamental indexing to give ourselves more beta in the expected market recovery,
which was a smart bet: it worked well. In the fall of 2011, we were extremely worried about the there is no unique
situation of the eurozone and the financial sector in particular. At the time, we had three smart
beta indexes: minimum volatility, EDHEC and RAFI. We put in place a min vol for North America way of looking at the
and Europe. But in our thought process, we have decided, well, the name is smart, but we are
not smart enough necessarily to pick the right times to take one index or another. Our perception factors.
is that in the alpha generation of the total performance of smart beta indexes, there is more
than just factor biases. And basically we believe there is the volatility harvesting premium to be
earned. For us, the traditional factor premia do not explain all of the performance of smart beta.
In our regressions, something is left. And frankly, we have different schools of thought about
smart beta among the powerful houses which have all the right PhD resources and so on and
so on. One of them in the US promotes something very easy to emulate: equal weight. And they
say: Well, dont bother. Do just that and you will harvest the volatility premium. You will sell
high and buy low. That is a radically different proposition to others.

Anybody want to respond?

Neve: Equal weighting is also a smart beta example and much easier to implement. A lot of
smart beta strategies that we see actually have quite a lot of exposure to the same factors. We
should be aware that most smart beta strategies have large exposure to low volatility, value
and small caps. The smartness is in how you implement it and time it. Small caps have done
very well since the low in early 2009 - you have to be aware of that.

Rousseau: In our reckoning, the small cap factor is by far the most powerful factor in the
returns of smart beta relative to the cap-weighted strategy.

Leote de Carvalho: In our paper published in 2012, we made the effort of having consistency
in the way we built the risk-based strategies and the factors. Making sure that they were
rebalanced on exactly the same day, that they were based on exactly the same universe and
that if we imposed things like factor neutrality in the factor construction this was also perfectly
in line with what we implemented on the smart beta side. And as soon as one of these elements
is not there for example if the rebalancing is not the same day or the universe is different
then factors explain less of the risk and returns of smart beta. There are many ways of building
smart beta. But also there is no universally accepted way of building the factors that we can say
is the best or the worst. The question is open: there is no unique way of looking at the factors.

For professional investors

INSIGHTS #003 - March 2014 I 18 I
We are now in
the next phase
and researching
whether to add
other factors to our
low volatility factor.
For professional investors
Experts View
Voermans: You need to be aware that if you use certain steps in portfolio construction, such
as weighting, turnover and frequency of rebalancing, you introduce other tilts. If you equally
weight, you get a small cap tilt, if you use a market-cap weighting you will probably get a
neutral or large cap tilt.
Vincent: We often debate whether factors are risk factors or premium factors. Of course
they are both, but according to what you want to do, it is important to make this distinction
because if you want to be looking for alpha it is important to have factors of alpha which you
can understand should be a source of alpha.
Tol: The name risk factor is probably a misnomer. Momentum for instance is rooted in
behavioural finance. There is huge debate about whether value can be labelled a risk factor.
Is quality a risk factor? So we ought to be very careful when using the term risk factor.
Perhaps a better name would be factor premium.
What is the strategic rationale of implementing factor premium investing?
Neve: We implemented a risk-based equity pool because actually a lot of our pension fund
clients are de-risking. Fixed income is probably riskier than people thought. Normally when
you de-risk, you would sell equities and buy bonds. We wanted to offer an alternative within
equities that gives a much lower risk profile, 25 to 30 percent lower than standard equities.
And we wanted that diversified. So we used low volatility, but we use also other strategies,
implementing different weighting schemes such as equal risk contribution and maximum
diversification.
Roeloffs: Some of our clients also participated in the general trend towards passive
management. And this led then to a desire to get some extra, cheap exposure to certain
factors. Also sometimes there is some disappointment with more fundamental strategies and
more active traditional investment styles. In general, it was triggered by a greater awareness
of risks within the portfolios.
Rousseau: If we are really worried about bonds and not comfortable increasing the equity
allocation, the main answer is to have more alternative assets and management processes
in our portfolios. Among the smart beta indexes at least, the min vol MSCI is the one that
will not protect us against rising interest rates. Probably the min var FTSE is better in that
sense. And certainly the max diversification like the EDHEC (index) has proved much more
resilient in the face of rising interest rates.
 INSIGHTS #003 - March 2014 I 19 I

Experts View

Neve: I agree, the MSCI min vol is not a great index. We definitely like the Russell defensive
better as an index, which is half low vol, half quality tilted. Thus, it is balanced and less
interest-rate sensitive.

Voermans: For a long-term investor, a pension fund, the main risk is not being able to meet
the liabilities. So the long-term risk is only the return. Minimum variance does deliver some
added value and indeed a nice risk reduction. If you could blend it with, for instance, what
Russell did, a quality tilt, you will end up having a bit more return which will give you the
right risk reduction in the long run.

Tol: What we actually meant to achieve is to reduce the absolute volatility of our equity
portfolio. So far, that has worked very well. We are now in the next phase and researching
whether to add other factors to our low volatility factor.

Neve: If, for instance, interest rates are normalising or even overshoot the normal levels, you
would be better off in, for instance, low vol equities versus high yield or credits. That is also
because of liquidity. These types of equity instruments offer better liquidity. For high yield
and credits, only the primary market is liquid, the secondary market is not.

Vincent: Did any of you use risk-based strategies to actually increase the share of equities
or risky assets?

Voermans: We use the risk reduction of our equity strategies to allocate more towards
alternatives such as infrastructure and real estate.
The next step will
Rousseau: Our governance is sensitive to the nominal proportion of the equity component in
the total assets. And we would probably have a hard time trying to convince them that we be to figure out
can increase the size of the equity component because the equity that we will have will be on
average low-risk. So for us, including lower risk equity components is very much equivalent whether risk factor
to discretionarily reducing the amount of equity that the supervisory board has allowed us to
have. So we have to think twice before we do that. That is the constraint we operate in. And tilts or factor tilts
that is one of the reasons why we are definitely engaging into a strategic approach to smart
beta and factor investing. We believe that by combining smart beta indexes, we can actually can be used in asset
very substantially reduce the biases as compared with the cap-weighted indexes or only
retaining those biases that we feel most comfortable with and still be left with a substantial allocation.
and reasonably robust alpha as a result.

How to manage the selection of managers in this wide range of offerings?

Roeloffs: The starting point is what is your goal and what do you already have and want to
maintain in your portfolio, because it is always a combination with other existing portfolios
that clients already have.

Would you like to say how you build your portfolio and why?

Tol: As mentioned, we already implemented a low volatility equity portfolio. We managed

to have a well-diversified line-up of low volatility managers. We are able to identify and
hire more aggressive alongside more defensive types of low volatility strategies, which gave
us better diversification benefits, but also the possibility to re-allocate between them if
appropriate. We are now investigating whether to expand our equity allocation to other
factors as well. In terms of active versus passive, we decided to go down the active route
since we struggled with available suitable benchmarks. At that time, we had doubts about
the MSCI minimum variance index. First of all, it is heavily constrained in terms of sector
or country exposures and even risk factor exposures. On top of that, the default setting for
the optimisation currency is USD which is relevant for a US-based investor, but less so for a
European one. This year, we will be reconsidering the benchmark issue.

For professional investors

INSIGHTS #003 - March 2014 I 20 I

Experts View

Voermans: We are not convinced that we can find anomalies or inefficiencies in the credit
space. The market is not open to the same inefficiencies that the equity world is.

Rousseau: We remain to be convinced about the very applicability of the smart indexing for
the fixed income space. And I would be maybe more prudent on commodities. But at any rate,
the size of the opportunity in the fixed income space has to be small relative to what it is in
the equity space.

Leote de Carvalho: We have some research looking at anomalies particularly in fixed income.
It is clearly a challenge to implement them because the fixed income world is certainly
different from the equity world in terms of the liquidity of investments, the way the market
works, and also the simple fact that the risk of a bond is constantly falling as it approaches
maturity. And one of the challenges on top of those is indeed to handle the fact that for this
to be implemented in a portfolio, it must be rebalanced very cleverly to reduce as much as
possible the number of transactions. Transactions eat away the risk premiums that we talked
about. Minimising them is key to gain access to these risk premiums. In the bond space, this
problem is even bigger. Trying to exploit just one factor in the fixed income market can thus
be difficult. Hence, any smart beta approaches should look immediately at a combination of
some of them.

Vincent: What I would tend to advise clients is to go for the more diversified and wider
universe for statistical reasons, because of the fact that the wider the universe, the better the
opportunity set and so on. But I do not know if there is such a trend with clients.

Roeloffs: No, currently demand is mainly in the more liquid wider universes, while what we
see in research is actually that you should maybe look more in the somewhat smaller sub
asset classes. It is also a game of what the costs are and what the turnover is, so it is quite
logical that it starts really more in the liquid part of the asset classes.

Voermans: The next step will be to figure out whether risk factor tilts or factor tilts can be
used in asset allocation. Investment consultants or asset managers can assist asset owners
in getting more insight into these risk exposures and providing factor portfolios for several
asset classes. It is very complex, especially if you invest in very illiquid assets such as
infrastructure and real estate. You do not really know what the exposures to factors such as
value, momentum or quality in those portfolios are. It is difficult, but it would be interesting
to have an asset allocation programme running next to your typical asset allocation based on
factor premia or on risk premia. A couple of Nordic pension funds already started investing
in this way.

For professional investors

 INSIGHTS #003 - March 2014 I 21 I

Experts View

How will factor premium investing evolve over time?

Tol: We started with low volatility, but are now looking to extend that to other factor premia.
I think factor premium investing will remain popular for the time being. Low volatility became
a bit of fad, getting popular for the wrong reasons (simply because it was outperforming).
Factor premium is much broader and takes into account other factor premiums as well. As a
result, it depends less on the performance of one factor premium and the risk of all factors
premiums not working at the same time is obviously small. The fact that lots of institutional
investors are disappointed with the results of active managers also adds to the popularity of
factor premium investing. Some institutional investors consider this to be a replacement for
active managers, at least partly. If we further implement factor premium investing, we will
most likely run it alongside our traditional active strategies. It is important to bear in mind
that when implementing factor premium investing, you also need to be aware of the current
(implicit or explicit) factor premiums in your traditional active and passive portfolios.

Neve: We actually see factor investing as an alternative to passive investing and not to active
investing, because good active managers have the exposures to the anomalies we believe in.
But we like the combination of a fundamental approach with a pure quant approach.

Voermans: Smart beta has been around for a long time. But on the implementation and
crowding side, I have seen some interesting developments over the last couple of years.
Index providers have entered this market (let us say 10, 15 years after the quant asset
managers). Today I have already heard a couple of comments on the MSCI minimum variance
such as having certain unwanted tilts, sector tilts, country tilts. It is interesting for an index
provider to create a strategy. But when, similar to what we have seen at MSCI, the indices are
replicated with billions of AUM, that might be a bad thing. I believe tens of billions of AUM
are now replicating the MSCI Minimum Variance. For all of that money, the new positions in
the index are communicated (10 days) upfront. This means that any high frequency trader
or hedge fund knows upfront what positions the replicating asset manager needs to buy or
sell. That is for sure too much information to hand over to the market.

Rousseau: A license to front-running.

Voermans: MSCI should be aware of this potential problem and should change at least
their communications on the indices. Investors should stay away from replicating this MSCI
index at this moment. But if FTSE or Russell indices become more popular, the same holds
for those indices.

Vincent: There is a danger when smart beta stays or becomes a purely ETF-driven subject;
then we are bound to have at some point a scandal on one index or another and this might
be a scandal that could kill the whole subject, similar to we have seen before in the industry
with other types of subjects.

Neve: Definitely, smart beta should not be a pure replication of an index that is so-called
smart beta. It is important to avoid crowded trades.

Rousseau: Is smart beta active or passive in a sense? At the FRR, we build our equity
allocation starting from the general concept that if we do not know better, we should be
passive. Then there are segments where active management makes a lot of sense. And that
applies first to small caps, which are not followed by many analysts and where the privilege
of sitting face to face with the management is not available to everybody. Smart allocation
for us in small caps means you have to be active. Our experience is that our managers do
deliver very substantial alpha, even though there is a style which is very typical: quality
and growth in this segment. Our SRI specific mandates are also active mandates, and the
same for our mandates when we invest in Western companies exposed to emerging market
growth. Japan of course is active because in such an inefficient market, it would be sad not
to go active. If it is normal situation, you go passive. But there are different passives: there
is the traditional market cap and there is smart beta. For us, smart beta is a passive type of
indexing, but we would need to be a bit smarter about it.

For professional investors

INSIGHTS #003 - March 2014 I 22 I

Key capabilities

Quarterly reports
To update you on our key capabilities we have provided links to the
quarterly reports on some of our key capabilities to give you more
insights in their performance, risk indicators and portfolio positioning.

Europe Equity Low Volatility Global Listed Global Inflation

Equity Real Estate

Emerging Asian Fixed

Markets Local Income
Debt

The funds described in the quarterly reports that are attached are not available to US investors in a fund structure, but are
available as separate accounts. Performance, risk indicators and portfolio positioning may change with a separate account.

This is BNP Paribas Investment Partners:

Seventh largest asset manager in Europe1

Part of BNP Paribas group, one of the best rated banks in the world (A+)2

479 billion euro AuM3

A worldwide provider of investment solutions, tailored to your needs

1 Source: BNP Paribas Investment Partners, as at 31 December 2013

2 Source: Standard & Poor's, as at 31 December 2013
3 Source: BNP Paribas Investment Partners, as at 31 December 2013

For more information surf to: www.bnpparibas-ip.com

Colophon | Insights | #0003 March 2014

Insights is a quarterly publication of BNP Paribas Investment Partners

BNP Paribas Investment Partners

5 Aldermanbury Square,
London, EC2V 7BP

Subscription service: subscriptions, changes of e-mail addresses or cancellations can be

submitted to your local contact person.

For professional investors

 INSIGHTS #003 - March 2014 I 23 I

Contact persons
Belgium US and Canada
Mark Desmet Jackie Carr
mark.desmet@bnpparibas.com jackie.carr@bnpparibas.com

France Australia and New Zealand

Pascal Dumont Angus Carson
pascal.dumont@bnpparibas.com angus.carson@bnpparibas.com

Germany Hong Kong and Singapore

Barbara Jarzombek Paul Milon
barbara.jarzombek@bnpparibas.com paul.milon@bnpparibas.com

Italy Puay Lit

Elisa Ori puaylit.tan@bnpparibas.com
elisa.ori@bnpparibas.com
Japan
Netherlands Toshio Wada
Rogier van Harten toshio.wada@bnpparibas.com
rogier.vanharten@bnpparibas.com
Brazil
Joost Hoppener Ana Santini
Joost.hoppener@bnpparibas.com ana.santini@bnpparibas.com

Norway Mexico
Nils Andresen Manuel Vega
nils.andresen@alfredberg.com manuel.vega@bnpparibas.com

Sweden
Jorgen Jonsson
jorgen.jonsson@alfredberg.com Consultant Relations team
Nicolas Moriceau
Switzerland Head of Consultant Relations
Thomas Zugwurst nicolas.moriceau@bnpparibas.com
(German speaking)
Thomas.zugwurst@bnpparibas.com Shona Whitesmith
Consultant Relations Director
Marco Lanci shona.whitesmith@bnpparibas.com
(French and Italian speaking)
marco.lanci@bnpparibas.com Jackie Carr
Head of US Consultant Relations
UK and Ireland jackie.carr@bnpparibas.com
Shona Whitesmith
shona.whitesmith@bnpparibas.com Paul Milon
Consultant Relations Manager Asia
paul.milon@bnpparibas.com

Patricia Donnelly
Head of Consultant Services
patricia.donnelly@bnpparibas.com

Wendy Vardon
Assistant
wendy.vardon@bnpparibas.com

For professional investors

 www.bnpparibas-ip.com

This material is issued and has been prepared by BNP Paribas Investment Partners (BNPP IP)*.
This material is produced for information purposes only and does not constitute:
1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or
commitment whatsoever or
2. any investment advice.
This material makes reference to certain financial instruments (the Financial Instrument(s)) authorised and regulated in
its/their jurisdiction(s) of incorporation.
No action has been taken which would permit the public offering of the Financial Instrument(s) in any other jurisdiction,
except as indicated in the most recent prospectus, offering document or any other information material, as applicable, of
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(as such term is defined in Regulation S of the United States Securities Act of 1933). Prior to any subscription in a country in
which such Financial Instrument(s) is/are registered, investors should verify any legal constraints or restrictions there may
be in connection with the subscription, purchase, possession or sale of the Financial Instrument(s).
Opinions included in this material constitute the judgment of BNPP IP at the time specified and may be subject to change
without notice. BNPP IP is not obliged to update or alter the information or opinions contained within this material. Investors
should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing
in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an
investment therein, if permitted.
- P1402081

This document is directed only at person(s) who have professional experience in matters relating to investments (relevant
persons). Any investment or investment activity to which this document relates is available only to and will be engaged in
only with Professional Clients as defined in the rules of the Financial Services Conduct Authority. Any person who is not a
relevant person should not act or rely on this document or any of its contents.
February 2014 - Design :

* BNP Paribas Investment Partners is the global brand name of the BNP Paribas groups asset management services.
The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for
information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your
locally licensed Investment Partner.