Six Sigma for Investing - CIFPs · 2008-05-14 · Six Sigma for Investing: Delusions of Adequacy...

Six Sigma for Investing:Delusions of Adequacy

Chris Jenkins, CIMA®Vice PresidentIndependent, Bank & NYSE DivisionFranklin Templeton Distributors, Inc.

Dealer Use Only Source: Source: S&P/TSX, Globe Hysales

S&P/TSX - December 1997 to December 2007

$8,000

$12,000

$16,000

$20,000

$24,000

$28,000

Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07

What Are Your Clients’ Expectations?

Dealer Use Only1. “Quantitative Analysis of Investor Behavior,” Dalbar, Inc., 2007. The S&P 500 is an unmanaged index; one cannot

invest directly in an index.

S&P 500Index

Average EquityFund Investor's

Annualized Return

Inflation

4.3%

11.8%

3.0%

The Impact of Real ReturnsJanuary 1987 to December 2006

Investor Return vs. Investment Return1

Dealer Use Only

Jumping Out of the Market Could Cost MoneyThe risk is missing the day the market begins recovering

Average Annual Return Growth of $10,000Fully Invested 9.47% $24,720

Missed 10 Best Days 5.26% $16,660

Missed 20 Best Days 1.91% $12,061

Missed 30 Best Days -0.96% $9,090




Source: Bloomberg as of December 31, 2007. Distributions are reinvested.

S&P/TSX – 10 Years Ending December 31, 2007

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Six Sigma Statistical Goal

Six Sigma

Uses data and statistical analysis to measure and improve a company’s operational performance

Identifies and eliminates “defects” in manufacturing and service-related processes

3.4 defects per million opportunities or 99.99966% perfection

Dealer Use Only1. Source: Rath & Strong in Motion; www.rathstrong.com.2. Source: USA Today; “Feds to Unleash Six Sigma on Terrorism,” 10/31/02.

Industry DefectsIndustries operating at 97% or a level below Six Sigma,could lead to the following results:1, 2

5,000 incorrect surgical procedures per week

20,000 articles of mail lost per hour

200,000 incorrect drug prescriptions each year

One hour of unsafe drinking water per month

Two long or short landings at a major airport each day

50 newborn babies dropped each day

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201510305

1725124

16 DaysAverage Cycle

8 DaysAverage

Source: Jack – Straight From the Gut by Jack Welch with John Byrne. Copyright 2001. Published by Warner Books.

Existing Process Improved Process

50% Improvement

Case Study: GEDelivery time of its plastic products

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Improved Process

2 (-6) 8 (+9) 17Six Days

EarlyNine Days

Late

Source: Jack – Straight From the Gut by Jack Welch with John Byrne. Copyright 2001. Published by Warner Books.

1725124

8 Days

Case Study: GECustomer Expectation: 8 Days

Dealer Use Only Source: www.ge.com/sixsigma.

“Often, our inside-out view of the business is based on average or mean-based measures of our recent past. Customers don’t judge us on averages, they feel the variance in each transaction.Six Sigma focuses first on reducing [investment] variation and then on improving capability.”

“Customers value consistent, predictable business [investments] that deliver world-class levels of quality. This is what Six Sigma strives to produce.”

The Idea of Six SigmaCustomers Feel the Variance, Not the Average

Dealer Use Only 1. Source: Jack – Straight From the Gut by Jack Welch with John Byrne. Copyright 2001. Published by Warner Books.

Case Study: GE

Reduce the Variance

79987

8 Days

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Expectations vs. Reality

Making Sense of Averages

Reducing Portfolio Risk

Agenda

Expectations vs. Reality

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Average Annual Total Returns Since InceptionFor the Period Ending 12/31/07

Source: Globe Hysales, as of December 31, 2007.

AverageAnnual Total

ReturnInception

S&P 500 Composite 7.10% 1926

Russell 2000® 12.77% 1979

MSCI EAFE 11.56% 1970

MSCI World 10.77% 1970

DEX Universe Bond Total Return 10.23% 1980

S&P/TSX Composite 7.10% 1973

Blend: 60% S&P/TSX, 40% DEX Universe 10.41% 1980

What Is Expected?

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One-Year Holding Periods through 12/31/07Average

Annual TotalReturn

Inception+/- 10% of

Average AnnualTotal Return

S&P 500 Composite 7.10% 1926 2 of 81

Russell 2000® 12.77% 1979 0 of 28

MSCI EAFE 11.56% 1970 4 of 37

MSCI World 10.77% 1970 2 of 37

DEX Universe Bond Total Return 10.23% 1980 4 of 27

S&P/TSX Composite 7.10% 1973 2 of 34

Blend: 60% S&P/TSX, 40% DEX Universe 10.41% 1980 3 of 27

Source: Globe Hysales, as of December 31, 2007

Missed Expectations?

Dealer Use Only Source: “Quantitative Analysis of Investor Behavior,” Dalbar, Inc., 2007.

Average investor retention rates based on the past:

Type of Investor: 1 Year 3 Years 5 Years 10 Years 20 Years

Average Equity Investor 4.3 4.3 3.7 3.3 3.0

Average Fixed Income Investor 3.7 3.5 3.2 3.1 3.2

Average Asset Allocation Investor 5.2 5.4 5.0 4.7 4.2

Missed Expectations?Mutual Fund Holding Periods (in years)

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Five-Year Holding Periods through 12/31/07

AverageAnnual Total

ReturnInception

+/- 10% ofAverage Annual

Total Return

S&P 500 Composite 7.10% 1926 4 of 77

Russell 2000® 12.77% 1979 1 of 24

MSCI EAFE 11.56% 1970 4 of 33

MSCI World 10.77% 1970 0 of 33






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Three-Year Holding Periods through 12/31/07Average

Annual TotalReturn

Inception+/- 10% of

Average AnnualTotal Return

S&P 500 Composite 7.10% 1926 7 of 79

Russell 2000® 12.77% 1979 5 of 26

MSCI EAFE 11.56% 1970 3 of 35

MSCI World 10.77% 1970 1 of 35






Dealer Use Only Source: Globe HySales. Past performance does not guarantee future results.

50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

60%

70%

10-Year 25-Year5-Year3-Year1-Year

27.8%16.8%

86.9%

11.5%

35.7%

Best Average Annual Total Return

Worst Average Annual Total Return

-1.91% 6.6%

-39.2%

9.1%

-11.1%

Average Annual Total Return

10.6% 10.2%13.7%

10.5%11.4%

The Impact of Range of Returns

For the 30-Year Period Ended 02/29/081

S&P/TSX Average Annual Returns Over Rolling Periods

80%

90%

Making Sense of Averages

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• Time-Weighted Return or Investment Return- Calculated by multiplying a series of numbers and taking the nth

root of the product(1 + r)t – 1

TVRCFRCF DWDW =+++ )1()1( 102

• Dollar-Weighted Return or Investor Return- Measures the present value of an investment's cash inflows with the present

cost of the investment

The Three Averages• Arithmetic Average

- Value obtained by dividing the sum of a set of quantities by the number of quantities in the set

+50 – 50 = 00 ÷ 2 = 0

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Time-Weighted ReturnInvestment Return and the Impact of Compounding

Year Two: $150,000 X -50% = $75,000

Year One: $100,000 X 50% = $150,000

%131)50)(.50.1( 2/1 −=−

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$0 (1.5)2 + $100,000 (.5) = $50,000

TVRCFRCF DWDW =+++ )1()1( 102

Investor Return = -50%

Dollar-Weighted Return

In 1999, XYZ Fund was up 50%, however we decided to purchase the Fund on January 1, 2000, only to watch it drop 50%.

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$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

Nov-97 Jul-99 Mar-01 Nov-02 Jul-04 Mar-06 Nov-07-$10-$5$0$5$10$15$20$25$30$35

Growth of $10,000 Investment Net New Flows

1. Source: Strategic Insight. Lipper, Inc., as of 12/31/07.

The Investor ExperienceGrowth of a $10,000 Investment vs. Net Flows ($Millions)


Dealer Use OnlySource: Strategic Insight (Simfund), as of 12/31/07.

■ Net New Flows ■ Growth of $10,000 Investment

-$30

-$20

-$10

$0

$10

$20

$30

$40

$50

Q1'95 Q2'96 Q3'97 Q4'98 Q1'00 Q2'01 Q3'02 Q4'03 Q1'05 Q2'06 Q3'07-$30,000

-$20,000

-$10,000

$0

$10,000

$20,000

$30,000

$40,000

$50,000

The Investor ExperienceGrowth of a $10,000 Investment vs. Net Flows ($Millions)

Morningstar Large-Cap Growth Category1

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“A dollar-weighted-return is not a reflection of how the manager has done in generating the performance. The idea is that while a fund may have provided good returns on a time-weighted basis, the investor experience could be quite different if investors went in and out of the funds at the wrong time.”

Paul Kaplan

Vice President of Quantitative Research

Morningstar

Source: Morningstar.com.

The Investor Experience

Reducing Portfolio Risk

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Beta – Measures an investment’s relative volatility and the movement of

an investment in relation to a benchmark index

Standard Deviation– Measures the degree to which an individual value in a probability

distribution tends to vary from the mean of the distribution.

How Do You Define Risk?Beta vs. Standard Deviation

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11%-34% 56%

+45%-45%

99%

-19% 41%

+30%-30%

95%

-15% +15%

26%-4%

68%

Standard Deviation Profile11% Average Annual Total Return and 15% Standard Deviation

Dealer Use Only Source: Morningstar Research Inc. Not all funds are representative due to a fund history of less than 15 years.

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

0.00 5.00 10.00 15.00 20.00 25.00Standard Deviation (%)

Ret

urn

(%)

Fund A:Risk: 9.90

Return: 13.41

Fund B:Risk: 19.77

Return: 15.33

Risk vs. Return RelationshipLargest 100 Domestic Equity Funds Based on Net Assets For the 15-Year Period Ending 12/31/07

15 Year Risk-Return Chart

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95%

+10

-10

33%

-7%

13%

13% Return, 10% Standard Deviation 15% Return, 20% Standard DeviationFund A Fund B

15%68%-10

+1023%

3%

35%

-5%

+20

-2068%

-25%

55%+20

-20

95% 99%

+1043%

-10-17%

75%

-45%

+20

-20

Tale of Two Funds: Risk vs. Return Profile

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Funds with higher volatility often exhibit large short-term gains, which in turn attracts investors

Funds with lower volatility, by contrast, tend not to attract fickle short-term investors with explosive gains and also do a better job of protecting shareholders’ capital during downturns

1. Source: Morningstar Advisor , Spring 2007, Your Mileage May Vary by Christine Benz and David Kathman.

Linking Risk with Investor ReturnTM1

Narrowing the Gap

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1. Source: “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability”; Journal of Banking and Finance, August 2006. For each fund, calculations include the average monthly arithmetic, geometric and dollar-weighted returns over the entire sample period. Performance gap is the difference between fund geometric and dollar-weighted returns. Funds are divided into objective categories using the CRSP SI-Objective variable, and summary statistics are reported for each objective category. Standard deviations are reported for the average geometric return and performance gap. T-statistics for the mean performance gap are reported in parentheses. Returns are percent per month. Past performance does not guarantee future results.

0.51%0.03%0.68%0.71%Income-Growth

0.70%0.06%0.51%0.57%Growth and Income

0.91%0.14%0.26%0.40%Growth

0.94%0.13%0.64%0.77%Mid-Cap Growth

1.00%0.16%0.75%0.91%Small-Cap Growth

1.31%0.25%0.13%0.37%Aggressive Growth

Standard Deviation of

Average Fund Return

Performance Gap

Dollar Weighted Return

Time-Weighted Return

Morningstar©

Category

Lower the Risk to Decrease the Performance Gap1

Dealer Use Only 1. Source: Morningstar© Advanced Analytics for Principia. “Putting Risk in its Place,” by John Rakenthaler, 5/27/94.

Putting Risk in Its Place

“It wasn’t even close. Historic returns did a very poor job of predicting future returns. In contrast, the connection between past risk and future risk was very powerful. Despite very different market conditions, the riskiest funds stayed the riskiest, and the safest funds stayed the safest. The pattern held true along the risk spectrum.”1

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Improving your Clients’ Portfolio through AllocationImportance of diversifying your clients’ Portfolio by asset classes, market capitalization, management style and geographic region:

93% of variability of returns across time is explained by asset allocation

90% of portfolio returns can be attributed to diversification by market capitalization

A one-style portfolio is exposed to 65% more risk than a blended-style portfolio

Diversification by geographic region can reduce portfolio risk by up to 64%

Source: Equisoft, 2007.

Dealer Use Only Based on Morningstar Research Inc. as of December 31, 2007.

Why Diversify? Because winners rotate

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The Predictability of Risk

Based on Morningstar Research Inc. as of December 31, 2007.

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“From the study, it appears that the low-volatility funds with higher levels of return […] perform better in percentage withdrawal mode than do high-return, high-volatility funds.”

— Source: FPA Journal, “Sustainable Retirement Withdrawls,”by Ahmet Tezel, Ph.D., 7/04

“Ideally, investors’ sustainable withdrawal in retirement depends not only on expected returns in the future, but also on the variability of returns.

— Source: Financial Planning,“Survival of the Fittest,” by Craig L. Israelsen and Keith Sechler, 1/1/05.

“During retirement, a spike in volatility increases the very real possibility that the nest egg will be permanently damaged by a steep market decline.”

- Source: Journal of Financial Planning, “In Retirement: What Matters”,May 2001 John Rekenthaler Vice President, Morningstar

Beware of Risk

Dealer Use Only 1. Assumes withdrawal and loss are calculated based on initial account value.

Over 5 Years with a 5% Withdrawal1Over 1 Year Losses

-10% -15% -20%

11%18%

25%

54%67%

82%

-40%

-20%

0%

20%

40%

60%

80%

100%

The Mathematical Catch-Up GameCumulative Gain Required to Return to Original Value1

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Risk of Stocks

Risk of Bonds

Risk of the Interaction Between Stocks and Bonds

sbssp ρσσσσσ bsbs2

bb2 W2WWW 22 ++=

How to Reduce Portfolio Risk

Dealer Use Only 1. Source: Morningstar® Advanced Analytics for Principia. “Predicting the Future,” by Catherine V. Sanders, 9/1/95.

“The upper left-hand section of the equity style box, including large-cap value, large-cap blend and mid-cap value, represented the funds with the least historic volatility. The lower right-hand corner housed the highest risk funds—small-cap growth, mid-cap growth and small-cap blend. And the rest— large-cap growth, mid-cap blend and small-cap value—fell somewhere in between.1

Risk of Stocks

Dealer Use Only

Source: Globe Hysales as of 02/29/08. Stocks as represented by the S&P/TSX Index. Bonds/Stocks as represented by the Blend: 60% S&P/TSX,40% S&P/TSX.. Risk is measured by the annualized standard deviation of monthly total returns. Successive data points on the line represent incremental changes of 20% in the portfolio allocations from 100% stocks / 0% bonds to 0% stocks / 100% blend. Portfolios were rebalanced monthly. Indexes are unmanaged, and one cannot invest directly in an index. Past performance does not guarantee future results.


February 29, 1988 - February 29, 2008

7%

8%

9%

10%

11%

12%

13%

14%

15%

7% 8% 9% 10% 11% 12% 13% 14% 15%Risk - Annualized Standard Deviation

Ann

ualiz

ed R

ate

of R

etur

n

100% S&P/TSX

100% Blend

Risk of BondsBlend: 60% S&P/TSX, 40% DEX and S&P/TSX Index

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sbssp ρσσσσσ bsbs2

bb2 W2W W W 22 ++=

= Correlation between stocks and bondssbρ

Risk of Interaction

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Risk of Interaction

“To reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little more protection than the uncertain return of a single security”.

— Source: Journal of Finance, “Portfolio Selection”by Harry Markowitz., 1952

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1 2 3 4 5 6 7 8 9 10 11 1312

Morningstar Research Inc., December 31, 2007.

BMO NB Small Cap 1.00 -0.45 -0.50 0.67 0.54 0.72 0.49 0.50 0.70 0.83 0.06 0.41 0.88

LB Global Agg 1.00 0.88 -0.33 0 -0.28 -0.01 -0.05 -0.2 -0.42 0.35 -0.05 0

LB US Agg Bond 1.00 -0.34 -0.08 -0.3 -0.09 -0.06 -0.17 -0.46 0.29 -0.01 -0.18

MSCI BRIC 1.00 0.61 0.88 0.55 0.57 0.56 0.68 0.05 0.46 0.78

MSCI EAFE 1.00 0.71 0.95 0.93 0.66 0.64 -0.04 0.79 0.86

MSCI Emerg. Mkts 1.00 0.63 0.71 0.66 0.74 0 0.62 0.88

MSCI Europe 1.00 0.9 0.65 0.59 -0.06 0.77 0.8

MSCI World 1.00 0.71 0.68 -0.07 0.95 0.85

Russell 2000 1.00 0.7 0.03 0.68 0.92

S&P/TSX 1.00 0.04 0.61 0.86

DEX Universe Bond 1.00 -0.07 0.48

S&P 500 1.00 0.77

S&P/Citigroup <2B 1.00

12345678910111213

Low Correlation Is Key to Reducing RiskMajor Investment Index Correlation


Dealer Use Only

How Different Funds are or are Not From Each OtherCorrelation coefficients are the statistical measure of the differences in return patterns between different asset classes.

A correlation coefficient of 0 indicates assets whose movements are unrelated. 1 indicates a perfect positive correlation and -1 a perfect negative correlation.

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Low Correlation is Key to Reducing Risk

Correlation coefficients are calculated using data from the past 36 months only. The following funds have less than 36 months of data: Bissett All Canadian Focus Fund and Franklin Templeton Canadian Small Cap Fund.

A diversified portfolio of assets with low correlation is subject to less downdrafts in single markets; some assets will tend to move up while others move down. This smoothes out long-term portfolio returns and helps protect it from large losses.

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Expectations vs. Reality– Investor returns rarely meet the average or investor expectations– Each investor has a unique experience that may not truly reflect the “average”

Making Sense of Averages– How investors measure average annual returns and how investment return

averages are measured are often not the same

Reducing Portfolio Risk– Investments with lower standard deviation can reduce the gap between dollar-

weighted and time-weighted returns– Designing portfolios with lower risk and a low or negative correlation it will

enable your clients portfolios to be more closely aligned with investorexpectation and investment reality

Review

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Next Steps

Meet with your clients to assess their expectations vs. the reality of their investment returns and determine whether there are any performance gaps

Take time to educate your clients about risk and how it impacts the performance of their investments

Contact your Franklin Templeton Sales Manager to discover how our bestbuilt service can help your clients & request to receive a free portfolio optimization report

Questions & Answers

Dealer Use Only

Six Sigma for Investing - CIFPs · 2008-05-14 · Six Sigma for Investing: Delusions of Adequacy...

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