Can Enhanced Indexing Combine the Best of

Both Worlds: Active and Passive?

Carl MossSenior Investment OfficerInternational Division

28 November 2007

FOR INSTITUTIONAL INVESTOR USE ONLY / NOT FOR PUBLIC VIEWING OR DISTRIBUTION

1

Agenda

� Growth of Enhanced Indexation

� Key Characteristics Of Enhanced Indexation

� How Is It Typically Done?

� Emergence of Stochastic Portfolio Theory

� Why is a High Information Ratio so Important?

� Longer-Term Performance - Skill or Luck?

� Summary

2

Growth of Enhanced Indexing

Growth of Enhanced Indexed Assets

(in Billions)

$449

$332

$275

$53

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

$500

1995 1999 2003 2006

Enhanced Indexed Total Assets

Source: Pensions & Investments

3

Key Characteristics Of Enhanced Indexation

� Definitions of Enhanced Indexation may vary, but the following

are key components:

� Returns and risks are relative, not absolute.

� Consistency of outperformance is an explicit objective.

� Risk control is an integral part of portfolio construction.

� Highly efficient trading and settlement is required.

4

How Is It Typically Done?

� Tilts to Alpha� Overweight the stocks, sectors, industries, etc. that are expected to outperform. Use either traditional stock

analysis or quantitative models.

� Derivative Enhancements� Use derivatives as a substitute for plain stock exposure to be more efficient/use arbitrage/change risk-return

characteristics.

� Portable Alpha� Construct a package of assets that are uncorrelated to the benchmark; have minimal market exposure; and

have a positive expected excess return.

� Trading Enhancements� Gain extra performance through smart trading (especially in illiquid assets).

� Tax Efficiency� Manage the portfolio to maximise its after-tax return.

5

Emergence of

Stochastic Portfolio Theory

6

“Modern” Portfolio Theory

� Harry Markowitz, “Portfolio Selection,” 1952

� Seminal work on risk and return. Introduced the concept of correlation and

covariance.

� Presented the idea of the “efficient frontier” of optimal investment.

� This frontier maximized expected return for a given level of standard deviation of

return.

πR

pσ

∑=

=

n

i

ii RR1

ππ

∑=

=

n

ji

ijji

1,

2σππσ

π

Portfolio average return depends on the portfolio weights

and average returns of each stock

Portfolio variance or standard deviation depends on

the portfolio weights and the variance and covariance

of stocks’ returns

7

� James Tobin and the Separation Theorem, 1958

� Said the problem of “optimal” investment could be broken down into two elements: (1) an optimal

combination of risky securities and, (2) the borrowing or lending of money at the risk free rate

� The “efficient frontier” then becomes a single portfolio of risky securities plus lending or borrowing.

This would dominate any other combination.

� William Sharpe, The Capital Asset Pricing Model (CAPM), 1964

� Delineated between systematic risk (the risk of being in the market) and unsystematic risk (company

specific risk)

� Since unsystematic risk can be diversified away, Sharpe argued in CAPM that a portfolio’s expected

return hinged solely on its systematic risk, or “beta.” Beta was defined as a portfolio’s sensitivity to

variability in the market.

“Modern” Portfolio Theory (cont’d)

8

� CAPM assumptions:

� All investors share the same outlook for the future behavior of the stocks in the market.

� All investors have the same investment horizon.

� They are all seeking mean/variance efficiency.

� One can borrow or lend unlimited amounts at the risk free rate.

� One can sell short unlimited amounts of stock with no cost or penalty.

CAPM Conclusion: Above-market expected return requires above-market risk.

� If the assumptions for CAPM are not satisfied, there is no reason to expect the conclusion to hold. Therefore, there is no theoretical impediment to creating a portfolio with market risk, but above-market expected return.

“Modern” Portfolio Theory (cont’d)

These assumptions allowed Sharpe to argue mathematically that the market portfolio, as

represented by the S&P 500, was a mean/variance efficient portfolio.

This fuelled the move to indexing and passive management.

9

A Critical Distinction

� In June of 1991 and again in 2005, Harry Markowitz made a distinction between an efficient portfolio and

an efficient market. The terms are often used synonymously because of the assumptions underlying

CAPM.

� The floor of the NYSE may be “efficient” in an equilibrium sense, but the “market portfolio” is

constructed by matching the portfolio weights with the capitalization weights of the stocks in the index.

� No consideration is given to covariance.

� Covariance is the critical element in

Markowitz’s theory. The market portfolio

is very unlikely to be mean/variance

efficient, i.e., to have the highest return for a

given level of risk.

There is no theoretical impediment to creating a portfolio with market risk, but above market expected return

σ

{RM

RF

e.r.

e.r.= excess return above the benchmark index

10

Stochastic Portfolio Theory

� Stochastic Portfolio Theory (SPT) is a new framework for

� Portfolio construction

� Analyzing portfolio behavior

� Understanding the structure of equity markets.

� Stochastic Portfolio Theory is descriptive rather than normative.

� SPT explains how it is possible to outperform a cap-weighted benchmark index by

exploiting the natural volatility of stock prices, without using return forecasts.

� The theory has been successfully applied since 1987 to build portfolios which aim to

create an excess return over the benchmark index without increasing the risk.

11

The Emergence of Stochastic Portfolio Theory

� Robert Fernholz, PhD, Mathematics (Columbia)� Taught statistics at Princeton in the late 1970’s

� Consulted with Markowitz – option pricing

� Approached portfolio theory from the perspective of a pure mathematician

� Stochastic Portfolio Theory and Stock Market Equilibrium, Journal of Finance, 1982

� Presented the idea of excess growth rates for portfolios

� Excess growth is a function of the weighted average stock variance and the portfolio variance

� Excess growth is defined by:

� Portfolio Growth Rate

Portfolio Growth Rate = weighted average stock growth rate + excess growth rate

Excess growth rate = ½ [weighted average stock variance – portfolio variance]

n

∗∗∗∗

=

+= ∑ πππππγγγγγπγ

i

i

i

1

π

−= ∑ ∑ σππσ ijj

n n

i,j=1 iii

2

2

1

i=1

∗∗∗∗

ππππγγγγ

12

Summary of Key Concepts

� The market portfolio is unlikely to be an efficient portfolio.

� Stochastic Portfolio Theory uses growth rate instead of rate of return, and does not require the estimation of the future growth rates of stocks.

� We believe it is possible to create a portfolio of greater efficiency than the

market portfolio.

� The technique involves considering the covariance of stocks, and adjusting stock weights to achieve a more efficient combination than the benchmark index.

� Stochastic Portfolio Theory has been successfully implemented since

1987.

13

Why Is A High Information Ratio So Important?

Shortest Period With at Least a

95% Probability of Outperformance

0

5

10

15

20

25

30

35

0.3 0.5 0.7 1.0

Annual Information Ratio

Years

Data obtained from simulations, assuming relative returns are normally distributed and uncorrelated. Source: INTECH.

14

� The One Tail Significance is the estimated probability that pure luck would

produce the portfolio’s observed alpha or better.

*Source: National Consulting Firm.Data presented reflects past performance, which is no guarantee of future results.Data presented is quarterly data from first full quarter since inception through 9/30/07, and is calculated gross of fees.Chart includes strategies with at least a three-year track record.

Skill vs. Luck?

Std Dev

Inception Residual Information t One Tail

Quarter Alpha* Return* Ratio* Statistic Significance

Enhanced Plus 1987 Q3 1.48% 2.18% 0.68 3.02 0.17%

Broad Enhanced Plus 2001 Q2 2.03% 2.10% 0.97 2.41 1.19%

Large Cap Growth 1993 Q3 5.35% 4.47% 1.20 4.33 0.00%

Broad Large Cap Growth 2001 Q1 2.56% 3.02% 0.85 2.20 1.87%

Large Cap Value 1993 Q3 3.05% 3.31% 0.92 3.33 0.08%

Broad Large Cap Value 2004 Q4 1.52% 2.17% 0.70 0.95 18.28%

Enhanced Index 1998 Q2 1.30% 1.32% 0.98 3.01 0.24%

Large Cap Core 2001 Q1 3.49% 3.34% 1.05 2.46 1.10%

� Information Ratio = Alpha ÷ Residual Risk.

Longer-Term Performance: Skill or Luck?

15

293 500

0.97 1.00

0.99 1.00

22.2 22.8

1.78 1.68

24.6 22.6

5.57 4.72

$104.7 B $111.4 B

$56.2 B $59.1 B

Weighted Average Market Cap

Number of Securities

EPS (5 Yr. Historical)

Price/Book Ratio

Portfolio Characteristics - Enhanced Index*

September 30, 2007

*Portfolio characteristics are based on a representative account.

Beta and R-Squared source: National Consulting Firm

Portfolio characteristics source: FactSet/Reuters

Beta (Since Inception)

R-Squared (Since Inception)

Price/Earnings Ratio (Trailing 12 Mos)

Dividend Yield (Current)

Weighted Median Market Cap

INTECH

Enhanced Index

S&P 500

Index

16

Conclusion

� Mathematical strategies are innovative alternatives to the range

of enhanced index processes

� Return patterns often diverge from traditional strategies, helping

to improve the risk-reward profile in a multi-manager line-up.

� Risk/Reward characteristics are well defined and tend to be

favourable vs. traditional portfolio construction techniques.

17

Disclaimer

INTECH is a Janus Capital Group Company. Past performance cannot guarantee future results. Your principal may be at risk during certain market periods. Performance results reflect the reinvestment of dividends and other earnings. Portfolio performance results shown are time-weighted rates of return using daily valuation and include the effect of transaction costs (commissions, exchange fees, etc.). The composites include all actual fee paying accounts managed on a fully discretionary basis according to the investment strategy from inception date, including those no longer under management. Accounts meeting such criteria enter the composite upon the full first month under management.The gross performance results presented do not reflect the deduction of investment advisory fees and returns will be reduced by such advisory fee and other contractual expenses as described in the individual contract and INTECH’s Form ADV Part II.

INTECH will act as sub-adviser to Janus Capital International Limited. Nothing herein is intended to amount to investment advice. This information does not constitute or form part of an offer to provide discretionary or non-discretionary investment management or advisory services, other than pursuant to an agreement in compliance with applicable laws, rules and regulations.

Issued in Hong Kong by Janus Capital Asia Limited, licensed and regulated by the Securities and Futures Commission.The distribution of this document or the information contained in it may be restricted by law and may not be used in any jurisdiction or any circumstances in which its use would be unlawful.

FOR INSTITUTIONAL INVESTOR USE ONLY / NOT FOR PUBLIC VIEWING OR DISTRIBUTION

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