PORTFOLIO VALUATION, MANAGER SELECTION AND Andreas Graflund, PhD., CQF.

PERFORMANCE ATTRIBUTION. GrafCap AB

 AGENDA

1. Background

2. Holding based performance attribution

3. Return based performance attribution

4. Where and how we can use it

5. ESG: An European (EEA) perspective. The SDFR.

2
 PERFORMANCE RATIOS…

1. Alpha
2. Selection Return
3. Beta
4. Portfolio Turnover
5. Active Share
6. Tracking Error
7. Information Ratio
8. Sharpe Ratio
9. Traynor Ratio
10. Sortino Ratio
11. There are several more performance ratios, ex: Omega Ratio…

3
 WHY MEASURING PERFORMANCE?
1. Evaluate the active bets
• Which bets/securities contributed to what?
• Which team contributed to what?
• Tactical bets?
• Security selection?
• How active has the portfolio manager been?

2. Evaluate the investment strategy in relationship to peer group

• Is the manager true to the stated strategy?
• Documentation of the investment process.
• The investment strategy's exposure to market risks and/or risk factors…
• An ESG investment strategy's exposure to ESG factors and alignment to the ESG strategy…

3. Product development and product evaluation

• Does the new strategy deliver on its intended performance?
• Which teams deliver?
• Replicating/Cloning strategies and performance evaluation…
4
 ACADEMIA VERSUS THE REAL WORLD…
1. Financial research assumes
• Ex ante: expected returns and expected values
• Real returns
• Known distributions
• Homoscedastic distributions (generally)
• Strong focus on statistical significance
• Theoretical models

2. Real world
• Ex post evaluations
• Estimation Errors (often 3 years monthly observations = 36 observations)
• Little interest in statistical significance…
• Strong focus on financial and economic significance
• Practical models
5
THE MORNINGSTAR STARS…
• Ratings are based on minimum 3-years
rolling monthly returns

• Morningstar ”rates”
• 3-year rolling returns
• 5-year rolling returns
• 10-years rolling returns

• Morningstar Stars are a mix of the

rolling Morningstar rates

• It is well-known that 5 stars produces an

increasing inflow into the investment
strategy (most cases)

• An example on another important

rating institute is Lipper. Consultants/
consultant houses rates mutual funds,
hedge funds and investment
strategies…
6
 PAST PERFORMANCE AND FUTURE PERFORMANCE…
An ongoing debate
• Practitioners focuses on the
investment process and the
portfolio management teams.

• Morningstar ratings are used by

all professionals.

• Morningstar uses a combination

of holding based performance
attribution and past
performance evaluation.

• Wall Street Journal has

questioned the predictive power
of the Morningstar ratings…

• Why do we see the results in the

picture?
Source: Wall Street Journal, 2017.
7
WHICH INVESTMENTS PROCESSES ARE GAINING?…

8
HOLDING BASED PERFORMANCE ATTRIBUTION

1. Performance Attribution

2. Active Share

3. Portfolio Turnover

9
 PERFORMANCE ATTRIBUTION: SOME DEFINITIONS

Weight of asset i in portfolio = ,

Weight of asset i in benchmark (index) = ,

Return of asset i in portfolio = ,

Return of asset i in benchmark (index) = ,

Portfolio return = , ,

Benchmark (index) return = , ,

10
 PERFORMANCE ATTRIBUTION
Performance attribution, Brinson, Hood and
Beebower (1986). Holding based
Returns performance attribution compares the
Benchmark Portfolio value-added return of an investment
strategy versus its benchmark.
Benchmark

Purpose:
𝑟 =𝑟 = 𝑤 , ×𝑟 , 𝑟 = 𝑤 ×𝑟
, , Identify where and how the return has been
generated.
Weights

Performance (portfolio return) is composed

into:
• Tactical allocation
Portfolio

𝑟 = 𝑤 , ×𝑟 , 𝑟 =𝑟 = 𝑤 , ×𝑟 , • Security selection
• Interaction

Source: Brinson, Hood and Beebower (1986). Practicability:

The drawback is that you need the portfolio
weights of each security and the
benchmarks weights. Hence, it often used
internally by asset managers.
11
 PERFORMANCE ATTRIBUTION (CONT.) Performance attribution
• Standard package in
Bloomberg.

𝑻𝒂𝒄𝒕𝒊𝒄𝒂𝒍 𝑨𝒔𝒔𝒆𝒕 𝑨𝒍𝒍𝒐𝒄𝒂𝒕𝒊𝒐𝒏 = 𝐼𝐼 − 𝐼 = 𝑤 −𝑤 ×𝑟 • Used by all professionals.

, , ,

• A variant of holding based

𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐒𝐞𝐥𝐞𝐜𝐭𝐢𝐨𝐧 ("𝑠𝑡𝑜𝑐𝑘 𝑝𝑖𝑐𝑘𝑖𝑛𝑔") = 𝐼𝐼𝐼 − 𝐼 = 𝑤 , × 𝑟 , −𝑟 , performance attribution is the
methodology used by
Morningstar.
Interaction 𝑎 𝑐𝑟𝑜𝑠𝑠 𝑡𝑒𝑟𝑚 = 𝐼𝑉 − 𝐼𝐼𝐼 − 𝐼𝐼 + 𝐼 = 𝑤 , −𝑤 , × 𝑟 , −𝑟 ,
• Holding based performance
attribution is often used in
𝐓𝐨𝐭𝐚𝐥 𝐕𝐚𝐥𝐮𝐞 𝐀𝐝𝐝𝐞𝐝("𝑆𝑘𝑖𝑙𝑙/ℎ𝑜𝑡 ℎ𝑎𝑛𝑑𝑠") = 𝐼𝑉 − 𝐼 = 𝑤 , ×𝑟 , −𝑤 , × 𝑟 , combination with other
performance measures such as
return based performance
attribution.

• Total Value Added: the

over/under performance vs.
benchmark.

12
ACTIVE SHARE
Active Share, Cremers and Petajisto
(2009) and Petajisto (2013), measures
the “distance”, the difference in assets
weights, between a given portfolio and
its benchmark.

Purpose:
Identify where a manager lies in the
passive-to-active spectrum.
, ,
Active Share = 0:
If and only if the portfolio is identical to
its benchmark

Active share = 1:
If and only if the portfolio holds non-
benchmark securities.

Active Share relies on a relevant

benchmark!
13
 PORTFOLIO TURNOVER
Portfolio turnover, is a
measure of the market value
of the total traded assets in
the portfolio divided by the
min(𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠, 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠) market value of the portfolio
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑒 = × 100 over a specific time period,
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 net 𝑎𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
usually a year.
Source: SEC, see also Investopedia

Purpose:
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑒 = × 100 Identify active and passive
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 investment managers and to
Source: ESMA (EEA/EU standard reporting)
serve as an indication and
evaluation of the investment
strategy.
Comment: There are today two widely used definitions of Portfolio Turnover, the
SEC definition and the EU/ESMA definition. In short this means that mutual funds
sold within EU report a portfolio turnover calculated different from a fund being
Practicability:
sold outside the EU. In 2019 ESMA has conducted a industry consultation where the The measure is very common.
financial industry is in favour of EU /ESMA adopting the SEC definition. Easy to communicate and
easy to evaluate.

14
 RETURN BASED PERFORMANCE EVALUATION

1. Capital Asset Pricing Model

2. Multivariate Asset Pricing Models, Arbitrage Pricing Models (APT)

1. Arbitrage Pricing Models (APT)
2. Sharpe Return Based Style Analysis
3. Alternative Risk Factor Models (Fama-French-Carhart)

3. Advanced models

15
DIVERSIFICATION

Expected
Return

Portfolio A Asset A

Mkt risk Diversification

Asset B

Risk (Volatility)

16
OPTIMAL PORTFOLIOS AND THE EFFICIENT FRONTIER

Expected
Return Efficient frontier

Portfolio N
Asset A

Diversification

Portfolio A Asset B

Risk

17
MARKOWITZ MEAN VARIANCE AND THE EFFICIENT FRONTIER
 Assumes that investors
maximize their wealth.
Expected
Return Efficient frontier
 Relevant risk is variance.

Portfolio N  Give a quantitative

approach to portfolio
selection

 Very nice theory! Leads

to a lot of insight!

Risk

18
 INTUITION OF SHARPE RATIO
 Sharpe Ratio, 𝑠𝑟 ,
measures the reward per
Expected
Excess
unit of risk defined as
Capital Market Line volatility.
Return
Sharpe Ratio
 Relevant risk is variance.
Efficient frontier
Market Excess Return Market portfolio
 Relevant reward is excess
Risk free return, 𝑟 − 𝑟 ,. The return
over the risk-free rate
Market Risk Risk

 High Sharpe ratios are

𝑟 −𝑟 indications of more
𝑠𝑟 = efficient portfolios, or
𝜎
skilled managers (positive
alpha) or both.

 Sharpe ratios differs

between asset classes…
19
 INTUITION OF SHARPE RATIO
 Sharpe Ratio, 𝑠𝑟 ,
measures the reward per
Expected “High” Sharpe Ratio
Excess
unit of risk defined as
Capital Market Line volatility.
Return
Skilled Sharpe Ratio
manager
 Relevant risk is variance.
Alpha (positive) Efficient frontier
Market Excess Return Market portfolio
 Relevant reward is excess
Risk free return, 𝑟 − 𝑟 ,. The return
over the risk-free rate
Market Risk Risk

 High Sharpe ratios are

𝑟 −𝑟 indications of more
𝑠𝑟 = efficient portfolios, or
𝜎
skilled managers (positive
alpha) or both.

 Sharpe ratios differs

between asset classes…
20
 INTUITION OF SHARPE RATIO
Capital Market Line
 Sharpe Ratio measures
the reward per unit of
Expected risk defined as volatility.
Excess “High” Sharpe Ratio Efficient frontier
Return
Sharpe Ratio  Relevant risk is variance.

Market portfolio  Relevant reward is excess

Market Excess Return return. The return over
Risk free the risk-free rate
Market Risk Risk
 High Sharpe ratios are
indications of more
𝑟 −𝑟 efficient portfolios, or
𝑠𝑟 = skilled managers
𝜎
(positive alpha) or both.

 Sharpe ratios differs

between asset classes…

21
 OPTIMAL PORTFOLIOS AND SHARPE RATIOS
Expected
Portfolio
Return Efficient frontier
“High Risk”
“Low” Sharpe Ratio
Portfolio
Portfolio “High Risk”
“Medium Risk”

Portfolio
“Medium Risk”
“Medium” Sharpe Ratio

Portfolio
“Low Risk”
Portfolio
“Low Risk”
Risk “High” Sharpe Ratio
Weight (%)

100 %
Portfolio
“Low Risk”

T-bills
Gvt. Bonds
0% Corp. Bonds
Low Risk High Risk Equities

22
 OPTIMAL PORTFOLIOS AND SHARPE RATIOS
Expected
“High” Sharpe  Sharpe Ratio measures the efficiency of the
Return
“Medium” Sharpe investment.
“Low” Sharpe
Portfolio
Portfolio “High Risk”  In the figure we have three fixed income
“Medium Risk” low risk portfolios:
A) Efficient good portfolio
B) Mediocre portfolio
Portfolio
“Low Risk” Efficient good portfolio C) Poor portfolio

Mediocre portfolio  Note that the Sharpe ratio of the mediocre

Risk free rate Poor portfolio portfolio is equivalent to the Sharpe ratio
of the efficient “medium” risk portfolio,
which is a good portfolio.
Risk

 Note that the Sharpe ratio of the poor

fixed income portfolio is equivalent to the
Share ratio of the efficient high-risk
portfolio.
 Sharpe ratios differs between asset classes.

23
 OPTIMAL PORTFOLIOS AND SHARPE RATIOS
Expected
“High” Sharpe  Often investors have a target return. This is
Return
“Medium” Sharpe almost always the case with institutional
“Low” Sharpe
Portfolio investors, such as pension funds
Portfolio “High Risk” endowments, insurance companies etc.…
“Medium Risk”
Target Return  In the case of a target return the investor
will not choose an aggregated portfolio
Portfolio that have an expected return below the
“Low Risk” Efficient good portfolio target return even though these portfolios
have a higher Sharpe ratio
Mediocre portfolio
Risk free rate Poor portfolio  In practice an investor will/should maximize
the Sharpe ratio of the overall portfolio
Risk and the portfolio managers within the
portfolio, high Sharpe fixed income
manager, high Sharpe corporate bond
manger and high Sharpe equity manager.
 In practice Sharpe ratios is mostly used to
compare investment within asset classes…

24
INTUITION OF SHARPE RATIO
 In theory an investor should pick the
portfolio with the highest Sharpe
ratio, the market portfolio
Expected  In theory the investor should invest
Efficient frontier Capital Market along the Capital Market Line
Return
Line
 In theory the investor should choose a
Sharpe Ratio linear combination of a risk-free
asset and the market portfolio to
match the investors risk preference or
Market Return Market portfolio by borrowing money and invest in the
market portfolio, i.e. leverage the
Risk free
market portfolio…
 In practice the institutional investors
are often restricted from using
leverage, so this is not a feasible
Market Risk Risk solution.
 Institutional investors can invest in
long/short strategies via Hedge
funds. Institutional investors are also
allowed to hedge risk exposure.

25
 CAPITAL ASSET PRICING MODEL
• All return based performance
In CAPM we expect the portfolio return to be a linear combination measures build on Modern Portfolio
of the risk free rate and an risk compensation for bearing non Theory (MPT) or Post-Modern Portfolio
diversifiable market risk. Theory (PMPT)
𝐸 𝑟 =𝑟 +𝛽 𝑟 −𝑟 • Relevant risk is non-diversifiable risk,
beta
Ex post CAPM can be tested by running the following OLS
regression. • Relevant reward is excess return.
𝑟 −𝑟 =𝛼 +𝛽 𝑟 −𝑟 +𝜀 • A positive alpha is interpreted as
manager skill
In practice the market portfolio is unknown and replaced with a
benchmark portfolio. • A negative alpha is interpreted as an
𝑟 −𝑟 =𝛼 +𝛽 𝑟 −𝑟 +𝜀 unskilled manager

Where the portfolios realized non-diversifiable benchmark risk, • Alpha is also model miss-specification
Beta, is defined as: • A negative alpha can also be
explained by the managers cost
𝑐𝑜𝑣(𝑟 , 𝑟 structure
𝛽 =
𝑣𝑎𝑟(𝑟 )

26
 SECURITY MARKET LINE (CAPM) AND TREYNOR RATIO
• Treynor Ratio measures the
reward per unit of non-
diversifiable risk, beta.
Expected
Return Security Market Line • Relevant risk is non-diversifiable
risk, beta.
Treynor Ratio
• Relevant reward is excess return.
The return over the risk-free rate.
Market Return Market portfolio
• High Traynor ratios are indications
of more efficient portfolios, or
Risk free skilled managers (positive alpha)
or both.
• Treynor ratios depends on the
choice of market portfolio, Hence,
Beta =1: Market Risk Risk Treynor ratios are benchmark
𝑟 −𝑟
𝑡𝑟 = specific and not widely used in
𝛽 practice…

27
INTUITION OF TREYNOR RATIO

Expected
Excess Security Market Line
Return
Higher Treynor Ratio

Market portfolio

Treynor Ratio

Market Risk Premia

(Excess return)

Beta =1: Market Risk Risk

28
 TRACKING ERROR, ALPHA AND INFORMATION RATIO
• Return based performance measure is
CAPM on portfolio-benchmark level usually measured using 36 months of
data
𝑟 −𝑟 =𝛼 +𝛽 𝑟 −𝑟 +𝜀
We can rewrite the models miss specification as: • Monthly data is more stable than daily
data (less noise)
𝑟 −𝑟 −𝛽 𝑟 −𝑟 =𝛼 +𝜀
The volatility of the estimation error is called Tracking Error. • The advantage is that managers are
evaluated based on their market
𝑇𝑟𝑎𝑐𝑘𝑖𝑛𝑔 𝐸𝑟𝑟𝑜𝑟 = 𝑉𝑜𝑙 𝜀 =𝜎 (benchmark) risk exposure
The statistical significance of alpha can be tested with a t-test:
𝛼 −𝛼 • Tracking error is also called active risk
𝑡 − 𝑠𝑡𝑎𝑡 =
𝜎
• An index manager (passive manager)
𝑛
should have a low tracking error
Where n is the number of observations.
The performance return (alpha) per unit of active risk (tracking • An active manager should have a high
error) is expressed by the Information Ratio: tracking error
𝛼
𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜(𝐼𝑅) =
𝜎 • IR measures the managers active skill
29
 ACTIVE SHARE, TRACKING ERROR AND INVESTMENT PROCESS
Combining the information from a portfolio managers
active share with the portfolio managers tracking
Different Types of Active Management error gives an insight into the managers investment
Active Share process (Cremers and Petajisto)

High Concentrated
Diversified Purpose:
stock picks stock picks
Identify the investment process. Is the manager true to
the investments process?

Closet indexing, Closet indexing:

Enhanced indexing
Factor bets / Closet indexing are investment processes being
alternative beta marketed as active managers when in practice the
Low investment process is better described as “enhanced
0
Pure indexing indexing”. Usually there is a price difference
0 Low High between enhanced indexing (low price) vs closet
indexing being sold as active strategy (high price).
Tracking Error

Sources: Cremers and Petajisto (2009), GrafCap AB Hence, there is an ongoing debate concerning closet
Comment: This is an illustrative figure. indexing and active managers. This has resulted in
Active Share being a regulatory official metric to be
disclosed by asset managers. 30
 ARBITRAGE PRICING THEORY MODEL (APT)
• The Arbitrage Pricing model is a
Arbitrage Pricing Theory model multifactor model.
R = a+BF + 𝜀
• The model is the basis behind BARRA.
Assumptions BARRA is a software that is widely
used in portfolio management and
portfolio construction.
𝐸 𝜀 =0,
• The models specify additional risk
𝐸 𝜀 𝜀 =Σ, factors than market risk…
𝐸 F =𝜇 ,
• Macro factors such as inflation, interest
rates, etc. …
𝐸 F −𝜇 F −𝜇 =Ω ,

𝐶𝑜𝑣 F , 𝜀 = 0, ∀𝑘, ∀𝑖, • Can you predict/construct portfolios

using Macro factors?

31
 RETURN BASED STYLE ANALYSIS
• Sharpe’s Return Based Style Analysis,
Return Based Style Analysis Sharpe (1992), uses the past returns of
a portfolio manager regressed on a
R = a+BF + 𝜀 set of benchmarks.
Assumptions are often
• The intercept alpha is referred to as
0 ≤ 𝛽 ≤ 1, selection return. Think of selection
return as a tougher alpha…
𝛽 = 1.
• In practice the model uses a 36-month
Hence, the betas can be interpreted as portfolio weights. rolling regression. Hence, the style
analysis captures the (smoothed)
dynamics of the portfolio managers
investment strategy.

32
MANGER SELECTION: IS THERE A DIFFERENCE?
Passive manager Active manager

33
MANGER SELECTION: IS THERE A DIFFERENCE?
Passive manager Active manager

34
WHAT IS THE DRIVER: ALPHA, BETA OR BOTH?

Equity return can be explained by known factors:

1. Market risk
2. Size
3. Valuation
4. Momentum

The remaining part is often denoted Alpha or Selection return or

Manager skill.

If return is explained with the Capital Asset Pricing Model, CAPM, the
effect of Size, Valuation and Momentum will turn up as (traditional) alpha.

35
THE FAMA-FRENCH-CARHART FACTOR MODEL

Return can be explained by Post Modern Portfolio theory:

𝑟, = 𝛼 +𝛽 𝑅𝑀𝑅𝐹 + 𝛽 𝐻𝑀𝐿 + 𝛽 𝑆𝑀𝐵 + 𝛽 𝑈𝑀𝐷 + 𝜀 ,

Constant, Market Value: Size: Momentum:

intercept, excess High Small Up minus
alpha… return minus minus Down
Low Big
Note that there is an extensive literature on new “risk factors”. These risk factors
are often referred to as “Smart Beta” and “Alternative Risk Premium”(ARP).

36
FACTORS EXPLAINED…

37
 THE FAMA-FRENCH FIVE-FACTOR MODEL

Return can be explained by Post Modern Portfolio theory:

𝑟, = 𝛼 +𝛽 𝑅𝑀𝑅𝐹 + 𝛽 𝐻𝑀𝐿 + 𝛽 𝑆𝑀𝐵 + 𝛽 𝑈𝑀𝐷 + 𝛽 𝑅𝑀𝑊 + 𝛽 𝐶𝑀𝐴 + 𝜀 ,

Constant, Market Value: Size: Momentum: Profitability: Investment:

intercept, excess High Small Up minus Robust minus Conservative
alpha… return minus minus Down weak minus
Low Big Aggressive

Note that there is an extensive literature on new “risk factors”. These risk
factors are often referred to as “Smart Beta” and “Alternative Risk
Premium”(ARP).

38
 EX: EXTENSION OF THE FAMA-FRENCH FIVE-FACTOR MODEL

The Fama-French-Carhart model can be extended to incorporate additional

factors:
𝑟,
=𝛼 +𝛽 𝑅𝑀𝑅𝐹 + 𝛽 𝐻𝑀𝐿 + 𝛽 𝑆𝑀𝐵 + ⋯ + 𝛽 𝑇𝐸𝑅𝑀 + 𝛽 𝐷𝐸𝐹 + 𝜀 ,

Constant, Market Value: Size: Term structure: Default/Credit:

intercept, excess High Small
alpha… return minus minus
Low Big
The above model includes a term structure and a credit factor and can be
employed to evaluate equity, balanced and fixed income managers…

39
THE DRIVERS OF INVESTMENT RETURNS

40
 WHAT IF RETURNS ARE NOT NORMAL AND SKEWED?
• Post Modern Portfolio Theory focuses
on Down side risk and factors.

• Risk is often a return below a specific

return target or wealth below a
specific wealth target.

Source: Keating and Shadwick 2002

41
 POST MODERN PORTFOLIO THEORY: DOWN SIDE RISK

Cumulative probability distribution and loss target

Source: Keating and Shadwick 2002

42
 POST MODERN PORTFOLIO THEORY: DOWN SIDE RISK
• Increasing focus on non-normal
Semi-Deviation, Down Side Volatility distributions.

𝑆𝐷 = 𝔼 𝑟 − 𝔼 𝑟 I 𝔼 • Semi Deviation, Down side risk, Lower

Where Partial Moments focuses on the loss
distributions.
1, 𝑟 ≤𝐸 𝑟
I 𝔼 =
0, 𝑟 >𝐸 𝑟 • Can be used as a below target return
and is often indirectly used by
Below target semi deviation, below target down side volatility insurance companies.
𝑇𝑆𝐷 = 𝔼 𝑟 − T I
• In practice Sortino ratio is used as an
alternative to Sharpe ratio: Excess
Sortino ratio return divided by Down side volatility
𝑟 −𝑟 (down side risk).
𝑠𝑟 =
𝑆𝐷
• A similar regulatory driven spin-off is
excess return divided by capital
requirements.

43
EUROPEAN SYSTEM FOR FINANCIAL STABILITY

Pillar 1:
ESRB
Financial
European
Macro
Systematic Risk
Stability Risk
Board

EBA EIOPA ESMA

Pillar 2:
European European European
Financial Micro
Banking Insurance and Security
Stability Risk
Authority Occupational and
Pensions Markets
Authority Authority

Source: Andreas Graflund, GrafCap AB.

44
 SUSTAINABLE INVESTMENT: EU DEFINITION
“Sustainable investment’ means an investment in an economic activity
that contributes to an environmental objective, as measured, for
example, by key resource efficiency indicators on the use of: energy,
renewable energy, raw materials, water and land, on the production of
waste, and greenhouse gas emissions, or on its impact on biodiversity
and the circular economy, or an investment in an economic activity that
contributes to a social objective, in particular an investment that
contributes to tackling inequality or that fosters social cohesion, social
integration and labour relations, or an investment in human capital or
economically or socially disadvantaged communities, provided that such
investments do not significantly harm any of those objectives and that
the investee companies follow good governance practices, in particular
with respect to sound management structures, employee relations,
remuneration of staff and tax compliance”.
Source: Regulation (EU) 2019/2088 ”on sustainability-related disclosures in the financial services sector” Art. 2(17)

45
 The EU Sustainable Finance Disclosure Regulation (SFDR)
Non-Sustainable funds. Environmental and socially Products targeting sustainable
promoting funds. investments.
No sustainability investment focus “ESG” funds “Impact” funds
SFDR Article 6 SFDR Article 9
SFDR Article 8
Funds with no integration of any
kind of sustainability into the Applies “… where a financial Covers products targeting
investment process. product promotes, among other bespoke sustainable investments
Funds need to state Y/N if the characteristics, environmental or and applies “… where a financial
find sustainability risks to be product has sustainable investment
relevant. social characteristics, or a
The investments can include stocks combination of those as its objective and an index has
excluded by ESG funds such as characteristics, provided that the been designated as a reference
fossils, tobacco and weapons. companies in which the investments benchmark.
Funds that fall under SDFR 6 has are made follow good
to be labeled non-sustainable to governance practices.”
be marketed within EU.

Sources: Andreas Graflund, GrafCap AB, and Regulation (EU) 2019/2088 ”on sustainability-related disclosures in the financial services sector”.

46
The EU Sustainable Finance Disclosure Regulation (SFDR)
The SDFR reporting forces fund mangers to actively
Investment universe and SFDR classification engage and to revise the funds investment strategy. A
non sustainable fund, SDFR art 6, with no
consideration of sustainability risk has the largest
investment universe.
Non-sustainable
funds. Impact SDFR 9 and ESG SDFR 8 funds have a stricter
SDFR reporting requirements.
“ESG" funds
Art 6
SFDR Art 8 A funds investments strategy is monitored by the
Financial Supervision Authority (FSA).
In Europe the 27 member states FSA:s are
coordinated and report to ESMA.
“Impact”
funds SDFR Non-compliance with the stated investments strategy
Art 9 can lead to fines, reclassification and removal of
marketing approval.
Asset managers, Independent Financial Advisors,
Source: GrafCap AB Banks, Insurance companies, Pension schemes based
within EEA have to asses and report on ESG.

47
 The SFDR classification of mutual funds and AIF in Sweden, June 21
The SDFR classification came into force in March
The SFDR classification of mutual funds and AIF in Sweden 2021. Asset managers need to report on 1st January
2022. Regulatory Technical Standards (RTS) are
1,50%
delayed and will be published in June 2022.
5,50%
The RTS include holding based calculations/formulas
for calculation, carbon, social, governance and
19,10%
environmental impact.
The pie chart shows the classification of the total
universe mutual and alternative investment funds
Art 6 SFRD: Non-relevant sust. risks managed in Sweden, 785 funds from 69 asset
73,90% Art 6 SFRD: Rel. sust. risks managers.
Art 8 SFRD: "ESG"
More than 75 pct are classifies as “green” (SDFR Art
Art 9 SFRD: "Impact"
8 and art 9). If we measured Asset under
Management (AuM) the number is likely to be higher.
The grey funds are most likely AIF (hedge funds) and
specialist funds.
Source: www.fi.se and GrafCap AB

48
 EU CLIMATE BENCHMARKS
“EU Climate Transition Benchmarks can be
EU Climate Transition Benchmark ‘EU CTB’ perceived as tools to "accompany" the
An 'EU Climate Transition Benchmark' means a benchmark that is labelled transition to a low-carbon economy.
as an EU Climate Transition Benchmark where the underlying assets are
EU Paris Aligned Benchmarks can be
selected, weighted or excluded in such a manner that the resulting benchmark perceived as tools for investors at the
portfolio is on a decarbonisation trajectory and is also constructed in forefront of the transition, favouring today
the players of tomorrow's economy.”
accordance with the minimum standards laid down in the delegated acts.
EU Paris-aligned Benchmark ‘EU PaB’ Source: EU Technical Expert Group on Sustainable
Finance.
An 'EU Paris-aligned Benchmark' means a 'benchmark that is labelled as an
EU Paris-aligned Benchmark where the underlying assets are selected in such
a manner that the resulting benchmark portfolio's GHG emissions are aligned
with the long-term global warming target of the Paris Climate Agreement and
is also constructed in accordance with the minimum standards laid down in the
delegated acts'.

Sources: GrafCap AB, and EU Technical Expert Group on Sustainable Finance,

https://ec.europa.eu/info/sites/default/files/business_economy_euro/events/documents/finance-events-190624-presentation-climate-
benchmarks_en.pdf.

49
EU Recommendations for climate benchmarks: Minimum Standards

Comments: GHG is the abbreviation of Green House Gases.

Source: EU Technical Expert Group on Sustainable Finance,

https://ec.europa.eu/info/sites/default/files/business_economy_euro/events/documents/finance-events-190624-presentation-climate-
benchmarks_en.pdf.

50
 EU Sustainable Benchmark Mandates
In-Scope Out-of-scope

Main asset classes  Interest rate benchmarks

 Listed equities  Currency benchmarks
 Corporate credit
 Sovereigns, supranationals and agencies

Other asset classes

 Private debt, Infrastructure
 Private Equities
 Hedge funds
 Commodities

Sources: GrafCap AB, and EU Technical Expert Group on Sustainable Finance,

https://ec.europa.eu/info/sites/default/files/business_economy_euro/events/documents/finance-events-190624-presentation-climate-
benchmarks_en.pdf.

51
GOING GREEN: HOW FACTORS CAN BE USED IN THE INVESTMENT PROCESS
The investment strategy can be tailored to deliver
Investment universe and investment strategy expected performance given investments restrictions.
The investment restriction are often:
• Asset classes.
• Region.
Investment
• Environment, social, sustainability, governance,
universe ethical etc…
Feasible
• Portfolio turnover.
Investment
universe, ex ESG • Tracking error.
screened… Purpose:
Factor bets / Create a high performance investment process given
the investment restrictions.
strategies
In practice
Investment process is internal and proprietary. Internal
evaluation of the investment process and contributions.
Source: GrafCap AB External valuation of investment process and
comparison to peer group by clients, consultants,
rating companies such as Morningstar.
52
 ADVANCED MODELS

1. Valuation: Investment strategy (and hedge fund) valuation using

Multifactor (linear) models of linear and non-linear factors
2. Replication/Cloning: Investment strategy (and hedge fund) replication
using Multifactor (linear) models of linear and non-linear factors, also
called cloning strategies…
3. Risk Management: Multifactor models can be used for “proxy” hedging
of risk.
4. Time varying factors: Increasing focus on time variation and non-linear
factors such as time varying down side risk and time varying down side
beta.
5. Portfolio and tailored benchmark construction: Estimation, selection and
portfolio and tailored benchmark construction using factors including ESG.
6. Alternative Risk Premia (ARP): Construction of beta neutral alternative
beta factor portfolios.

53
 CO N TACT I N FO RM ATI O N :

ANDREAS GRAFLUND
LinkedIN, Phone +46 733 65 65 67, E-mail: [email protected]
DISCLOSURE AND DISCLAIMER
DISCLAIMER

This material has been produced for co-workers at professional investors, professional institutions and within academia as a request for proposal. The
material is solely based on information accessible to GrafCap AB provided by the Client, You.

GrafCap AB does not accept any liability for the correctness, accuracy or completeness of the information in the material nor the services provided in an
insourcing agreement. In an insourcing agreement where GrafCap AB provides services the liability, accuracy and the quality assessment lies within the client
organisation.

Recommendations are not to be considered as offers to buy or sell the securities in question, and GrafCap AB or any representatives of GrafCap AB does not
accept no liability for transactions based on information presented in the material.

Information on previous returns, simulated previous returns or future returns presented in the material cannot be used as a reliable indicator of future returns,
and returns may be negative. Information on price developments presented in this material cannot be used as a reliable indicator of future price
developments, and price developments may be negative. If the material contains information on a specific tax treatment, it should be borne in mind that the
tax treatment depends on the investor's individual situation and may change in future. If the material contains information based on gross returns, however,
fees, commissions and other costs may reduce returns.

The material may not be reproduced or distributed.

Investment research and marketing material

Recommendations to the public or distribution channels concerning financial instruments not produced by the author is treated as education material and
marketing material. The material will be marked “education material" or “marketing material” and should not be considered as investment research, for
which reason no prohibition applies to trading in financial instruments referred to in the material prior to distribution.

55