how useful are risk premia ? a practitioner’s perspective
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How Useful are Risk Premia ? A Practitioner’s Perspective. September 2009 Roland Rousseau Independent Consultant Quantitative Investment Strategy and Portfolio Construction Research. “Daddy, Where do Excess Returns Come from?”. - PowerPoint PPT PresentationTRANSCRIPT
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How Useful are Risk Premia?A Practitioner’s Perspective...
September 2009
Roland Rousseau
Independent ConsultantQuantitative Investment Strategy and Portfolio Construction Research
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“Daddy, Where do Excess Returns Come from?”
-> skill is the residual excess-return, after all RELEVANT beta excess-returns have been accounted for
-> Excess returns come primarily from excess risk, not skill!
-> Imagine a world without alpha. How would you invest?
Return = risk free rate +Exposure x Equity factorExposure x Bond factorExposure x Currency factorExposure x Commodity factorExposure x Emerging Market factorExposure x Value factor
Exposure x Equity factorExposure x Bond factorExposure x Currency factorExposure x Commodity factorExposure x Emerging Market factorExposure x Value factor
uncorrelatedexcess skill fromfund manager
+
Source: Roland Rousseau
10% = 2% + 7% + 1%
Return = + risk (b) + skill (a)risk freerate
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Risk Premium vs Risk FactorRisk-Factoreg volatility, interest rates
Retu
rn Q
ualit
y, a
bilit
y to
’pre
dict
/mod
el’
Risk-Factors- Interest rates- Currency- Inflation- Volatility Risk-Premia- Equity, Bonds, Credit Risk- Event, Structural Risk- Liquidity Risk- Emerging Markets- Property, Art, Wine, Timber
Accounting Risk-premia- Book-to-Market Ratio- Cash-Flow to Price
Behavioural Risk-Premia- Momentum- Price Reversals- Earnings surprises/revisions
Risk-Premiumeg. value, momentum, emerging mkts, small caps
Why is eg. Value considered a risk-premium?
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How can we beat the following balanced-fund benchmark without skill:60% Equity, 30% Bonds, 10% Cash?
How can we beat the S&P 500 without skill?
How can we beat the MSCI World Index without skill?
Overweight value stocks or small caps – VRP 3-5%pa
Overweight Emerging Markets – EMRP 2-5% pa
Overweight Equities – ERP 3-6% pa
Are We Using the Right Benchmarks?Is it Skill or just Excess Risk?
Industry realisation: single-factor benchmarks like common indices (eg S&P 500, MSCI etc) are insufficient in a multi-factor world.
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Portfolio
Exce
ss R
etur
n
The New Industry FocusExcess Returns in addition to Alpha – Modular Portfolio Construction
Scalability, transparency and lower cost are driving the interest in new types of beta risk premia
Risk-Premium (long-only)-> Fama and French, Carhart 4-factor model, Barra
bRP
Primitive Trading Strategies - PTS (long-short)-> Merger Arbitrage, long/short equity, Man. Futures
bAlt
Alpha from long-only and long-short strategiesa
Asset Class/Risk Factor Betas (Long-only)-> emerging markets, bonds, commodities, property
bT
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Portable Beta Example (FTSE)
Source: FTSE, CS Tremont, Roland Rousseau
Using FTSE Value vs Growth Risk Premia…
Risk premia are extremely valuable sources of excess return and don’t require any skill…
0
50
100
150
200
250
1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Credit Suisse - Tremont, FTSE, Deutsche Bank calculations* dollar neutral returns (without costs) - no active management+ since inception 1999 (Investable index since inception 2003)
FTSE World Index
Risk-free proxy:US 10yr bond
CS Tremont - Market NeutralHedge Fund Index+
Long FTSE World ValueShort FTSE World Growth*
Option 1: use HF alpha asexcess return for portable alpha
Option 2: use beta risk premia asexcess return for portable beta
0
50
100
150
200
250
1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Credit Suisse - Tremont, FTSE, Deutsche Bank calculations* dollar neutral returns (without costs) - no active management+ since inception 1999 (Investable index since inception 2003)
FTSE World Index
Risk-free proxy:US 10yr bond
CS Tremont - Market NeutralHedge Fund Index+
Long FTSE World ValueShort FTSE World Growth*
Option 1: use HF alpha asexcess return for portable alpha
Option 2: use beta risk premia asexcess return for portable beta
Requiresno active
skill
Requiresactive skill
The reliability of the value risk premium is high:“Value stocks have higher returns than growth stocks
in markets around the world. For 1975-1995, the differencebetween average returns on global portfolios for high and
low book-to-market stocks is 7.60% per year and valuestocks outperform growth stocks in 12 of 13
major markets.” – Fama, French 1996
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‘Predicting‘ the Behaviour of Asset ClassesHow Predictable is the FTSE All World Index?
Source: FTSE, Roland Rousseau
y = 0.0296x + 0.0083
-20%
-15%
-10%
-5%
0%
5%
10%
15%
-20% -15% -10% -5% 0% 5% 10% 15%
Return (t)
Ret
urn
(t+1)
Correlation 0.03Correlation 0.03
Naive Test:Serial Correlation
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y = 0.0296x + 0.0083-10%
-5%
0%
5%
10%
15%
-10% -5% 0% 5% 10% 15%
Return (t)
Ret
urn
(t+1)
Correlation 0.20
‘Predicting‘ the Behaviour of Risk Premia
Source: FTSE, Roland Rousseau
Correlation 0.20
How Predictable is Long FTSE World Value, Short FTSE World Growth?
InformationCoefficient = 0.20!
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Example: The Legg Mason Primary Value Fund is one of the most successful active funds in the world and has outperformed the S&P500 for 13 years in a row.Dartmouth College lets its students, as part of their education, analyse how much the Legg Mason fund’s return variability comes from value, size and market risk. Their conclusion is: “The high returns are associated with the fund’s extreme exposure to small-cap and value risk rather than the skill of the manager. The three factors explain all but 8% of the variation in historical returns.” So 92% of the returns’ variability come from just 3 factors!
It is not about replication. It is about risk management and smarter portfolio construction and benchmarking. Fung: Alternative Beta is the most appropriate way to benchmark alternative investments.
Agarwal and Naik (2004) as well as Fung and Hsieh (2006) applied Sharpe’s style-based research to HF styles. They find that (small-cap – large-cap) + (credit spread) + long S&P 500 = 80% of aggregate long/short HF return variability
Risk-Premia Drive Active Portfolios!Risk Factors and Premia drive the majority of active return variability
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2001
-1-1
2001
-5-1
2001
-9-1
2002
-1-1
2002
-5-1
2002
-9-1
2003
-1-1
2003
-5-1
2003
-9-1
2004
-1-1
2004
-5-1
2004
-9-1
2005
-1-1
2005
-5-1
2005
-9-1
2006
-1-1
2006
-5-1
2006
-9-1
Date
Styl
e W
eigh
t
Historic breakdown of DOEQ returns using only few building blocksOut-of-sample Style Breakdown
ACI Domestic Equity Funds 91%
Allan Gray Equity Fund 87%Coronation Equity Fund 89%Investec Equity Fund 87%African Harvest Equity 89%Oasis Gen Equity Fund 82%OM Investors Fund 92%Prudential Equity Fund 85%
Conclusion: only ±10% of thevariability in portfolio returnsis due to manager stockselection skillSource: Proprietary Research
RESIINDI
FINI
Momentum
Value and Small Caps
Source: van Rensburg and Yu
The DNA of Portfolio ReturnsBlending Risk Factors and Risk Premia
Risk allocation drives portfolio returns, not skill. They are the DNA of portfolio returns.
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Summary:The key uses of Risk Premia (RP)- Without RP, we cannot even benchmark alpha (both long-only and long-short)! traditional equity indices, cash, CPI+x% are inadequate benchmarks in a multi-factor world
- Well-defined risk premia make excellent cheaper core-portfolio investments- RP are highly correlated to active portfolios and therefore provide new ways to construct portfolios in an ‘active-risk’ manner- RP are being listed and made tradable. They can be priced and hedged now!- Without RP, there would no point in investing! They are the DNA of portfolio returns- Investing is primarily about risk allocation, not finding alpha skill
How Useful are Risk Premia?They are the DNA of all active portfolios