portfolio of risk premia: a new approach to diversification march 20, 2009 dan stefek, managing...

Portfolio of Risk Premia: A New Approach to DiversificationPortfolio of Risk Premia: A New Approach to Diversification

March 20, 2009

Dan Stefek, Managing Director, Research

1

© 2009. All rights reserved.© 2009. All rights reserved.

A significant portion of investment return arises from exposure (beta) to different sources of systematic risk and return

There is a growing interest in implementing investment views through exposures to these sources of return at low cost

In this session, we:

Review a range of risk premia that may be captured by rules-based indices

Examine the return and risk profiles of these sources of return

Illustrate their potential use in asset allocation

2

OverviewOverview


Traditional Beta captures broad asset class risk premia

Style Beta captures the systematic return to specific investment dimensions

Strategy Beta captures systematic return to trading strategies

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Return Equals Betas Plus AlphaReturn Equals Betas Plus Alpha

Return =Traditional

Beta+ Style Beta +

Strategy Beta

+ Alpha


This framework can be expanded to include alternative asset classes such as commodities and real estate, as well as additional strategies such as volatility arbitrage

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Examples of Sources of Systematic Risk and Return Examples of Sources of Systematic Risk and Return

Asset Class Traditional Beta Style Beta Strategy Beta

Size Merger Arbitrage

Value

Momentum

Credit Spread

High Yield SpreadConvertible Arbitrage

Term Structure Spread

Carry Trade

Momentum

Value

Equity

Fixed Income

Currency

Broad Equity Markets

Broad FI Markets


Historically, style and traditional betas were bundled together in investment vehicles.

Recently, there has been interest in isolating exposures to individual sources of return and capturing the return to that exposure in investment offerings.

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Capturing Style PremiaCapturing Style Premia

Market Market

GrowthValue

=Market Market

GrowthValue

-Value Growth

-


Define and maintain eligible universe

Create trades

Assume

Borrowing costs of 25 bps

Short Interest: Libor -25 bps

Equally weight and rebalance monthly

6

Capturing Strategy Risk Premia: Convertible ArbitrageCapturing Strategy Risk Premia: Convertible Arbitrage

ConvertibleUnderlying

Stock -


For the purposes of illustration, style and strategy indices are constructed as simple combinations of long and short positions and cash

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Ways of Capturing Risk Premia - An IllustrationWays of Capturing Risk Premia - An Illustration

Risk premium

Traditional beta Equity exposureFixed income exposure

Long position Short position

Style beta Value MSCI World Value MSCI World GrowthSize AC World Small Cap AC World Large CapMomentum Simulated MSCI World Momentum MSCI WorldCredit Spread Lehman US Agg. Corporate (AAA) Lehman US Agg. GovernmentHigh Yield Spread ML High Yield US Corporate ML High Quality US CorporateTerm Spread SB US Gov 10+ years SB US Gov Bond 1-3 years

Strategy beta Merger Arbitrage Targets AcquirersConvertible Arbitrage Convertible Bond Underlying stockCarry Trade 3 highest interest rate G10 currencies 3 lowest interest rate G10 currenciesCurrency Value 3 most undervalued G10 currencies 3 most overvalued G10 currenciesCurrency Momentum 3 best performing G10 currencies 3 worst performing G10 currencies

Definition

MSCI EAFE, MSCI Japan, MSCI USA, MSCI EMLehman US Aggregate Index

© 2009. All rights reserved.8

Risk and Return Profiles of Selected Risk PremiaRisk and Return Profiles of Selected Risk Premia

Monthly data from May 1995 through October 2008* MSCI HFI Merger Arbitrage before 2003, afterwards as simulated Merger Arbitrage index

** MSCI HFI Convertible Arbitrage before 2003, afterwards as simulated Convertible Arbitrage index*** Merrill Lynch Domestic Master follows the US dollar denominated investment grade Public Corporate and Government Debt

Style / Strategy Beta Risk PremiumAnnualized Premium

Annualized Volatility

Sharpe RatioMaximum Drawdown

Style Value 1.6% 8.3% 0.20 -30.0%Size 0.6% 7.7% 0.08 -38.4%Momentum 0.9% 10.3% 0.09 -40.1%Credit Spread 0.3% 1.4% 0.18 -5.2%High Yield Spread -0.6% 7.3% (0.08) -33.2%Term Spread 2.8% 7.3% 0.39 -12.8%

Strategy Merger Arbitrage* 3.2% 3.5% 0.92 -12.0%Convertible Arbitrage** 2.0% 6.4% 0.31 -31.2%Carry Trade 7.1% 8.7% 0.82 -26.6%Currency Value 5.7% 7.6% 0.76 -9.2%Currency Momentum 3.0% 9.4% 0.32 -21.9%

Asset-Class Beta Risk PremiumAnnualized Premium

Annualized Volatility

Sharpe RatioMaximum Drawdown

Equity MSCI EAFE 0.3% 15.9% 0.02 -54.0%MSCI Japan -5.4% 19.4% (0.28) -69.0%MSCI USA 3.4% 15.5% 0.22 -51.7%MSCI Emerging Markets 3.2% 24.6% 0.13 -61.2%

Bonds Merrill Lynch Domestic Master*** 1.7% 3.7% 0.46 -7.6%


Correlations of style and strategy premia – May 1995 through October 2008

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Correlations with Traditional Asset ClassesCorrelations with Traditional Asset Classes

Value Size MomCredit

SpreadHY

SpreadTerm

SpreadMerger

Arb.Conv. Arb.

Carry Trade

Curr. Value

Curr. Mom.

Value 1

Size 0.11 1 < 0.25

Momentum -0.47 0.15 1 > 0.50

Credit Spread 0.07 0.06 0.15 1

High Yield Spread 0.06 0.26 0.20 0.56 1

Term Spread -0.05 -0.02 0.18 0.04 -0.09 1

Merger Arbitrage -0.02 0.18 0.33 0.29 0.49 -0.12 1

Convertible Arbitrage -0.02 0.18 0.52 0.25 0.39 0.17 0.44 1

Carry Trade 0.00 0.10 0.35 0.41 0.45 0.08 0.37 0.58 1

Currency Value 0.10 -0.04 -0.19 0.20 0.20 -0.03 0.00 -0.20 0.32 1

Currency Momentum -0.10 -0.20 -0.14 -0.13 -0.26 0.01 -0.20 -0.20 -0.01 -0.05 1


Returns from May 1995 through October 2008

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Correlations with Traditional Asset ClassesCorrelations with Traditional Asset Classes

MSCI EAFE

MSCI Japan

MSCI USA MSCI EMML

Domestic Master

Value -0.14 -0.15 -0.17 -0.12 -0.05

Size 0.05 0.13 -0.17 0.21 -0.04

Momentum 0.35 0.06 0.07 0.12 0.06

Credit Spread 0.46 0.28 0.52 0.44 0.15

High Yield Spread 0.59 0.34 0.59 0.60 -0.23

Term Spread -0.18 -0.09 -0.14 -0.23 0.91

Merger Arbitrage 0.52 0.34 0.54 0.51 -0.10

Convertible Arbitrage 0.41 0.23 0.32 0.37 0.30

Carry Trade 0.37 0.12 0.38 0.44 0.12

Currency Value 0.00 -0.08 0.17 0.14 -0.07

Currency Momentum -0.21 -0.22 -0.13 -0.14 -0.03


To illustrate a possible use of strategy and style betas, we compare two asset allocation schemes

A traditional 60/40 equity-bond mix.

A simple equally-weighted mix of strategy and style indices rebalanced monthly.

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Asset Allocation – Case StudyAsset Allocation – Case Study

100120140160180200220240260280

60/40 Index Risk Premia Index

60/40 Index Risk Premia Index

Annualized Excess Return 2.2% 2.7%

Annualized Volatility 8.4% 2.8%

Sharpe Ratio 26.0% 94.4%

Maximum drawdown -30.6% -11.8%

© 2009. All rights reserved.© 2009. All rights reserved.12

Performance During Extreme MonthsPerformance During Extreme Months

Note: Excess Returns for the month

Event Asian Crisis LTCM 9/11Quant

meltdownFinancial

Cris is

Monthly Return in Oct-97 Aug-98 Sep-01 Aug-07 Oct-08

60/40 Index -3.0% -7.8% -5.0% 0.1% -8.4%

Risk Premia Index 0.1% -1.8% -1.9% -1.3% -4.5%

Value 2.3% -3.4% -1.0% -0.6% 0.9%

Size 1.4% -2.0% -4.0% -1.8% -4.2%

Momentum 0.2% -2.3% 1.2% -3.2% -18.9%

Credit Spread -0.1% -1.2% -0.5% -0.4% -1.9%

High Yield Spread -0.6% -5.6% -8.0% 0.1% -10.4%

Term Spread 2.6% 3.3% -0.7% 0.9% -4.1%

Convertible Arbitrage 0.6% -1.9% 0.5% -1.4% -14.4%

Merger Arbitrage 0.3% -5.0% -2.2% 0.3% -3.7%

Carry Trade -1.5% -1.9% -5.1% -4.6% -14.6%

Currency Value -2.2% -1.7% -5.2% 2.0% 7.3%

Currency Momentum -1.8% 2.2% 4.1% -5.3% 14.1%


The use of risk premia as diversifying building blocks of return holds promise

We’ve scratched the surface

13

SummarySummary


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RV0209


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RV0209

portfolio of risk premia: a new approach to diversification march 20, 2009 dan stefek, managing...

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