Recent investment returns have been extremely disappointing for nearly all fund members – especially those who believed their portfolio was diversified and well balanced. Unfolding events have emphasised the importance of focusing on risk premia as the basic building blocks of an investment portfolio, writes Tyndall/Suncorp Investment Management’s SIMON O’GRADY.
At its most simplistic level, a risk premium is payment over and above the risk-free rate (cash) as compensation for putting capital at risk. If there were no risk premia, then investors would have no incentive to take risk and would leave all their capital in cash. The existence of a risk premium is therefore a key element in the way in which capital markets work. Asset classes are aggregates of several risk premia and ongoing market turbulence has highlighted that the mainstream asset classes of equities, credit and property are all fundamentally linked to the same risk factor – corporate earnings – and therefore share a similar risk premium.
When an investor focuses on risk premia as portfolio building blocks, it can deliver a number of benefits, such as: • ensuring investors are highly risk aware and prompts them to ask the question: “where is the risk coming from?” • making investors explicitly examine the premium they are paid for each particular risk and whether that premium is high enough • highlighting the fact that risks are like insurance premia and are ‘fat-tailed’ (i.e. experience infrequent but large losses) • providing a framework in which to evaluate the performance of all investments and identify other valuable non-traditional risk premia.
Risk premia as insurance premiums Capital markets transfer capital risk from one party to another in return for a premium, and thus function as risk transfer mechanisms. Returns earned by an investor over and above the “risk free” rate are insurance premiums paid to the investor for risking capital instead of the borrower risking theirs. By understanding the world of investments as being the transferral of risk for a premium, it forces the first investment question to be: “what is the risk that an investor is taking and where does that risk come from?”.
It is only if, and when, this question has been answered that the second one can be asked: “is the investor being paid enough for taking that risk?”. Mainstream risk premia There are generally held to be four mainstream risk premia: 1. Interest rate term premium: Investing in longer-term bonds has historically generated a long-term premium over cash. This premium is called the ‘term premium’ or the ‘yield curve premium’ 2. Credit premium: Adjusted for duration, credit has historically generated a premium over cash.