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.

The lower the credit,
the higher the premium 3. Equity premium: The equity risk premium has averaged
about three or four per cent per annum for over one hundred years 4. Property
premium: Property has paid a long-term premium above cash. The key words with
all these premia are ‘averaged’ and ‘long-term’. While the premia exist and are
real, there is a frightening ride associated with them over time. Chart 1 shows
that equities have displayed a historic tendency going back over 100 years to
deliver returns of negative 30 per cent and up to negative 50 per cent in one
year out of seven. Property , cre dit an d equity risk premia As stated
previously, the asset classes of credit, property and equities all rely on a
similar underlying risk factor. When a company decides on its capital structure,
it decides on how much equity to issue versus credit (bonds).

Investors rightly
view owning equity as riskier than owning credit. This is because in the event
of liquidation, bond holders receive their money back before equity holders. The
key point though is that while owning the credit is less risky, it is the same
risk – both are dependent on the earnings of the company. In addition, if, in
an attempt to stave off bankruptcy, the company downsizes and reduces its need
for office space, pressure is put on property prices. Thus, equity, credit and
property are exposed to the same risk factor and share the same risk premium
through changes in corporate earnings – an issue that has been highlighted in
recent market conditions. Alternative premia In addition to mainstream premia there
are other alternative premia that are also systematic payments of a premium for
the transfer of risk. Another term for alternative premia is ‘alternative
beta’.

Alternative beta/premia are any sources of return that are able to be
replicated in a systematic and transparent manner – that is, insurancelike payments
for taking risk – and that currently lie outside the mainstream asset classes. Growing
deman d for alternative beta The credit crisis of 2008 and its fallout is
likely to give significant impetus to ‘alternative beta’ strategies as
investors recognise that they have been too reliant on the common sources of
risk premia in mainstream asset classes.

In addition, the crisis has pushed expected
risk premia of all forms to abnormally high levels, and the post-crisis, more
regulated, environment will likely offer higher rewards to investors who focus
on risk premia-based strategies. While hedge funds have traditionally provided
access to a range of alternative risk premia, a growing number of investment
managers believe that charging four percent per annum for exposure to what is
essentially a risk premium is excessive. They seek access to alternative
premia/beta at more cost- effective and transparent
levels. Two candidates for efficient sources of non-traditional premia are the
volatility and the currency carry premia.

Volatility premium The volatility risk premium is related to the more widely accepted
idea of the equity risk premium. While the equity risk premium refers to the
return an investor expects to gain on average in exchange for the possibility
that they may incur a loss, the volatility risk premium refers to the return an
investor expects to gain on average in exchange for the risk that volatility
may turn out to be higher than expected. The potential for this strategy to generate
investment returns is shown in Chart 2.

The top panel shows the historical one month
implied volatility and subsequent one month realised volatility for the S&P
500 Index from 1986 to 2008. The gap between implied and realised volatility is
shown in the second panel. On average, realised volatility has been lower than
implied volatility, confirming the existence of a volatility risk premium. Currency cary premium For many decades there has been a well
documented tendency for higher yielding currencies to depreciate less than
would be expected against lower yielding currencies over long periods of time.

This tendency is punctuated, like equities, by periods of extreme moves but is
nevertheless real, demonstrable and positive. In other words, countries with
higher yielding currencies are paying a premium for borrowing money from low
yielding currency countries over and above the interest rate differentials. Back to the basics – ris k premia an d
alternative beta Over the past year
investors have developed an aversion to risk, which itself has resulted in
increased investor interest in understanding more precisely what risk is in
their portfolios; the return (premium) for the risk; and the existence of non
traditional risk premia.

If there is a basic lesson to be learnt from the
present investment market chaos it is that effective investing should always
focus on risk premia as the basic building block rather than asset classes. A
priority for managers putting together diversified portfolios will be finding
more cost and risk-effective ways of accessing both traditional and alternative
premia in a more targeted fashion.

 

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