Harvesting risk premium
in equity investing
Active
Management
Harvesting risk premiums is a common investment strategy in fixed
income or foreign exchange investing. In equity investing it is still
rather new, but promising.
Dr. Klaus Teloeken
is CIO Systematic
Equity at Allianz Global
Investors.
Basu, S. (1977) Investment Performance of
Common Stocks in
Relation to their
Price-Earnings Ratios,
Journal of Finance
1
Rolf W. Banz (1981),
The Relationship
Between Market Value
and Return of Common
Stocks, Journal of Financial Economics
2
3
Jegadeesh, N. and
Titman (1993), Returns
to Buying Winners and
Selling Losers: Implications for Stock Market
Efficiency, Journal of
Finance
For institutional investors, harvesting risk premiums
is a common investment strategy. In asset classes
like fixed income or currencies, it is straightforward
for investors to think of investing in terms of harvesting risk premiums like the term premium or the
credit premium in fixed income, or the carry premium in “FX” (foreign exchange) trading.
Fixed income investors extend the duration of portfolios to capture the term premium in fixed income,
or add to corporates and high yields to earn the
credit premium. FX investors exploit the FX carry
premium by going long in high-yielding currencies,
and shorting low-yielding currencies. In all these
examples, investors take extra risks (duration risk,
credit risk, currency risk) and expect to be compensated for this extra risk by means of an extra return
potential – the risk premium.
For equity investors, however, thinking in terms of
equity risk premiums is still rather new. But risk premiums also exist here. Examples include the value
premium, the small cap premium or the momen-
tum premium. Value stocks, e. g. stocks with a low
price / book-ratio, are usually more risky, as value
stocks are typically less profitable, more leveraged
and more cyclical than other stocks.
The existence of all these risk premiums is well
documented in the academic literature. For
instance, Basu (1977)1 discovered that stock with
a low Price / Earnings ratio led stocks with a higher
Price / Earnings ratio on the NYSE. Banz (1981)2
described the size effect – small cap stocks outperform large cap names. Titman (1993)3 found the
momentum anomaly – stocks that led the market
over the last six to twelve months have a tendency
to continue to lead markets.
The existence of these risk premiums is documented
for all major investment regions, and over extended
time spans. And, based on our experience, there are
not too many patterns in investing that are as persistent as these risk premiums. Therefore, it does make
sense to explicitly build a portfolio around the idea
of harvesting these equity risk premiums.
Understand. Act.
Focus: Harvesting risk premium in equity investing
Implicitly, the performance of equity managers is
to a large extent explained by their exposures to a
few equity risk premiums anyway – and this is true
irrespective of whether the manager is aware of this
investment style exposure or not.
Chart 1: Where do active returns come from?
Empirical evidence
Active return decomposition of global
equity managers 1990 – 2013
2.5 %
Residual
2.0 %
Value
1.5 %
Active Returns
=
Momentum
1.0 %
0.5 %
Revisions
0.0 %
Growth Size Quality
– 0.5 %
Risk
Source: Allianz Global Investors, 31 July 2013
As the above performance decomposition based on
Mercer’s GIMD database shows, investment style risk
premiums are main drivers of active equity returns.
Index providers have reacted, and have recently
launched a whole series of indices that target these
risk premiums – under a variety of different labels
like smart beta indices, alternative beta indices or risk
premium indices.
As we are proponents of the idea of harvesting risk
premiums, we think these indices are a good start.
But we think investors can do better when it comes
to harvesting individual risk premiums than just
buying individual smart beta indices. Typical smart
beta indices are not designed to harvest the equity
risk premiums in the most efficient way for a client
portfolio, but are more designed as an easy-to-grasp
index methodology.
For example, simple value indices like the Research
Affiliates Fundamental Indices (RAFI) or the MSCI
value weighted indices are biased towards companies in financial disarray, but the value premium
can be earned more efficiently by avoiding these
companies. Minimum volatility indices like the MSCI
minimum volatility index, while targeting the low
volatility premium, leave the exposure to other risk
premiums like value or momentum largely unmanaged, which can result in adverse exposures to these
risk factors.
These examples demonstrate that, while smart
beta investing is a good starting point, investors
can do better in terms of capturing individual risk
premiums like value or low volatility. And investors
can also do better in terms of capturing multiple
risk premiums than just buying a multiple of smart
beta indices.
The reason is that just buying a multiple of smart
beta indices often leads to insufficient diversi­
fication.
However, diversification across multiple risk premiums is warranted. Many risk factors like value
or momentum have been very successful over the
longer term, but have also experienced significant
short-term drawdowns. For example, the value
investor had to endure a sharp decline in the run-up
to the TMT (technology, media and telecommunications) bubble, or as the financial crisis unfolded
in 2007. Similarly, the momentum investor suffered
from a painful setback after the burst of the TMT
bubble, or during the market recovery in 2009.
A diversified blend of the value and momentum
investment styles has earned the risk premiums
attached to these investment styles in a much more
stable way than each of the individual investment
styles.
2
Focus: Harvesting risk premium in equity investing
Chart 2: Investment style diversification is key to
stable performance
Hypothetical example: Relative performance of
investment styles for a global universe
exposures are unmanaged. This makes correlations
between smart beta indices rather unstable, and
hence renders an efficient diversification impossible.
For example, the correlation between the MSCI risk
premium indices for value and momentum shifts
over time. Most of the time, like today, the correlation of relative returns is negative, hence there
can be a substantial diversification advantage from
blending value with momentum.
120 %
100 %
80 %
60 %
40 %
20 %
0%
89 91 93 95 97 99 01 03 05 07 09 11 13
Momentum
Diversified Style Mix
Value
Source: Allianz Global Investors
Hypothetical example: Dec 1989 – Dec 2013 Historic simulation:
Monthly rebalancing, performance after transaction costs. Assumptions of the historic simulation: The chart above represents the relative performance of hypothetical portfolios with the investment
styles noted above using the success factors described on the
investment style pages in this presentation. Performance results for
hypothetical portfolios have certain inherent limitations. The results
do not reflect the results of trading in actual accounts or the material economic and market factors that could impact an investment
manager’s decision-making process. The performance figures are
before taxes and after transactions costs of 50bps, dividends are
reinvested. The model portfolio comprises approx. 150 stocks, all
overweighs in the portfolio are of equal size, underweights relative
to the benchmark are restricted to 1 %. No constraints are in place
with respect to sector or country deviations from the benchmark.
The strategy is rebalanced semi-annually, on average 50 % half turn
portfolio changes p.a. The relative performance of the strategy is
shown relative to a global investment universe that represents the
liquid investment opportunities over time. The performance of this
investment universe may differ from the performance of a benchmark like the MSCI World. Unless otherwise noted, performance
results and valuation presented are in U.S. Dollars.
The chart above is for illustration only. There is no guarantee that
these investment strategies and processes will be effective under
all market conditions and investors should evaluate their ability to
invest for a long-term based on their individual risk profile especially
during periods of downturn in the market. There is no assurance
that a portfolio will match the profits or losses shown, or that the
portfolio will be able to achieve the results of these hypothetical
portfolios.
Diversification is key
The chart underpins the fact that harvesting risk
premiums diversification across multiple risk factors has been key to stable performance. But investors can do better in terms of diversification across
multiple risk factors than just buying a multiple of
smart beta indices. Typical smart beta indices have
varying exposures to risk factors – to the targeted risk
factors, and also to non-targeted risk factors where
However, in prolonged cyclical value rallies like the
one from 2003 to 2007, value and momentum typically go hand in hand, and hence there is no diversification advantage left from blending value with
momentum. But diversification was badly needed at
the end of the value rally in 2008, as both value and
momentum stocks tanked as the global economy
grinded to a halt after the Lehman collapse.
However, for investors in these two MSCI risk premium indices there was nothing that could be done
to restore diversification; investors just had to accept
the loss of diversification. Smart beta indices like the
MSCI risk premium indices are simply not designed
with a view to a diversified combination with other
smart beta indices, but are designed as stand-alone
products.
A portfolio manager in an integrated portfolio
solution, though, can provide the proper diversification across multiple risk premiums by structuring
the individual risk premium portfolios with a view
towards the subsequent diversification across multiple risk premiums.
To do so, the portfolio manager should manage the
composition of the individual risk premium port­
folios in a way that allows stable mutual correlations,
and hence effective diversification. For example, if
the correlations between value and momentum are
becoming too high the portfolio manager will:
• put more weight on those value stocks that are
not also momentum stocks
• put more weight on those valuation criteria that
will have a lower correlation with momentum
factors
to effectively restore diversification between value
and momentum.
In addition to this, an integrated portfolio solution
not only achieves the proper diversification across
3
Focus: Harvesting risk premium in equity investing
multiple risk premiums, but also allows the successful mitigation of exposures to unwanted risk factors
like macro-economic or interest rate sensitivities that
stand in the way of harvesting the risk premiums in
a stable way, i. e., largely independent from the economic or market environment.
Smart beta investing, harvesting equity risk
premiums and beyond
An active equity management approach built around
the idea of harvesting smart betas – or investment
style risk premiums – in a disciplined, systematic
approach can go further.
• First, seek to capture the risk premiums attached
to investment styles like value and momentum.
• In a second layer, seek to generate additional alpha within the investment style framework based
on bottom-up company research.
Understand. Act.
• Harvesting risk premiums can be a successful
investment strategy across asset classes
• This concept has also been well-rewarded in
equity markets
• Index providers have started to offer a variety of
risk premium strategies under labels like smart
beta, alternative beta or risk premium indices
• These smart beta indices are an easy-to-grasp
index methodology, but in our view they fail to
efficiently earn the risk premiums of investment
styles in a stable way
• Strategies can go further by looking to harvest
investment style risk premiums in a stable way
across time
These two layers can be combined with a diligent
portfolio construction that implements a diversified
investment style mix. In doing so, in addition to harvesting investment style risk premiums, proper diversification across risk premiums can be sought.
Chart 3: Investment approach:
Harvesting risk premium in equity investing
Investment style research to earn the smart
beta risk premiums of investment styles
↓
Harvesting risk premium in equity investing
↓
Global company research to generate
stock selection alpha within investment styles
Imprint
Allianz Global Investors Europe GmbH
Bockenheimer Landstr. 42 – 44
60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn), Stefan Scheurer (st),
Ann-Katrin Petersen (akp)
Data origin – if not otherwise noted:
Thomson Financial Datastream.
Calendar date of data – if not otherwise noted:
April 2014
Source: Allianz Global Investors
Investing involves risk. Diversification does not ensure a profit or protect against loss in declining markets. The value of an investment and the income from it will
fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for
informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an
offer to sell or a solicitation of an offer to buy any security.
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