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Capturing the Equity Premium

by Erik Gosule


Erik Gosule is a director, and head of Client Solutions and Investment Strategy at PanAgora Asset Management. As such, he is responsible for assisting in the development and implementation of investment strategies across the firm, including customized solutions that combine multiple investment capabilities designed to meet clients’ specific needs. Prior to joining PanAgora, Mr Gosule worked at the D. E. Shaw Group, where he was most recently a member of their Institutional Asset Management team, focused on systematic equity strategies. Prior to joining D. E. Shaw, Mr Gosule held investment oriented roles at Putnam Investments and Fidelity Investments.

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The level of volatility in the markets through 2011 and 2012 has caused many institutional clients and high net worth individuals to become more interested in investment strategies that, at the very least, give them a smoother passage. Can you explain your concept of a portfolio based on risk parity, or the equal weighting of risk?

Investors’ fear of heightened volatility and lower returns has led to increased interest in more efficient approaches to capturing equity risk premium, including strategies that target low-volatility stocks. An increasing number of academic studies show that stocks whose share price is more or less stable, or whose price varies significantly less than stocks that are down one minute and up the next, generate a better return over the long term (say, upwards of three years). To many investors this is somewhat counterintuitive since the established view is that there is no reward without risk. Looking at it from this perspective, when you select stocks to create a low-volatility portfolio you are selecting stocks that are likely to have lower returns. However, the real question is whether you are getting compensated for the risk that you take.

It remains to be seen whether the outperformance of lower-volatility stocks will persist. However, at a minimum we believe that many low-volatility approaches suffer from a dilemma similar to that which plagues cap-weighted equity indices—in particular, risk concentration which you may not be compensated for in the long run. As a result, we believe that an approach that balances risk across the most important dimensions within an equity portfolio is a more efficient way to capture equity risk premia, as it results in a truly diversified portfolio solution. The question to ask is simple: do you want to make a bet that low-volatility names persistently outperform on a risk-adjusted basis over time because they offer something unique and are thus unlikely to see their advantage arbitraged away? Or is the objective to truly capture equity risk premia in an efficient manner so as to stabilize returns and minimize downside while still capturing most of the market’s upside when things are going well?

Our research has shown that most approaches to portfolio construction result in concentrated risk exposures. By tilting portfolios toward a particular risk concentration, such as lower-volatility names, or to a particularly sector or country (as is the case in cap-weighted indices), you risk embedding a fairly large and persistent bias into your portfolio. If the bias works, fine, you do well. But to the best of my knowledge no one has a crystal ball, and as a result no one gets it right all the time. Our research has shown that a portfolio that exhibits a balanced risk allocation and limits concentrated risk exposures does better over time than a portfolio with inbuilt bias.

This is one of the reasons why the big institutions, such as the large pension funds, are increasingly considering alternatives to portfolios that track the traditional cap-weighted benchmarks. If you take the FTSE 100, for example, financial and oil stocks have a very large presence, and as a result these two sectors have a large influence on the index’s performance. Investors who allocate to funds that are proxies of the FTSE benchmark are essentially expressing a view that these two sectors are likely to outperform other sectors on a risk-adjusted basis over time, regardless of where we are in the business cycle or prevailing economic conditions.

To many investors, it has become clear that this kind of approach is not paying off, particularly over the last few years, so people are looking for alternatives. But many of these alternatives suffer from the same problem. An obvious alternative is a diversified risk portfolio—one that balances the most important foreseeable risks. If you think about this, there are multiple dimensions on which you would want to balance risks. When you do this, what you find is that you create a fund that is less likely to suffer large drawdowns (sharp or sustained downward movement in market prices) and that leads to better risk-adjusted returns over time.

The goal of this kind of approach to investing is to efficiently capture equity risk premia by dampening volatility and mitigating drawdowns while still participating in the market’s upside. It is distinguished from minimum-variance and other low-volatility approaches, which, as I previously mentioned, may tend to experience greater risk concentrations, or biases, that result from their tendency to focus on low-volatility stocks. Once again, biases may be fine when they lead to outperformance, but they are also subject to bubbles and underperformance, and when the bubble bursts you may realize significant drawdowns (losses).

When using a balanced approach to better diversify a portfolio’s risk exposures, such as that which is deployed in PanAgora’s diversified risk equity strategies, we are not solely concerned about solving for low volatility; rather, we are simply determining the most important dimensions of risk and balancing our exposures across these dimensions to achieve true diversification. Technology stocks, for example have significantly more volatility relative to industrial stocks, so the risk contribution of an allocation to technology stocks is meaningfully higher than a similar capital allocation to the industrial sector, all else equal. What you want to do is to balance your risk allocation across as many dimensions as possible, targeting those dimensions that really matter. We have seen this lead to smaller drawdowns when the market goes against you and better returns in the medium to longer term. We find it to be a very robust strategy. When we look into portfolios constructed across sectors and across countries, a balanced risk portfolio outperforms on all these dimensions.

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How willing are pension funds to allocate part of their portfolio to this kind of investment strategy?

For years now institutional investors have been anchored to cap-weighted benchmarks, and that may have served them well in the bull markets. However, after investors experienced the precipitous fall of cap-weighted equity indices in 2008, and subsequent regime shifts that seem to have occurred with increasing frequency over the past several years (an effect known as “risk-on/risk-off” trading), the door opened for alternative approaches to equity investing.

We have seen an array of strategies in the aftermath of the global crash of 2008, including the shift in interest toward lower-volatility approaches such as minimum variance and other strategies that target lower-volatility stocks. These approaches are intuitively appealing since by definition low-volatility stocks tend to be more stable, defensive stocks, and when institutions are experiencing large drawdowns they may tend to favor such strategies. That is understandable.

However, to say that low-volatility stocks are going to persistently outperform other stocks over the long term may be unreasonable, and there is always the possibility that the bulk of institutional money heading into low-volatility strategies is moving too late. Although volatility does play a role in the allocation decisions within a diversified risk portfolio, it is only one of many elements considered in the process. Focusing on low volatility alone may result in some very significant risk concentrations, such as material country or sector imbalances.

Gradually, with a great deal of educational effort, pension funds are starting to see the merits of a diversified, balanced risk approach. In some instances, the allocations that these plans make can be quite significant; however, on balance many investors begin with a modest allocation which they are likely to scale up over time. When allocating to alternative beta strategies as a whole, investors often consider appointing two or three managers using different alternative beta approaches to run a segment of their portfolio. In these instances, our diversified risk approach is often complementary to these other approaches, including minimum-variance and other defensive strategies.

In addition, the strategy is very scalable, and what funds want above all else is to capture the equity premium without having to suffer really uncomfortable levels of volatility. PanAgora’s diversified risk equity strategies provide a robust solution to this objective. What we are definitely seeing is that, while it is early days for the entire pension fund universe to move, there are now a lot more conversations about alternatives to cap-weighted benchmarks, and the velocity of conversations about alternatives is picking up.

Our argument is that if you are going to move from a cap-weighted index, which is biased toward a handful of companies and a couple of sectors and/or countries that have outperformed in the recent past, the last thing you should be doing is moving to another strategy that has a strong bias toward this or that sector or type of stock (small-cap, mid-cap or large-cap, for example). What you should be thinking about is a fund that avoids bias as much as possible and tries to collect the pure equity premium. Of course, if you do not believe that there is such a thing as an equity premium—in other words, that equities will outperform cash over time—then you should not be in any equity strategy at all, except perhaps tactically in certain circumstances.

To the extent that an investor wishes to express a particular tactical view with respect to the likely relative performance of a particular attribute (i.e. low volatility), we believe that applying an approach which balances risk exposures to express or target a particular attribute will achieve the desired result with better diversification. Our research has shown that when targeting specific attributes, such as lower volatility or higher dividend yield and quality, an approach based on risk parity generates higher risk-adjusted returns relative to other approaches.

However we caution that tactically targeting specific attributes may be speculative investing in its purest form, and it is debatable whether pension funds have ever had much success long term pursuing such strategies. The “right” biases change continuously over time, and it is an excellent investor indeed that can time the markets accurately enough to switch from one bias to the next at just the right moment.

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From what you are saying it sounds as if risk parity, or a balanced weighting of risk in a portfolio, is a passive strategy.

I like to think of risk parity as being the ultimate passive equity investment strategy. It is an agnostic approach that essentially expresses no implied view that one particular attribute is likely to outperform another on a risk-adjusted basis because the approach mitigates such risk concentration within the portfolio. To invest in a cap-weighted fund or other portfolios built using processes that result in some form of risk concentration generally implies that one believes that certain sectors, countries, or other such concentrations will outperform on a risk-adjusted basis. They may, but then again they may not. Or they may perform for a while, then cause the fund to experience a drawdown that more than wipes out that performance.

From this standpoint, investing in a cap-weighted index—even in a passive index tracking fund—is somewhat akin to investing with an active manager. With an active manager, you are betting on his selection of market bias. With a cap-weighted index tracker, you are betting on the inherent bias in the index. To the extent that a fund wishes to express a view that low-volatility strategies will outperform—because it believes that there is a strong possibility that recent volatility is going to persist and damage performance—we would still argue that applying an approach based on risk parity to target low-volatility stocks will generate better risk-adjusted returns.

As an example, during the crash, which ran from April 2000 to the end of September 2002, the cap-weighted index fell by some 45%. Our diversified risk portfolio fell by just 16%. This makes it a great deal easier for a diversified risk portfolio to recover from a downturn. The October 2008–April 2009 global financial crash saw the cap-weighted index drop by almost 48%. This time around diversified risk portfolios suffered as well, since the crash was all-encompassing, but they fell by just 41%. Applying the diversified risk process to a portfolio that was targeting lower-volatility stocks would have further mitigated drawdowns during these periods.

However, a characteristic that distinguishes the approach from other low-volatility strategies is that, in addition to mitigating downside and reducing volatility in difficult periods, an approach based on risk parity often participates in the market’s upside during periods of strong performance. As markets recovered in the latter half of 2009, the diversified risk strategy strongly outperformed many low-volatility approaches.

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It sounds simple, balancing out risk, but in practice it looks like being a very complicated exercise, since when you balance risk in one direction you find you are increasing it in another.

It is not a simple exercise. As you say, balancing one dimension can have knock-on effects on other risk dimensions. It has taken us a very significant investment of time and skill to solve the problems associated with viable risk balancing. You have to consider all the trade-offs that are relevant to do this. In addition, you have to put a significant amount of resources into the effort. It is not easy for any fund management house to simply shift from what they may be doing today—whether it is offering a low-volatility fund or a long short strategy—and produce a risk parity fund that is actually going to do what it says on the tin.

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So you would say that the Sharpe ratio, a measure of return per unit of absolute risk, is more important as a performance measure for your strategy than any attempt to provide a tracking error against a benchmark?

Exactly. We believe that the most efficient capture of the equity risk premium is what we are after. The Sharpe ratio is indicative of the amount of return (in excess of the risk-free rate) that an investor receives for each incremental unit of risk they take on. Our back-testing of the diversified risk approach shows a greater than 100% improvement in the Sharpe ratio by comparison with cap-weighted funds over time, and we have seen similar relative results since launching our first non-US diversified risk strategy.

We have found the diversified risk approach to be quite robust. Our research shows that the approach adds value in every region and virtually every sector. The one area that we have discovered where a risk parity approach struggles to outperform a cap-weighted index is in the technology sector. Within this sector much of the performance is heavily concentrated in a handful of stocks, with Apple and Google dominating for example. A few stocks driving the whole of a sector can be very good for the sector for a while, but when they run out of steam it can have a profound effect on the whole sector.

Interestingly, our findings show that the diversified risk approach is a good strategy even where you are trying to construct a portfolio that is tilted toward exposures which are intended to generate higher returns because balanced risk exposure is something that adds value to almost any portfolio that benefits from diversification. You can balance risk across and within many dimensions. When constructing a risk parity portfolio, you begin by identifying the various risk dimensions, then you solve for the weight that achieves the risk exposure you want for the strategy. It is important to realize that this is a very systematic approach and the portfolio will always maintain a balanced risk allocation. Once the selection is made, we continuously monitor portfolios to ensure that the risks remain balanced and that a portfolio is not wandering away from the key parameters over time. What this means is that if there are external shocks to the market, or if the business cycle changes, the portfolio should be able to weather the storm.

In contrast, if you are in a cap-weighted fund, you will be in more cyclical stocks, and when the business cycle changes your fund will lose performance. With a minimum-variance approach, for example, the reverse is true and you will be too defensively positioned if the business cycle moves into a more positive phase.

In conclusion, there are clearly far-reaching events that can happen that are going to cause a shock regardless, and there are circumstances in which no equity portfolio can outperform. However, a risk parity approach is clearly better at capturing the equity premium over a wide range of conditions.

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Further reading


  • Grinold, Richard C., and Ronald N. Kahn. Active Portfolio Management: A Quantitative Approach for Providing Superior Returns and Controlling Risk. 2nd ed. New York: McGraw-Hill, 1999.
  • Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. 1841. Online at:
  • Qian, Edward E., Ronald H. Hua, and Eric H. Sorensen. Quantitative Equity Portfolio Management: Modern Techniques and Applications. Boca Raton, FL: Chapman & Hall/CRC, 2007.
  • Shiller, Robert. Irrational Exuberance. 2nd ed. New York: Broadway Books, 2006.

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