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Home > Asset Management Viewpoints > Capturing the Equity Premium

Asset Management Viewpoints

Capturing the Equity Premium

by Erik Gosule
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Introduction

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.

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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Further reading

Books:

  • 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: www.gutenberg.org/ebooks/24518
  • 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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