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Asset Management Viewpoints

Capturing the Equity Premium

by Erik Gosule

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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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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