Putting a premium on risk

Investors these days are much happier to embrace a wide range of assets in their  portfolios as they search for more diversified, and therefore more certain, returns. Unfortunately, as the experience of the last few years attests, the results are still sometimes unpredictable.

20/05/2014

Investors these days are much happier to embrace a wide range of assets in their portfolios as they search for more diversified, and therefore more certain, returns. Unfortunately, as the experience of the last few years attests, the results are still sometimes unpredictable.

The truth is that an understanding of the underlying risk factors in a multi-asset portfolio - and whether or not they are being properly compensated - is an essential part of modern portfolio management. Asset classes are convenient categories, but they are in reality made up of combinations of risk premia. It is only through an understanding of these underlying risks that we can build portfolios that more accurately reflect the insights of the investment team and help to ensure more diversified portfolios.

What is a risk premium?

All investments start with one goal: earning a return (or premium) in excess of cash that compensates the investor for the risk taken. The extra risk can be idiosyncratic(security specific)  or systematic (market-related), or it can be a result of structural or behavioural factors. Identifying a portfolio’s exposure to these different risks is the key to understanding whether a portfolio is diversified. Idiosyncratic risk (for example) can be diversified away, so investors should not expect to be paid for this exposure.

One of the roles of investment research is to understand whether these risks are adequately compensated – in the short, medium or long term. Take style-based investing as an example. There is a risk premium associated with value investing (buying companies with low prices relative to fundamental attributes such as dividends, sales, book value, earnings or cashflow), but no such systematic long-term premium is associated with the growth style (buying stocks that are growing more rapidly than the market overall). It should be remembered, however, that risk premia are time varying.

 

From asset classes to risk premia

Despite the fact that the concept of risk premia is well covered in academic research, investors still tend to organise their portfolios along asset class lines. The problem with traditional asset class descriptions is that they are 

merely labels. They do not provide information about the risks associated with them, and this
limits the ability of investors to predict the way in which different market events may affect
portfolio returns. An asset class can be thought of as being like crude oil: it is familiar and
traded easily but it is only when it is cracked and refined into its component elements (such as
gasoline and propylene) that it becomes much more useful.


An investor may believe his or her portfolio to be diversified because it contains a variety
of different asset classes. However, several asset classes can be sensitive to the same
underlying risk factor, and a portfolio diversified along the lines of asset class alone could
suffer significant losses under certain scenarios. Breaking asset class exposures down into
their constituent risk factors allows concentrations of risk from the same sources to be identified.

A ‘risk premium’ is the return that an investor expects to receive for assuming
a systematic risk (see box ‘What is a risk premium?’).

In some cases, an asset class may best be represented by a single, dominant risk premium; in others it may best be described as a combination of several risk premia. Either way, this knowledge is vital in determining whether or not an asset should be included in a portfolio, and in what quantity.

Deconstructing an asset class according to its risk premia

In Figure 1 we show how the composition of the yield on US investment grade credit (measured by analysing the spread differential between US cash, government bonds and investment grade credit) has varied over time. We look at two snapshots, one taken at the end of October 2008 and the other five years later in 2013. Over this period, not only has the overall yield level decreased significantly, but the composition of the underlying risk premia exposures has also changed. In 2013, the exposure to the duration risk premium (compensation for the risk of rising interest rates) has become the dominant proportion of the yield on investment grade bonds. This has serious implications since, if investors were positive on credit but negative on duration in October 2013, then a long-only investment in investment grade bonds would be unlikely to reward them.

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