Issue: March / May 2013

Economic intuition and risk premia returns

The quest for new sources of uncorrelated investment returns is accelerating as more investors participate in equity and capital markets. Now regularly included in asset-allocation mixes, finds Momentum Manager of Managers research head Jean Badenhorst, are non-traditional asset classes such as hedge funds and real estate.

Badenhorst . . . evolving demands

Market beta (benchmark-aligned) returns, in conjunction with risk premia (additional possible returns associated with risk taking), provide the building blocks for a systemic investment process which can be used to increase diversification, add additional sources of return and enrich tactical asset allocation.

Investment manager selection, which is another important component of delivering on the investment mandate, involves spending a large amount of time analysing the advisory company’s portfolio-structuring and risk-premia strategies. There is an increasing need for managers to take advantage of uncorrelated return (returns with a low correlation to other indices or strategies) opportunities with a view to maximising the diversification required for optimal capital growth.

An in-depth, qualitative and quantitative analysis of an investment manager, undertaken over an extended period of time, is the most effective predictor of skill that can be applied on a sustainable basis.The ability to clearly articulate a risk premia investment philosophy aimed at outperforming the appropriate benchmark is therefore essential.

Investors are also demanding transparency, as well as insight into the building blocks of returns, resulting in the commoditisation of investment strategies becoming increasingly prevalent. An investment manager having a sound and demonstrable investment approach is therefore more important than ever before.

Many managers are, as a result of the evolving demands of an increasingly sophisticated market, beginning to focus on risk premia beyond traditional market betas. Strategies that seek to capture these alternative betas include non-standard weighting of index constituents, the use of shorter investment time frames, leverage and liquid derivatives.Techniques and instruments used vary widely and in accordance with asset class.

Risk premia strategies have historically been the domain of hedge funds and other active investment managers. Assessing whether a traditional manager does, in fact, offer a risk premium strategy involves both qualitative and quantitative analysis of whether the approach involves:

  • simple, transparent and well-established investment principles;
  • excess returns that can be explained by economic intuition;
  • risk premium that varies over time but requires structural change in the market for it to be ‘arbitraged away’;
  • long and short positions, often utilising derivatives to take full advantage of anomalies; - leveraged and dynamic timing;
  • comparatively stable characteristics (such as volatilities and correlations);
  • positive excess returns over long periods of time (which can be subject to drawdowns when risk exposures are experienced).

Building robust and intelligently-diversified solutions involves utilising time-tested investment managers capable of identifying risk premia opportunities across a variety of local and global asset classes. The optimal combination of these strategies facilitates the delivery of investment objectives and a stress-free savings experience for clients.