How Useful are Risk Premia ? A Practitioner’s Perspective...

1. How Useful are Risk Premia? A Practitioner’s Perspective... September 2009 Roland Rousseau Independent Consultant Quantitative Investment Strategy and Portfolio Construction Research

2. “Daddy, Where do Excess Returns Come from?” -> skill is the residual excess-return, after all RELEVANT beta excess-returns have been accounted for -> Excess returns come primarily from excess risk, not skill! -> Imagine a world without alpha. How would you invest?

3. Risk Premium vs Risk Factor Risk-Factors • Interest rates • Currency • Inflation • Volatility Risk-Premia • Equity, Bonds, Credit Risk • Event, Structural Risk • Liquidity Risk • Emerging Markets • Property, Art, Wine, Timber Accounting Risk-premia • Book-to-Market Ratio • Cash-Flow to Price Behavioural Risk-Premia • Momentum • Price Reversals • Earnings surprises/revisions Risk-Factor eg volatility, interest rates Return Quality, ability to ’predict/model’ Risk-Premium eg. value, momentum, emerging mkts, small caps Why is eg. Value considered a risk-premium?

4. Are We Using the Right Benchmarks?Is it Skill or just Excess Risk? How can we beat the following balanced-fund benchmark without skill:60% Equity, 30% Bonds, 10% Cash? Overweight Equities – ERP 3-6% pa How can we beat the S&P 500 without skill? Overweight value stocks or small caps – VRP 3-5%pa How can we beat the MSCI World Index without skill? Overweight Emerging Markets – EMRP 2-5% pa Industry realisation: single-factor benchmarks like common indices (eg S&P 500, MSCI etc) are insufficient in a multi-factor world.

5. The New Industry FocusExcess Returns in addition to Alpha – Modular Portfolio Construction bT Asset Class/Risk Factor Betas (Long-only) -> emerging markets, bonds, commodities, property bRP Risk-Premium (long-only) -> Fama and French, Carhart 4-factor model, Barra Portfolio Excess Return bAlt Primitive Trading Strategies - PTS (long-short)-> Merger Arbitrage, long/short equity, Man. Futures a Alpha from long-only and long-short strategies Scalability, transparency and lower cost are driving the interest in new types of beta risk premia

6. Portable Beta Example (FTSE) Using FTSE Value vs Growth Risk Premia… Risk premia are extremely valuable sources of excess return and don’t require any skill… The reliability of the value risk premium is high: “Value stocks have higher returns than growth stocks in markets around the world. For 1975-1995, the difference between average returns on global portfolios for high and low book-to-market stocks is 7.60% per year and value stocks outperform growth stocks in 12 of 13major markets.” – Fama, French 1996 Source: FTSE, CS Tremont, Roland Rousseau

7. ‘Predicting‘ the Behaviour of Asset Classes How Predictable is the FTSE All World Index? Naive Test:Serial Correlation Correlation 0.03 Source: FTSE, Roland Rousseau

8. ‘Predicting‘ the Behaviour of Risk Premia How Predictable is Long FTSE World Value, Short FTSE World Growth? InformationCoefficient = 0.20! Correlation 0.20 Source: FTSE, Roland Rousseau

9. Risk-Premia Drive Active Portfolios! Risk Factors and Premia drive the majority of active return variability Example: The Legg Mason Primary Value Fund is one of the most successful active funds in the world and has outperformed the S&P500 for 13 years in a row. Dartmouth College lets its students, as part of their education, analyse how much the Legg Mason fund’s return variability comes from value, size and market risk. Their conclusion is: “The high returns are associated with the fund’s extreme exposure to small-cap and value risk rather than the skill of the manager. The three factors explain all but 8% of the variation in historical returns.” So 92% of the returns’ variability come from just 3 factors! Agarwal and Naik (2004) as well as Fung and Hsieh (2006) applied Sharpe’s style-based research to HF styles. They find that (small-cap – large-cap) + (credit spread) + long S&P 500 = 80% of aggregate long/short HF return variability It is not about replication. It is about risk management and smarter portfolio construction and benchmarking. Fung: Alternative Beta is the most appropriate way to benchmark alternative investments.

10. Out-of-sample Style Breakdown ACI Domestic Equity Funds 91% Allan Gray Equity Fund 87% Coronation Equity Fund 89% Investec Equity Fund 87% African Harvest Equity 89% Oasis Gen Equity Fund 82% OM Investors Fund 92% Prudential Equity Fund 85% Conclusion: only ±10% of thevariability in portfolio returnsis due to manager stock selection skill The DNA of Portfolio Returns Blending Risk Factors and Risk Premia Historic breakdown of DOEQ returns using only few building blocks RESI INDI FINI Momentum Value and Small Caps Source: Proprietary Research Source: van Rensburg and Yu Risk allocation drives portfolio returns, not skill. They are the DNA of portfolio returns.

11. How Useful are Risk Premia? They are the DNA of all active portfolios • Summary:The key uses of Risk Premia (RP) • Without RP, we cannot even benchmark alpha (both long-only and long-short)! traditional equity indices, cash, CPI+x% are inadequate benchmarks in a multi-factor world • Well-defined risk premia make excellent cheaper core-portfolio investments • RP are highly correlated to active portfolios and therefore provide new ways to construct portfolios in an ‘active-risk’ manner • RP are being listed and made tradable. They can be priced and hedged now! • Without RP, there would no point in investing! They are the DNA of portfolio returns • Investing is primarily about risk allocation, not finding alpha skill