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A different approach to equities

What lies beneath market returns?

CAPE TOWN – The way in which we understand the stock market and how fund managers generate performance has come a long way over the last 70 years. Before the 1950s all returns were considered to be the result of smart active management; however, we have since learnt that manager skill really only accounts for a tiny portion of this.

The bulk of equity returns come from factors that are inherent in the market itself. And in recent years, there has been a growing understanding that you actually don’t need any skill to exploit them.

To understand this, you need to think of the market as a combination of different factors. These factors are always present, but they perform differently at different times.

They are the likes of value, momentum, quality and low volatility, which are well-appreciated as drivers of returns. More recently they have become known as risk premia.

In all investing, it is understood that you take some measure of risk in order to achieve a certain reward. Portfolio management is about finding an appropriate balance between the two.

For instance, investors understand that equities as a whole carry a certain risk. In order to compensate for this, the asset class offers a return premium over the likes of bonds or cash.

However, it is also possible to break equities down into these different factors that also each offer different return profiles. And it is possible to isolate and exploit them individually.

In a sense, this is a bit like a multi-asset environment. If you have a diversified portfolio of equities, listed property, bonds and cash, you can manage your exposure to each to create a more stable risk-reward profile.

Risk premia allow you to do much the same within equities alone. They are essentially the building blocks of an equity portfolio.

To illustrate this point, the table below shows how eight risk premia have performed in the South African context relative to each other and the market itself over the last 16 years. ‘Portfolio’ refers to a blend of factors:

Click image to enlarge

table

The value example                                                            

Perhaps the most widely understood risk premium in South Africa is value. It has long been established that if you buy value you will out-perform over the long term.

However, value is highly cyclical. It will be volatile in the short term and could produce periods of significant under-performance.

If you wanted to exploit this risk premium you could invest with an active value manager who picks stocks based on their fundamental valuations. If that manager follows a deep value approach, it means that they will be highly exposed to this risk premium. As a result, when the market is not rewarding value, their returns will be extremely poor. When value is being bought, however, returns will be exceptional.

The question this creates is whether such a manager is really showing skill, or if they are simply exposing you to high levels of risk. The returns may be very good over the long term, but that may simply be because of the risk that the manager has taken.

Real diversification

This may be acceptable to some investors, and those that are willing to take this risk may well be rewarded. However, this kind of extreme volatility is unlikely to be suitable for pension funds, and for the many investors who prefer more stable returns.

Using rules-based quantitative models it is therefore possible to extract this value risk premium and build it into a diversified portfolio with others. You can even enhance this with a rotation model that increases exposure to those risk premia that the market has been buying, and down-weights those that are out of favour.

“It is possible to exploit the value risk premium without being a value manager,” explains the chief investment officer at Prescient, Raphael Nkomo. “We can disentangle the risks and buy those risks. If you then get the reward it’s not because you were clever, but because you were prepared to take the risk.”

This approach to investing is becoming increasingly popular around the world. Quants teams that were for many years hidden in back offices are now coming to the forefront as the concept of isolating and exploiting these risk premia gains more traction.

“Every asset class is a combination of risk and if you can unpack what those risks are you can identify what you should be buying,” Nkomo explains. “Buy the risk premia and you can make better allocations.”

Because this approach uses rules-based models, it is also more transparent and lower cost than active management.

“You never know which premium is going to do well, so the best you can do is to have passive exposures,” says Nkomo. “First of all, that is to the market through a broad index tracker fund, and then to the premia. A portfolio like that is much lower cost and easy for you to control.

“I’m not saying risk premia will always out-perform, but it is a very clear way of distributing your assets across the risk spectrum.”

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