The trouble with risk premia



RISK PREMIA – ALSO known by its aliases ‘liquid alternatives’ and ‘smart beta’ – is the latest buzzword strategy for superannuation fund investments. It is also a disaster waiting to happen.

Go to any investment conference and the phrase ‘harvesting risk premia’ will be bandied about casually, as though risk premia – which are the investment returns from taking these ‘special’ market risks – were just lying around waiting to be collected.

I’m not convinced. In 40 years in investments, I have never seen returns that are not accompanied by commensurate levels of risk – no matter how ‘smart’ a strategy may proclaim itself to be.

So, what is the problem with risk premia strategies? In these strategies, rather than having exposure to a whole market (such as Australian equities), the focus is on having exposure to only one, or a few, of the risk factors (market betas) that make up the overall market.

There is nothing new about looking at a market as a combination of risk factors. Market risk factors have been analysed for decades and academic researchers claim to have identified hundreds of betas.

Two things are new:
1 | First, the use of moderately sophisticated portfolio construction techniques to create investments with exposure to a greater number of more specific/ narrower market factors and associated returns (risk premia).

2 | Second, the focus on marketing these risk premia investments by saying they are supported by academic research. The proposition is that market factors identified by research as performing well in the past will be sources of ‘good risk premia’ that can be ‘harvested’ regularly and continuously in the future. It follows that a smart investor will invest in these ‘good’ betas and exclude the other ‘bad’ market betas.

It is this seemingly magical promise of liquid alternative smart beta risk premia to deliver consistent excess returns that is so attractive, along with the fact that, as market exposures, they are available at minimal cost with no management fees.

Unfortunately, it is the reliance on an academic foundation that is the Achilles heel of the whole risk-premia approach. Academic research is only as good as its underlying theory and, unfortunately for risk-premia strategies, current academic theory does not reflect the real investment world.

For example, a basic premise of the current best academic investment theory – modern portfolio theory (MPT) – is that we get rewarded for taking risks (defined as the volatility of returns) and higher risks are associated with higher returns over time.

This is the basis of the classic risk/reward trade-off and underpins the proposition that a strategy with exposure to good risk premia will consistently deliver excess returns that can be harvested.

Unfortunately, even this core proposition of MPT does not hold up in reality – at least not over timeframes that are of relevance to superannuation fund investors.

According to MPT, the returns of Australia’s balanced superannuation funds should have a positive, or upward sloping, relationship with volatility; however, the actual risk/return trade-off is consistently downward sloping over longer periods.

In reality, risk premia are based on market risks, and markets, which consist of a diversified mix of risk factors, can and do underperform for long periods of time. We can expect that single market factors will also underperform – i.e., have negative risk premia – for even longer periods.

Given that many risk premia were supposedly identified during the period of low interest rates and quantitative easing following the GFC, it is not surprising that the results being ‘harvested’ since QE are not living up to expectations.

John Peterson, portfolio manager for alternative investments, Local Government Super.

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