Style Premia Investing
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The document discusses style premia investing, which refers to allocating to risk factors across asset classes that have historically generated significant risk-adjusted returns. It provides examples of academic research highlighting factors like value, momentum, and defensive styles that have persisted over decades. Practitioners like Neil Woodford and Warren Buffett are analyzed in the context of harvesting these style premia without explicitly targeting them. The document explores how style premia may represent alpha that is misclassified as beta. It also discusses evaluating strategies in different economic regimes, the evolution of separating alpha from beta, and comparing style premia to smart beta approaches. Finally, it analyzes ways for investors to access style premia through total return swaps on bank indices or asset managers
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Style Premia Investing
- 1. Style Premia Investing Wednesday 26th February 2014 Private & Confidential Style Premia Investing 26 February 2014 1
- 2. What is Style Premia Investing? Style Premia Investing refers to allocating to various risk factors, within and across asset classes, that have been proven to generate significant risk-adjusted returns over time. Many names, same underlying premise… Private & Confidential Style Premia Investing 26 February 2014 2
- 3. What Characteristics do Style Premia have? - A style premium is a risk premium and thus should have some economic intuition or behavioural explanation why an investment in it should carry an excess return (why am I getting paid?). - Style premia should be well-documented in academic research and persist over time (multiple decades). - Style premia are pervasive, existing across regions and asset classes. - Style premia need to be liquid and be scalable to allow for institutional investment. - Style premia will be dynamic and not hold a static allocation to any asset class or market. Private & Confidential Style Premia Investing 26 February 2014 3
- 4. Section 1: Style Premia Case Studies Private & Confidential Style Premia Investing 26 February 2014 4
- 5. Neil Woodford: Style Premia in Practice 350 300 250 200 150 100 50 0 Invesco Perpetual High Income Fund FTSE All Share Source: Invesco, Bloomberg - Neil Woodford presents us with an intriguing practical look into style premia investing in the UK. - His track record is impressive – he has beaten the FTSE All Share over the past 12 years by 3.4% p.a. - But is this the correct benchmark to use to assess his performance? Private & Confidential Style Premia Investing 26 February 2014 5
- 6. Betting Against Beta – Frazzini and Pedersen (2013) - Frazzini and Pedersen (2013) find that “betting against beta” has been a very effective investing strategy across many asset classes (US equities, 20 international equity markets, Treasury bonds, corporate bonds and futures). - By going long low beta assets while going short high beta assets, this has historically produced a significant premium. - They posit that due to leverage aversion, many investors seeking high returns will bid up high volatility assets rather than choosing to lever low volatility assets. - This leads to a premium for those willing to invest in low beta assets which can be termed a “defensive style premium”. Private & Confidential Style Premia Investing 26 February 2014 6
- 7. Academic Research Has Highlighted Other Effects Over Long Periods of Time Fama & French (1992) Jegadeesh & Titman (1993) - Buying rising stocks and selling falling stocks leads to excess outperformance of about 1% per month (1965-1989). This is known as the (price) momentum factor. - Small cap stocks outperform large cap stocks over the long term (1962-1989). (On a risk-adjusted basis, however, the difference is negligible.) - ‘Cheap’ stocks (based on fundamental rations such as priceto-book or price-to-earnings) outperform ‘expensive’ stocks. This holds up even on a risk-adjusted basis and is known as the value factor. Private & Confidential Style Premia Investing 26 February 2014 7
- 8. Applying Style Premia to Neil Woodford 350 300 250 200 150 100 50 0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Regressed Invesco High Income Fund FTSE All Share Source: Deutsche Bank, Invesco, Bloomberg; Calculations: Redington Market Portfolio Weights Value Momentum Defensive 75% 13% 19% 52% Woodford’s performance can broadly be explained by: a lower than 100% weight to the market (represented by the FTSE All Share) along with allocations to value, momentum and defensive factors. Private & Confidential Style Premia Investing 26 February 2014 8
- 9. Buffett’s Alpha - Like Neil Woodford, Warren Buffett provides another fascinating example of style premia investing in equities. - In a paper titled ‘Buffett’s Alpha’, AQR Capital Management principals Frazzini, Kabiller and Pedersen find that: • • Berkshire has levered 1.6-to-1 on average, borrowing partly through its insurance company’s float at rates over 3% below the US T-bill rate giving it ultra-cheap financing (2.2% on average). • When controlling for exposures to style premia and leverage, Buffett’s alpha over the S&P 500 becomes insignificant. • - Berkshire Hathaway has a Sharpe ratio of 0.76 from 1976 to 2012, double that of S&P 500 (0.37). This is a higher Sharpe ratio than any other US stock or mutual fund over that period. Buffett has suffered large absolute and relative drawdowns. His success stems from being able to stick with his strategy over the long run. Neither Woodford nor Buffett ever likely thought about ‘harvesting’ premia. They do, however, state similar characteristics for companies they like: cheap, stable, profitable, growing and with high payout ratios. Can their approach to investment be done systematically? Private & Confidential Style Premia Investing 26 February 2014 9
- 10. Section 2: The Evolution of Alpha and Beta Private & Confidential Style Premia Investing 26 February 2014 10
- 11. Is Alpha Just Beta Waiting to be Discovered? Time Alpha Alpha Other Market Risk Premia Alpha Equity Risk Premium Prior to capweighted indices, all returns were effectively viewed as alpha Equity Risk Premium With the introduction of CAPM, the equity market effect was separated from returns This was then extrapolated to include other asset classes such as bonds and commodities Alpha Style Premia Other Market Risk Premia Equity Risk Premium Now we can separate out a number of risk premia with much less being left as pure alpha Source: Figure 2, ‘Is Alpha Just Beta Waiting To Be Discovered?’, AQR Capital Management Private & Confidential Style Premia Investing 26 February 2014 11
- 12. A Continuum Between Beta and Alpha Low High Alpha C A P A C I T Y F E E S Style Premia Market Risk Premia High Low Source: Figure 11, ‘Is Alpha Just Beta Waiting To Be Discovered?’, AQR Capital Management Private & Confidential Style Premia Investing 26 February 2014 12
- 13. Style Premia vs. Smart Beta - Alternative indexation strategies, otherwise known as ‘smart beta’, are related to style premia. Many smart beta equity strategies take exposure to the same factors identified as style premia here. - However, smart beta strategies are long-only and therefore have a high amount of market exposure. Style premia strategies are long/short in implementation and should have little to no market exposure. Exposures of a typical smart beta strategy Alpha Style Premia Market Risk Premia - Our preferred structure for most pension schemes is to access liquid market risk premia through futures/swaps (e.g. volatility-controlled equities or risk parity) and to access style premia directly. This is usually lower cost than through a total return swap (TRS) on smart beta indices. Private & Confidential Style Premia Investing 26 February 2014 13
- 14. Style Premia Decomposition of the RAFI Fundamental Index 250 200 150 100 50 0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Regressed RAFI Fundamental Index Source: Deutsche Bank, Research Affiliates, Bloomberg; Calculations: Redington Market Portfolio Weights Value Momentum Defensive 100% 21% 8% 0% Mostly market exposure gained along with some value and momentum style premia. Private & Confidential Style Premia Investing 26 February 2014 14
- 15. Section 3: Style Premia Performance Private & Confidential Style Premia Investing 26 February 2014 15
- 16. Major Style Premia Families Cutting Across Liquid Markets Value Momentum •Buying assets that are “cheap” relative to their fundamental value and selling “expensive” assets •For example: go long lowest price-to-book stocks, go short highest price-to-book stocks •Involves buying assets that recently outperformed peers and selling those that recently underperformed •For example: go long stocks with highest 3 month return, go short stocks with lowest 3 month return Carry •Implies buying high-yielding assets and selling lowyielding assets •For example: go long highest yielding currencies, go short lowest yielding currencies Defensive •Consists of buying low-risk, high-quality assets and selling high-risk, low-quality assets •For example: go long high return-on-equity stocks, go short low return-on-equity stocks Need to be able to go long, go short and to leverage across multiple asset classes. Private & Confidential Style Premia Investing 26 February 2014 16
- 17. Style Premia Returns Have Been Strong Performance of Style Strategies (log value, excess return over cash) 200% Cumulative Return 150% 100% 50% 0% -50% Dec-89 Dec-92 AQR Value Dec-95 Dec-98 AQR Momentum Dec-01 AQR Carry Dec-04 AQR Defensive Dec-07 Dec-10 MSCI World Source: AQR Capital Management An individual style premium may not work for a number of years. This is why diversification matters. Private & Confidential Style Premia Investing 26 February 2014 17
- 18. Performance Over Various Economic Regimes Has Held Up Better Than Asset Classes Sharpe Ratio All 0.71 -0.18 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down Sharpe Ratio 0.46 All 0.71 -0.09 Sharpe Ratio 0.32 All 0.06 0.43 2.0 1.5 1.0 0.5 0.0 1.21 0.52 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down All 1.34 1.14 0.93 0.81 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down Carry 0.88 All 0.72 0.9 0.88 1.1 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down Defensive Source: Exhibit 2, ‘Exploring Macroeconomic Sensitivities’, AQR Capital Management Private & Confidential 1.02 -0.09 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down 0.51 0.76 Momentum 0.1 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down 0.73 2.0 1.5 1.0 0.5 0.0 All 1.22 Commodities 2.0 1.0 0.0 -1.0 2.0 1.5 1.0 0.5 0.0 0.71 0.29 Global Bonds 2.0 1.0 0.0 -1.0 Sharpe Ratio 0.31 1.03 Sharpe Ratio Sharpe Ratio Global Equities 2.0 1.0 0.0 -1.0 2.0 1.5 1.0 0.5 0.0 Sharpe Ratio Value For period 1972 to 2013 Style Premia Investing 0.85 All 1.07 0.88 0.53 0.89 Growth Up + Growth Up + Growth Down Growth Down Inflation Up Inflation + Inflation Up + Inflation Down Down 26 February 2014 18
- 19. Style Premia are Generally Uncorrelated to Each Other and to Equities Style Premia Rolling 12 Month Correlation to Equities Average Pairwise Rolling 12 Month Correlation for Style Premia Factors 0.3 0.8 0.6 0.2 0.4 0.1 0.2 0 0 -0.1 -0.2 -0.4 -0.2 -0.6 -0.3 -0.4 1990 -0.8 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 -1 1990 1992 Style Premia Correlation (1990-2013) Value Momentum Carry Value -0.60 -0.09 0.22 -0.04 0.12 -0.03 2000 2002 2004 2006 2008 2010 2012 Value Momentum Carry Defensive Composite Equities Defensive 1.00 Defensive 1998 Style Premia Performance (1990-2013) 1.00 Carry 1996 1.00 Momentum 1994 Excess Return 3.29% 7.61% 4.86% 12.55% 2.09% Volatility 1.00 4.82% 12.0% 12.0% 12.0% 12.0% 12.4% 15.5% 0.27 0.40 0.63 0.40 1.01 0.14 Sharpe Ratio Source: AQR Capital Management Private & Confidential Style Premia Investing 26 February 2014 19
- 20. Frequently Asked Questions Q1: How do I know these style premia haven’t just been ‘data-mined’? A: Firstly, there needs to be some intuitive reason as to why a premium exists. The premium should have been tested out-of-sample, either in a different time period or in a different region. Style premia should pervade across time and across markets/regions. Q2: Won’t these style premia disappear over time as more people invest in them? A: Yes, that’s a possibility. However, behavioural characteristics which cause some of these premia to exist are ingrained in human behaviour. It would take a significant change in the way people invest as a whole to affect style premia returns. Note that this would have the same impact on fundamental active management, in which case the Warren Buffett way of investing may also cease to work. Q3: Will correlations between the premia increase as people invest on this basis (i.e. a package of style premia)? A: Yes, this may begin to happen. This would lower the appeal of style premia, however, if they remain uncorrelated to major asset classes they should remain of use to most investors. Additionally, investors should consider risk-controlled structures such that increased correlations lead to lower exposures. Q4: How can I invest in style premia? A: You may already have exposure to style premia through investments in active managers. However, this is typically not in a pure, risk-controlled format. The next section will highlight direct pathways for investment. Private & Confidential Style Premia Investing 26 February 2014 20
- 21. Section 3: Accessing Style Premia Private & Confidential Style Premia Investing 26 February 2014 21
- 22. Ways to Access Style Premia Via TRS on various bank style premia indices Asset Managers trading bank swaps on style premia Asset Managers trading underlying instruments Private & Confidential - Banks have live track records for style premia indices going back a number of years. - This route is complex from a governance perspective. The investor has to choose how to allocate and de-allocate to styles. - These could potentially be transacted by a scheme’s LDI manager. - Banks have a number of indices in each area, some of which may not have performed so well (adverse selection). - This places a fiduciary in between the bank and the pension scheme. - Is the asset manager truly independent of the bank? - Has the potential to tap into a lot of quantitative talent within banks. - Has the asset manager thoroughly due diligenced the intricacies of the swap documentation? - For pension schemes, this is the most familiar pathway to invest in style premia. - The managers may be able to trade more cheaply than the costs embedded in a bank swap. Style Premia Investing - Few managers have a long track record in a style premia product, especially in a multi-asset context (hedge funds have been employing similar strategies within their funds previously though). 26 February 2014 22
- 23. Mapping Style Premia to Asset Classes Manager A Value Momentum Carry Equities Bonds Rates FX Commodities Defensive Exposures to style premia within different asset classes will vary from manager to manager. Private & Confidential Style Premia Investing 26 February 2014 23
- 24. Conclusions - A large part of the returns of some very successful investors can be explained by exposures to style premia. - Much of what had previously been thought of as alpha is now being classed alternative beta. This includes style premia which are systematic, liquid market strategies shown to produce significant risk-adjusted returns. - Style premia performance has been strong with a low level of dependence on the economic environment. - Style premia are especially attractive because they are generally uncorrelated to each other and to major asset classes. - By accessing them through systematic, liquid and risk-controlled structures, investors can diversify their risk while lowering manager fees. - Given lower credit spreads, pension schemes looking for other diversifiers to equities may need to look at strategies such as style premia in order to achieve their objectives. Private & Confidential Style Premia Investing 26 February 2014 24
- 25. References Crowell, B., R. Israel, D. Kabiller and A. Berger (2012), “Is Alpha Just Beta Waiting To Be Discovered?”, AQR Capital Management Fama, E.F. and French, K.R. (1992), “The cross-section of expected stock returns”, Journal of Finance, 47, 2, pp. 427-465 Frazzini, A. and L.H. Pedersen (2013), “Betting Against Beta”, working paper, AQR Capital Management and New York University Frazzini, A., D. Kabiller and L.H. Pedersen (2013), “Buffett’s Alpha”, working paper, AQR Capital Management and New York University Ilmanen, A., T. Maloney and A. Ross (2013), “Exploring Macroeconomic Sensitivities”, AQR Capital Management Jegadeesh, N. and S. Titman (1993), “The returns to buying winners and selling losers”, Journal of Finance, 48, 1, 65-91 Private & Confidential Style Premia Investing 26 February 2014 25
- 26. Contacts Aniket Das FIA FIAA CFA Vice President Direct Line: 020 3326 7153 [email protected] Disclaimer For professional investors only. Not suitable for private customers. The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference Private & Confidential rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this document is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence. This presentation may not be copied, modified or provided by you , the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipient to any other party without Redington Limited’s prior written permission except as may be required by law. “7 Steps to Full Funding” is a trade mark of Redington Limited. Redington Limited is an investment consultant company regulated by the Financial Conduct Authority. The company does not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional, tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. Style Premia Investing Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is registered in England and Wales. ©Redington Limited 2013. All rights reserved. 26 February 2014 26