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Do smart beta risk premium exist? September 2009

This article explores the concept of smart beta and its ability to capture excess returns above required returns. It discusses various approaches to capturing excess returns and the importance of managing downside risk. The article also highlights the pitfalls of benchmark investing and the benefits of active and smart beta strategies. Additionally, it explores the stock specific alpha and the value premium in the South African context. The article concludes by discussing the challenges and benefits of smart beta investing and the opportunities to beat the market.

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Do smart beta risk premium exist? September 2009

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  1. Do smart beta risk premium exist? September 2009

  2. “Oh, if only it were so simple.”

  3. The Holy grail?

  4. Introduction Definition of risk? • Beta or • Protecting capital & generating a real return over time • Smart beta implies capturing excess return above required return • This is credible and achievable • But how do you best capture it? The focus is on systematic risk • How do you best capture the stock specific excess return? • Many approaches to capturing excess returns – you decide?

  5. How should you define risk? • First and foremost, managing downside risk must be embedded in your investment philosophy • Risk does not reside in price changes and cannot be summarized into a single number • In the world of investing risk translates into • A permanent loss of capital • Your savings not keeping up with inflation • This is reflected in the difference between the share price & intrinsic value

  6. The pitfalls of “the market” - benchmark • Over allocation to large caps • BM’s are themselves inherentlyrisky and result in a misallocation of capital. They are biased towards momentum • Do not make best use of portfolio managers’ skills • BM strategies may do proportionally better in bull markets, they also participate fully in the inevitablebusts • Suffer from excessive levels of concentration Active managers & smart beta managers aim to exploit this

  7. Small Caps (69) 3% Resources (18) 11% Financials (34) 19% Small Caps (69) 42% Industrials (45) 27% Resources (18) 44% Industrials (45) 34% Financials (34) 20% Increasing the probability of out performance Sector Allocations in a Market Cap weighted Benchmark Sector Allocations in an Equal weighted Benchmark Source: SIM

  8. KEH GND BIL DSY SUI MUR AGL REI GRT TBS SOL SHP BVT MTN SLM OML FSR SAB GFI SBK IMP ANG CFR Concentration and stock specific risk in the benchmark How do we capture the stock specific alpha? A recent study has shown that the JSE All Share index performs similarly to an equal weighted portfolio of 16 stocks (Kruger and van Rensburg, IAJ, Nov 2008)

  9. 9 The “value premia” – it does exist (SA context) Source: SIM

  10. The link between business economics & value Great business economics DDM Model Business economics needs to be discussed, debated & rationalised – this is not a true Benjamin Graham investment Source: SIM

  11. 11 Best view investing • Exploit behavioural factors – fear & greed • Markets may be “efficient” in S-T, but • Market participants are often irrational in interpreting it! • Smart beta – can it capture this? • Mean reversion: returns & ratings mean revert! • How do you capture this in smart beta approach? • These two factors are timeless in nature • The “elusive” small cap premia

  12. 12 Behavioral factors – fear & greed • 97% value lost from peak to trough (1 yr) • 40 years to recover (compounding @ 10%) Herd mentality – fat tail event So markets are efficient? Source: INet

  13. 13 Mean reversion Mean reversion : Growth rates & PE ratios • PE = [(1+g)/(k-g)]* PR where :g = growth, k = required return, PR = payout ratio • Stock returns: dividends & future growth, not volatility! Source: SIM

  14. 14 Current PE Current ROE 30.0 70% 60% 25.0 50% 20.0 40% 15.0 30% 10.0 20% Not the time to have bought 5.0 10% 0.0 0% Oct 05 Apr 06 Oct 06 Apr 07 Oct 07 Apr 09 Apr 05 Apr 08 Oct 08 Jun 05 Jun 06 Jun 07 Jun 09 Jun 08 Feb 06 Feb 07 Feb 09 Feb 05 Feb 08 Aug 05 Dec 05 Aug 06 Dec 06 Aug 07 Dec 07 Aug 08 Dec 08 Example – misinterpretation of value (Amplats) • Returns were well above normalised, realistic levels • How do you capture this in smart beta approach? Source: SIM, Thompsons, Barra

  15. Challenges with smart beta • How do you leverage off active corporate governance? • There are benefits to L-T responsible investing • Can you avoid bubbles & turning points? • How do you avoid investing in potential bankruptcies? • Do you maximise wealth over time relative to best view investing? • How are you managing risk – protecting loss of capital, real returns? • How do you fully capture irrationality in the market?

  16. Benefits of “best view” investing • Benefit from active corporate governance & SRI • Avoid problems associated with “benchmarks” • More concentrated portfolios – benefit from best views • Move from market risk to manager risk • Risk defined as protecting capital & real returns (not volatility)

  17. Conclusion • Do smart beta exist? • It does, but does it maximise wealth over time? • Can active management add incremental alpha? • Yes, optimal portfolio construction, fundamental overlay • Do opportunities exist to beat the market? Yes. Why? • Markets are irrational – driven by fear & greed • A value premia is evident • Small cap premia exist at times • Rational behaviour & patience pays off

  18. Thank you

  19. Tool box

  20. How smart is beta? • Karl Popper – the best way to falsify a model: falsify its predictions • Beta: measuring risk i.t.o. variability of historical returns is bizarre • Example: • Consider a piece of land – price varies more than “the market” • It drops over three years by 90%, prime space, 15% yield • Beta = 1.5 • Compared to land moving in line with market, beta 1, yield 3% • Which one is more “risky”?

  21. 21 Current Price Beta 1,400.0 1.8 1.6 1,200.0 1.4 1,000.0 1.2 800.0 1 0.8 600.0 0.6 400.0 0.4 200.0 0.2 0 0.0 Apr 09 Apr 06 Oct 06 Apr 07 Oct 07 Jun 06 Jun 07 Jun 09 Oct 05 Apr 05 Apr 08 Oct 08 Jun 05 Jun 08 Feb 07 Feb 09 Feb 06 Dec 06 Aug 07 Dec 07 Feb 05 Aug 06 Feb 08 Dec 08 Aug 05 Dec 05 Aug 08 Beta – are you telling me that this stock is riskier? AMS price dropped 70%, Platinum price dropped 63%, beta rises to 1.7 Source: SIM, Thompson, Barra

  22. Alpha – what do we mean by it? • Alpha represents stock specific returns in excess of the “market” • Is this only what investors want to achieve? • Do investors not want to maximise geometric wealth? • Or to protect capital & generate real returns? • Is “the market” a good proxy for achieving above?

  23. Value & business economics “Can anything be considered cheap in current market conditions – Michael Coulsen, Finweek, 4/9/2008 “It may be best to hedge your bets in an unsettled world” – Sharon Wood, FM 22/02/2002 Emerging market bond crisis Staff strike How do you capture good business economics & value Source: INet

  24. J200 J201 & J202 J202 J200 & J201 J203 Diversification – not more stocks, but which stocks Total Risk vs Num Stocks for Different Universes - Average of 1000 random Portfolios 50% 45% 40% Average Total Risk 35% 30% 25% 0 5 10 15 20 25 30 35 40 Average Stocks in Portfolio

  25. 25 Factor returns Source: SIM,

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