Style Premia Investing

Private & Confidential Style Premia Investing 26 February 2014

Style Premia Investing

1

Wednesday 26th February 2014


What is Style Premia Investing?

2

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…


What Characteristics do Style Premia have?

3

- 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 4

Section 1:

Style Premia Case Studies


Neil Woodford: Style Premia in Practice

5

- 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?

0

50

100

150

200

250

300

350

Invesco Perpetual High Income Fund FTSE All Share

Source: Invesco, Bloomberg


Betting Against Beta – Frazzini and Pedersen (2013)

6

- 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”.


Academic Research Has Highlighted Other Effects Over Long Periods of Time

7

- 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 price-

to-book or price-to-earnings) outperform ‘expensive’ stocks.

This holds up even on a risk-adjusted basis and is known as

the value factor.

- 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.

Fama & French (1992) Jegadeesh & Titman (1993)


Applying Style Premia to Neil Woodford

8

0

50

100

150

200

250

300

350

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

Market Value Momentum Defensive

Portfolio Weights 75% 13% 19% 52%

Source: Deutsche Bank, Invesco,

Bloomberg; Calculations: Redington

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.


Buffett’s Alpha

9

- Like Neil Woodford, Warren Buffett provides another fascinating example of style premia

investing in equities.

Can their approach to investment be done systematically?

- In a paper titled ‘Buffett’s Alpha’, AQR Capital Management principals Frazzini, Kabiller and Pedersen

find that:

• 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.

• 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.

• 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.


Section 2:

The Evolution of Alpha and Beta


Is Alpha Just Beta Waiting to be Discovered?

11

Time

Alpha

Alpha

Equity

Risk

Premium Equity

Risk

Premium

Equity Risk

Premium

AlphaAlpha

Other

Market

Risk

Premia Other Market

Risk Premia

Style Premia

Prior to cap-

weighted indices, all

returns were

effectively viewed as

alpha

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

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


A Continuum Between Beta and Alpha

12

Alpha

Style Premia

Market Risk Premia

Low

C

A

P

A

C

I

T

Y

High Low

High

F

E

E

S

Source: Figure 11, ‘Is Alpha Just Beta Waiting To Be Discovered?’, AQR Capital Management


Style Premia vs. Smart Beta

13

- 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.

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.

Exposures of a

typical smart

beta strategy


Style Premia Decomposition of the RAFI Fundamental Index

14

0

50

100

150

200

250

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

Market Value Momentum Defensive

Portfolio Weights 100% 21% 8% 0%

Source: Deutsche Bank, Research Affiliates,

Bloomberg; Calculations: Redington

Mostly market exposure gained along with some value and momentum style premia.


Section 3:

Style Premia Performance


Major Style Premia Families Cutting Across Liquid Markets

16

Need to be able to go long, go short and to leverage across multiple asset classes.

•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

Momentum

•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

Defensive

•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

Value

•Implies buying high-yielding assets and selling low-yielding assets

•For example: go long highest yielding currencies, go short lowest yielding currencies

Carry


Style Premia Returns Have Been Strong

17

Source: AQR Capital Management

An individual style premium may not work for a number of years. This is why diversification matters.

-50%

0%

50%

100%

150%

200%

Dec-89 Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 Dec-10

Cu

mu

lati

ve R

etu

rn

Performance of Style Strategies (log value, excess return over cash)

AQR Value AQR Momentum AQR Carry AQR Defensive MSCI World


Performance Over Various Economic Regimes Has Held Up Better Than Asset Classes

18

Source: Exhibit 2, ‘Exploring Macroeconomic Sensitivities’,

AQR Capital Management

0.71 0.510.76

0.52

1.21

0.00.51.01.52.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Value

1.021.34 1.14

0.93 0.81

0.00.51.01.52.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Momentum

0.88 0.72 0.9 0.881.1

0.00.51.01.52.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Carry

0.310.71

1.03

-0.18 0.29

-1.0

0.0

1.0

2.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Global Equities

0.46-0.09

0.710.1

1.22

-1.0

0.0

1.0

2.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Global Bonds

0.320.73

0.060.43

-0.09

-1.0

0.0

1.0

2.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Commodities

0.851.07 0.88

0.530.89

0.00.51.01.52.0

All Growth Up +

Inflation Up

Growth Up +

Inflation

Down

Growth Down

+ Inflation Up

Growth Down

+ Inflation

Down

Sh

arp

e R

ati

o

Defensive

For period 1972 to 2013


Style Premia are Generally Uncorrelated to Each Other and to Equities

19

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Average Pairwise Rolling 12 Month Correlation for Style Premia Factors

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Style Premia Rolling 12 Month Correlation to Equities

Value Momentum Carry Defensive

Value 1.00

Momentum -0.60 1.00

Carry -0.09 0.22 1.00

Defensive -0.04 0.12 -0.03 1.00

Style Premia Correlation (1990-2013)

Value Momentum Carry Defensive Composite Equities

Excess Return 3.29% 4.82% 7.61% 4.86% 12.55% 2.09%

Volatility 12.0% 12.0% 12.0% 12.0% 12.4% 15.5%

Sharpe Ratio 0.27 0.40 0.63 0.40 1.01 0.14

Style Premia Performance (1990-2013)

Source: AQR Capital Management


Frequently Asked Questions

20

Q1: How do I know these style premia haven’t just been ‘data-mined’?

Q2: Won’t these style premia disappear over time as more people invest in them?

Q3: Will correlations between the premia increase as people invest on this basis (i.e. a package of style premia)?

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.

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.

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.


Section 3:

Accessing Style Premia


Ways to Access Style Premia

Asset Managers trading

underlying instruments

Asset Managers trading

bank swaps on style premia

Via TRS on various bank

style premia indices

- Banks have live track records for style premia indices going back a number of years.

- These could potentially be transacted by a scheme’s LDI manager.

- This route is complex from a governance perspective. The investor has to choose how to allocate and de-allocate to styles.

- Banks have a number of indices in each area, some of which may not have performed so well (adverse selection).

- 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.

- 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).

- This places a fiduciary in between the

bank and the pension scheme.

- Has the potential to tap into a lot of

quantitative talent within banks.

- Is the asset manager truly

independent of the bank?

- Has the asset manager thoroughly

due diligenced the intricacies of the

swap documentation?


Mapping Style Premia to Asset Classes

23

Manager A Value Momentum Carry Defensive

Equities

Bonds

Rates

FX

Commodities

Exposures to style premia within different asset classes will vary from manager to manager.


Conclusions

24

- 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.


References

25

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


Disclaimer

For professional investors only. Not suitable for privatecustomers.

The information herein was obtained from various sources.We do not guarantee every aspect of its accuracy. Theinformation is for your private information and is fordiscussion purposes only. A variety of market factors andassumptions may affect this analysis, and this analysis doesnot reflect all possible loss scenarios. There is no certaintythat the parameters and assumptions used in this analysiscan be duplicated with actual trades. Any historicalexchange rates, interest rates or other reference rates orprices which appear above are not necessarily indicative offuture exchange rates, interest rates, or other reference

rates or prices. Neither the information, recommendationsor opinions expressed herein constitutes an offer to buy orsell any securities, futures, options, or investment productson your behalf. Unless otherwise stated, any pricinginformation in this document is indicative only, is subject tochange and is not an offer to transact. Where relevant, theprice quoted is exclusive of tax and delivery costs. Anyreference to the terms of executed transactions should betreated as preliminary and subject to further due diligence.

This presentation may not be copied, modified or providedby you , the Recipient, to any other party without RedingtonLimited’s prior written permission. It may also not bedisclosed by the Recipient to any other party without

Redington Limited’s prior written permission except as maybe required by law. “7 Steps to Full Funding” is a trade markof Redington Limited.

Redington Limited is an investment consultant companyregulated by the Financial Conduct Authority. The companydoes not advise on all implications of the transactionsdescribed herein. This information is for discussion purposesand prior to undertaking any trade, you should also discusswith your professional, tax, accounting and / or otherrelevant advisers how such particular trade(s) affect you. Allanalysis (whether in respect of tax, accounting, law or of anyother nature), should be treated as illustrative only and notrelied upon as accurate.

Registered Office: 13-15 Mallow Street, London EC1Y 8RD.Redington Limited (reg no 6660006) is registered in Englandand Wales.©Redington Limited 2013. All rights reserved.

Contacts

Aniket Das FIA FIAA CFA Vice PresidentDirect Line: 020 3326 [email protected]

Date post:	18-Dec-2014
Category:	Economy & Finance
Upload:	redington
View:	347 times
Download:	3 times

Style Premia Investing

Economy & Finance