1. Style Premia Investing
Wednesday 26th February 2014
Private & Confidential
Style Premia Investing
26 February 2014
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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…
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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.
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4. Section 1:
Style Premia Case Studies
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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?
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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”.
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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.
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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.
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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?
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10. Section 2:
The Evolution of Alpha and Beta
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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
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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
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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.
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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.
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15. Section 3:
Style Premia Performance
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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.
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Style Premia Investing
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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.
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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
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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
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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
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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.
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21. Section 3:
Accessing Style Premia
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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
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- 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).
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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.
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24. Conclusions
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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.
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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
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26. Contacts
Aniket Das FIA FIAA CFA
Vice President
Direct Line: 020 3326 7153
aniket.das@redington.co.uk
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