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Portfolio of Risk Premia: A New Approach to Diversification Authors: Remy Briand, Frank Nielsen, Dan Stefek Source: MSCI Barra Research Insights Date: January 2009 |
In this article, Briand, Nielsen and Stefek note that classic strategies of allocation to equities and bonds lead to portfolios with insufficient diversification and high volatility. As a result, investor portfolios are not protected from losses during downturns. It has recently been argued that alternative asset classes, such as private equity, hedge funds or commodities, improve portfolio diversification, but this additional diversification did not shield portfolio returns from the effects of the 2008 crisis. According to the authors, an ideal portfolio is composed of large numbers of return-producing units, the risks of which are independent of one another. These return-producing units, or risk premia, are the fundamental factors inherent to the traditional asset classes. In this article, the authors first study the characteristics of these risk premia and then discuss how they can be captured in order to produce investable indices.
The return of a portfolio can be broken down into a systematic return, explained by its exposition to asset-class beta, style beta, and strategy beta, and a non-systematic return (alpha). To isolate exposure to style beta from exposure to asset-class beta, it is possible to go long one dimension of a style and short the opposite dimension. For example, pure exposure to small-cap assets can be obtained by going long small caps and short large caps, which eliminates most of the market exposure.
The authors investigate the characteristics of the style (value, size, and so on) and strategy (merger arbitrage, convertible arbitrage, and so on) risk premia in terms of risk, return and diversification potential over the period from May 1995 to October 2008. The correlation of the various style and strategy risk premia is relatively low, most often less than 0.25, which indicates that these risk premia offered diversification benefits over the period considered. The correlation of most style, strategy and asset-class risk premia is also relatively low. The exceptions indicate the existence of redundancy in terms of return sources for some risk premia.
These preliminaries serve for portfolio asset allocation applications. The authors compare a portfolio of 60% equities and 40% bonds--a traditional allocation--and an equally weighted portfolio of strategy and style indices. They find a comparable excess return for the two portfolios over the period from May 1995 to October 2008 but much lower volatility (2.8% as opposed to 8.4%) for the equally weighted combination of style and strategy indices; the Sharpe ratio for the equally weighted portfolio is thus higher. In addition, the 60/40 portfolio is highly sensitive to extreme events and posts higher losses during crises. For example, the burst of the technology bubble caused a loss of about 30% for the 60/40 portfolio, compared to only 12% for the equally weighted portfolio. This is explained by the way the strategies compensate for each other: if one strategy posts heavy losses, another will perform well.
The purpose of this article was to validate that a combination of risk premia, style and strategy indices, for example, provides a profitable alternative to traditional allocation to equities and bonds. The authors propose to go further in future research, by determining the most efficient means of allocating these style and strategy indices and by showing how best to create these indices, in order to have investable pure style indices and strategy indices with distinct performance characteristics.
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