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Private & Confidential Style Premia Investing 26 February 2014
Style Premia Investing
1
Wednesday 26th February 2014
Private & Confidential Style Premia Investing 26 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…
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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”.
Private & Confidential Style Premia Investing 26 February 2014
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)
Private & Confidential Style Premia Investing 26 February 2014
Applying Style Premia to Neil Woodford
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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.
Private & Confidential Style Premia Investing 26 February 2014
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.
Private & Confidential Style Premia Investing 26 February 2014 10
Section 2:
The Evolution of Alpha and Beta
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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.
Private & Confidential Style Premia Investing 26 February 2014 15
Section 3:
Style Premia Performance
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014
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.
Private & Confidential Style Premia Investing 26 February 2014 21
Section 3:
Accessing Style Premia
Private & Confidential Style Premia Investing 26 February 2014 22
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?
Private & Confidential Style Premia Investing 26 February 2014
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.
Private & Confidential Style Premia Investing 26 February 2014
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.
Private & Confidential Style Premia Investing 26 February 2014
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
Private & Confidential Style Premia Investing 26 February 2014 26
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