Read any decent book [1]
Modifying your portfolio like this unlocks the potential for greater performance in exchange for extra helpings of risk [4].
But how big are these premiums, and are they worth playing for?
Return premium size and volatility
Return premiums have historically been handsome. And they’ve delivered over prolonged periods of time, too, although we can’t know if their pep will stretch into the future.
The table below shows an example of US return premium pay-offs. It’s taken from a paper [5] published by Robeco Asset Management and is available in full from the Journal of Index Investing [6]:
[7]
The excess return column on the left shows the result delivered by each return premium portfolio over and above the return offered by ‘risk-free’ government bonds, between 1963 and 2009.
If you swoosh your eye to the right-hand column, CAPM Alpha, you can see what each return delivered on top of the broad US equity market, after adjusting for risk.
Particularly eye-catching is the extra 4.6% annualised excess return from the value and momentum portfolios – albeit at the expense of extra volatility [8].
Very tempting.
Risk it for a biscuit
That volatility column is not to be dismissed lightly. It shows that only the returns of low volatility stocks are subject to less violent swings than the equity market. (The clue is in the name, I guess).
Investors in return premium strategies therefore have to be able to tough it out when the market gives your cunning plan a right booting. Individual premiums have lagged the market for 10-20 years during the roughest patches.
But what the Sharpe ratio [9] tells us is that time spent adrift in the choppy seas of risk has proved worth it for the higher overall returns.
The higher the Sharpe ratio, the better the risk-reward trade-off. And every return premium portfolio beats the market in this respect.
Indeed, the momentum and value portfolios deliver a risk-adjusted reward that’s almost double the market index.
Correlation
It gets better. There’s plenty of evidence that the pitch and yaw of multiple return premiums has diversification [10] advantages when combined in a portfolio.
The Robeco paper illustrates this nicely by showing the relative lack of correlation [11] between the return premiums:
[12]
- A correlation score of 1 means that two assets move up and down together.
- -1 means they move in opposite directions.
- 0 means that the relationship is random.
Any score from around 0.3 to -0.3 implies a lack of correlation, which accounts for most of the relationships above, bar value with low volatility and small cap stocks.
However, value has been known to decouple from low volatility when recession strikes and value stocks come under pressure.
The lack of correlation between the different premiums implies that some may wax while others wane, rather than all plunge together like climbers on a rope.
Diversification
Here’s another study from the Journal of Indexes [13] (Europe) that shows the diversification benefits gained by melding return premiums into a joint portfolio, between 1990 and 2011:
[14](Click to enlarge)
- The S&P 500 stands in for the market portfolio.
- Fundamentally Weighted is a value premium strategy.
- Equal Weighted is a small cap strategy.
- Alternative Beta Composite is a portfolio that is divided one quarter each into the value, small cap, low vol and momentum strategies.
Note that the combined portfolio beats the market by 2% a year and with much better risk adjusted returns (see the Sharpe Ratio).
Even the overall risk is slightly lower – 14.2% as compared to 15.1% – indicating that the different equity strategies mesh together to create a stronger, more stable package.
We can see that the low volatility strategy has the best risk-adjusted returns and lowest risk overall, but it would be a courageous investor who hangs their hat on that bravura performance continuing. As always it’s best to spread your bets [10].
To illustrate the point, investment strategist and Larry Swedroe’s co-author, Jared Kizer [15], has analysed the likelihood of return premiums triumphing over longer time frames.
Kizer looked at US stock market data between 1927 and 2011 and came up with this table:
[16]
Over monthly periods, you can see that the chances of positive returns for size and value are only a smidgeon over 50-50.
Happily, performance is more satisfactory over longer horizons, though you still have to be prepared for size and value to lag the market 25% of the time over five-year periods.
More interesting still is the table below from Kizer showing that one of the premiums will bring home the bacon 96% of the time:
[17]
If diversification is a free lunch then let’s make it bacon sandwiches!
Caveat City
The strength of the return premiums change over time, by country and indeed according to how each premium is defined. So the numbers above may well differ from the results of other studies, and from the results in the UK.
Moreover, strategies that attempt to capture return premiums in reality tend to have bigger holes in their butterfly nets than is allowed for by the academic studies that originally pinpointed the opportunities.
There is though plenty of evidence to show that the premiums have persisted across international markets and the historical record.
I’ve seen enough to make me believe that it’s worth tilting my portfolio to collect at least some of the extra return juice. We’ll delve deeper into the possibilities in forthcoming posts.
Take it steady,
The Accumulator