One of the big surprises of the 2013 Budget is the new Help To Buy scheme. This will see the government topping up deposits of home buyers in a way more commonly done by parents via the so-called “Bank of Mum and Dad.”

There will be two strands to Help to Buy:

Help to Buy: equity loan – Starting 1 April 2013, the Help to Buy: equity loan will be opened up to provide equity loans worth up to 20 per cent of the value of a new build home, repayable once the home is sold. The eligibility criteria for shared equity will be widened, with the government saying the scheme will be open not only to first time buyers but also to all those looking to move up the housing ladder. The maximum home value will be £600,000 and there will be no income cap constraint.

Help to Buy: mortgage guarantee – The Government plans to create a mortgage guarantee scheme to “increase the availability of mortgages for those with small deposits across the UK”. This scheme will begin in January 2014 and will run for three years. It will offer a Government guarantee to lenders who offer mortgages to people with smaller-sized deposits of 5-20%.

The big potential benefit of these schemes will be enabling those with smaller self-saved deposits to access lower mortgage rates, thanks to the Government taking a share to raise the overall deposit.

Read the details for yourself by downloading the 2013 Budget document in full.

Why Help to Buy?

Cheerleaders for the new schemes will point out that not everyone has rich parents, and that even modestly well-off parents are becoming less able to remortgage their own homes to provide deposits for children due to rising living cost.

Critics of Help to Buy will argue that it looks like more support aimed at keep UK house prices inflated. That might be justifiable given our economic predicament, but would it not be more sensible to increase social housing provision to support housebuilders and provide plenty of new jobs and homes, without encouraging people to take out ever-larger mortgages in a market charging even higher prices due to this influx of new money? Such newly State-built homes could have been sold off into private hands at a later date via the Right to Buy scheme.

Surely the last thing we need is a new house price boom?

Help to Buy explained

Regardless of the rights and wrongs, many will want to know how to get their mitts on this government money, and whether it’s a good idea from their own perspective.

The scheme has only just been announced, but the Treasury has already released the following graphic to help us understand what’s on offer:

So what do you think about Help to Buy? Is it a sensible way to tackle Britain’s arguably iniquitous housing issues?

And would you consider using Help to Buy, or would you rather own all your own home for yourself?

Read any decent book on passive investing and you’ll learn about clusters of equities with the potential to turbocharge your returns. These equities deliver return premiums, and by favouring them you can customise your portfolio much like a car modder might bolt a giant spoiler onto his Vauxhall Astra.

Modifying your portfolio like this unlocks the potential for greater performance in exchange for extra helpings of risk.

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 published by Robeco Asset Management and is available in full from the Journal of Index Investing:

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.

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 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 advantages when combined in a portfolio.

The Robeco paper illustrates this nicely by showing the relative lack of correlation between the return premiums:

• 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 (Europe) that shows the diversification benefits gained by melding return premiums into a joint portfolio, between 1990 and 2011:

• 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.

To illustrate the point, investment strategist and Larry Swedroe’s co-author, Jared Kizer, 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:

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:

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

Good reads from around the Web.

This week we’ll see the Chancellor deliver another uninspiring budget. Everyone knows the economic figures will be bad, and nobody knows what to do about it. (Certainly far more unites our political parties than divides them).

My early optimism in 2010 about a return to growth in the UK turned out to be wildly misplaced (although happily it hasn’t retarded the UK stock market).

Like most people I underestimated how long the global crisis would drag on for – we haven’t seen the likes of this for 60 years. And while I knew UK consumers were living according to precepts of Brewster’s Millions, I didn’t appreciate just how ruinously this dovetailed (IMHO) with excessive state spending to produce a double-whammy of living beyond our means. Now we’re catching up with reality.

I used to think the Coalition government was making the best of a bad hand, but I’ve now concluded they’re simply way out of their depth in facing this challenge.

We all have our own opinions about why most politicians are now basically PR men and self-confident ex-public schoolboys largely untested in the real world. Personally I think the electorate must take most of the blame.

For example, I was rooting for Obama not Romney in the recent US elections, but you only have to see how the latter was vilified for his infamous 47% comment to understand that free debate is toxic in modern politics.

Better than nothing

In any event, there’s no evidence we’ll see anything bold from this lot. Even the things they’ve got right they’ve inched towards half-heartedly, and they’ve embraced stealth taxes to boot.

Being bolder would have at least been good for our animal spirits. I’d have raised the £10,000 personal allowance at a stroke, for example, which would have raised real incomes for the poorest, sent a clear signal about rewarding work, and delivered a boost for the economy.

I’d have been cleverer on spending, too.

I don’t apologize for seeing the need to make many of the cuts the government has started to make. State spending and a growing entitlement culture needed curbing in my view, even without the gigantic IOU left by the financial crisis.

But I’d have offset at least some of these cuts with targeted infrastructure spending. Now is the time for the government to borrow a few billion at today’s bargain rates to build a new town or two in the South East, for instance. Damming the Severn Estuary to create a massive hydroelectric resource would have been another capital spending project I’d have put into place. There are others.

I understand infrastructural spending has a mixed record, but in my view it’d be great for morale. And even if we end up slightly down on the deal in fiscal terms, at least a few hundred thousand young people would have been employed and would have had a better chance of one day owning a home. And there would be slightly less need for fossil fuels in the future, too.

Fiddling while Romford burns

Big bold actions like radical tax reform – say an across-the-board flat rate tax of 30% and all exemptions out the window – are unthinkable with these leaders.

Instead we’ll get more tinkering.

On that note, be especially alert to talk of changing the Bank of England’s inflation remit. The Bank’s own chief economist Spencer Dale warned as much this week in The Telegraph:

The lesson from history has been the best a central bank can offer for “a prosperous and vibrant economy was to deliver enduring price stability”, Dale said.

“Recently, there have been some worrying signs that cracks may be appearing in that consensus. A sense that inflation is somehow yesterday’s war. That central banks should focus more on growth. That a period of higher inflation may even aid the recovery. This is dangerous talk.”

Citing the experience of the late 1960s when policymakers let “inflation to get out of control after nearly two decades of price stability”, he cautioned against being “complacent about the risks posed by further stimulus”.

He added: “It would be irresponsible to repeat the same mistakes again.”

Dale is right to warn on this.

Today we find ourselves with political leaders who have never aspired to be much else. That means in my view that solving our problems via higher inflation – even if it means overall we’re worse off than we might have been – is an  appealing option, because the electorate doesn’t understand the real value of money.

Of course we could argue that politicians don’t, either.

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