Best Styles: Harvesting Risk Premium in Equity Investing

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1 Strategy Best Styles: Harvesting Risk Premium in Equity Investing Harvesting risk premiums is a common investment strategy in fixed income or foreign exchange investing. In equity investing it is still rather new, but well-rewarded. 16

2 Update I/

3 STRATEGY AUTHOR: DR KLAUS TELOEKEN For institutional investors, harvesting risk premiums is a common investment strategy. In asset classes like fixed income or currencies, it is straightforward for investors to think of investing in terms of harvesting risk premiums like the term premium or the credit premium in fixed income, or the carry premium in FX (foreign exchange) trading. Fixed income investors extend the duration of portfolios to capture the term premium in fixed income, or add to corporates and high yields to earn the credit premium. FX investors exploit the FX carry premium by going long in highyielding currencies, and shorting low-yielding currencies. In all these examples, investors take extra risks (duration risk, credit risk, currency risk) and expect to be compensated for this extra risk by means of an extra return the risk premium. Implicitly, the performance of equity managers is to a large extent explained by their exposures to a few equity risk premiums anyway and this is true irrespective of whether the manager is aware of this investment style exposure or not. (Chart 1) As the performance decomposition based on Mercer s GIMD database shows, there can be no doubt that investment style risk premiums are the true drivers of active equity returns. Index providers have reacted, and have recently launched a whole series of indices that target these risk premiums under a variety of different labels like smart beta indices, alternative beta indices or risk premium indices. As we are proponents of the idea of harvesting risk premiums, we think these indices are a good start. For equity investors, however, thinking in terms of equity risk premiums is still rather new. But risk premiums also exist here. Examples include the value premium, the small cap premium or the momentum premium. Value stocks, e.g. stocks with a low price/book-ratio, are usually more risky, as value stocks are typically less profitable, more leveraged and more cyclical than other stocks. The existence of all these risk premiums is well documented in the academic literature. For instance, Basu (1977) 1 discovered that stock with a low Price/Earnings ratio led stocks with a higher Price/ Earnings ratio on the NYSE. Banz (1981) 2 described the size effect small cap stocks outperform large cap names. Titman (1993) 3 found the momentum anomaly stocks that led the market over the last six to twelve months have a tendency to continue to lead markets. The existence of these risk premiums is documented for all major investment regions, and over extended time spans. And, based on our experience, there are not too many patterns in investing that are as persistent as these risk premiums. Therefore, it does make sense to explicitly build a portfolio around the idea of harvesting these equity risk premiums. UNDERSTAND. ACT. Harvesting risk premiums is a proven successful investment strategy across asset classes This concept is also well-rewarded in equity markets Index providers have started to offer a variety of risk premium strategies under labels like smart beta, alternative beta or risk premium indices These smart beta indices are an easy-to-grasp index methodology, but in our view they fail to efficiently earn the risk premiums of investment styles in a stable way AllianzGI Best Styles is a distinctive active equity management approach to harvest investment style risk premiums in a stable way across time Best Styles implements a diversified mix of long-term investment style winners, manages risk factors within investment styles, and also uses bottom-up alpha sources The Best Styles products have outperformed in 13 out of 15 years since inception, largely independent from the economic or the market cycle. 1 Basu, S. (1977) Investment Performance of Common Stocks in Relation to their Price- Earnings Ratios, Journal of Finance 2 Rolf W. Banz (1981), The Relationship Between Market Value and Return of Common Stocks, Journal of Financial Economics 3 Jegadeesh, N. and Titman (1993), Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance But we think investors can do better when it comes to harvesting individual risk premiums than just buying individual smart beta indices. Typical smart beta indices are not designed to harvest the equity risk premiums in the most efficient way for a client portfolio, but are more designed as an easy-to-grasp index methodology. 18

4 Update I/ WHERE DOES OUTPERFORMANCE COME FROM? EMPIRICAL EVIDENCE Active return decomposition of global equity managers ( ) RESIDUAL 2.5% 2.0% VALUE Active Returns MOMENTUM 1.5% 1.0% REVISIONS 0.5% GROWTH / SIZE / QUALITY RISK 0% Source: AllianzGI, 31 July 2013 For example, simple value indices like the Research Affiliates Fundamental Indices (RAFI) or the MSCI value weighted indices are biased towards companies in financial disarray, but the value premium can be earned more efficiently by avoiding these companies. Minimum volatility indices like the MSCI minimum volatility index, while targeting the low volatility premium, leave the exposure to other risk premiums like value or momentum largely unmanaged, which can result in adverse exposures to these risk factors. These examples demonstrate that, while smart beta investing is a good starting point, investors can do better in terms of capturing individual risk premiums like value or low volatility. And investors can also do better in terms of capturing multiple risk premiums than just buying a multiple of smart beta indices. The reason is that just buying a multiple of smart beta indices often leads to insufficient diversification. However, diversification across multiple risk premiums is warranted. Many risk factors like value or momentum have been very successful over the longer term, but have also experienced significant short-term drawdowns. For example, the value investor had to endure a sharp decline in the run-up to the TMT bubble, or as the financial crisis unfolded in Similarly, the momentum investor suffered from a painful setback after the burst of the TMT bubble, or during the market recovery in A diversified blend of the value and momentum investment styles has earned the risk premiums attached to these investment styles in a much more stable way than each of the individual investment styles. (Chart 2) 19

5 STRATEGY 02 INVESTMENT STYLE DIVERSIFICATION IS KEY TO STABLE OUTPERFORMANCE Relative performance of investment styles for a global universe 120% 100% Diversified Style Mix Value 80% 60% 40% 20% Momentum Source: AllianzGI, February 2014 Historic simulation Dec 1989 Dec 2012: quarterly rebalancing, performance after (estimated) transaction costs. Assumptions of the backtest: since no comparable fund existed in the period under consideration, assumptions were made in order to illustrate past performance as realistically as possible.the model portfolios use a similar breadth of investment opportunities as existing global funds. The performance figures are before taxes and after transactions costs of 50bps, dividends are reinvested. The model portfolio comprises approx. 300 stocks, all overweights in the portfolio are of equal size, underweights relative to the benchmark are restricted to 1%. No constraints are in place with respect to sector or country deviations from the benchmark. The strategy is rebalanced semi-annually, on average 50% half turn portfolio changes p.a. The relative performance of the strategy is shown relative to a global investment universe that represents the liquid investment opportunities over time. The performance of this investment universe may differ from the performance of a benchmark like the MSCI World index. Unless otherwise noted, performance results and valuation presented are in US Dollars. Diversification is key The chart underpins the fact that harvesting risk premiums diversification across multiple risk factors has been key to stable outperformance. But investors can do better in terms of diversification across multiple risk factors than just buying a multiple of smart beta indices. Typical smart beta indices have varying exposures to risk factors to the targeted risk factors, and also to non-targeted risk factors where exposures are unmanaged. This makes correlations between smart beta indices rather unstable, and hence renders an efficient diversification impossible. For example, the correlation between the MSCI risk premium indices for value and momentum shifts over time. Most of the time, like today, the correlation of relative returns is negative, hence there is a substantial diversification advantage from blending value with momentum. However, in prolonged cyclical value rallies like the one from 2003 to 2007, value and momentum typically go hand in hand, and hence there is no diversification advantage left from blending value with momentum. But diversification was badly needed at the end of the value rally in 2008, as both value and momentum stocks tanked as the global economy grinded to a halt after the Lehman collapse. However, for investors in these two MSCI risk premium indices there was nothing that could be done to restore diversification; investors just had to accept the loss of diversification. Smart beta indices like the MSCI risk premium indices are simply not designed with a view to a diversified combination with other smart beta indices, but are designed as stand-alone products. A portfolio manager in an integrated portfolio solution, though, can provide the proper diversification across multiple risk premiums by structuring the individual risk premium portfolios with a view towards the subsequent diversification across multiple risk premiums. To do so, the portfolio manager should manage the composition of the individual risk premium portfolios in a way that allows stable mutual correlations, and hence effective diversification. For example, if the correlations between value and momentum are becoming too high the portfolio manager will: put more weight on those value stocks that are not also momentum stocks put more weight on those valuation criteria that will have a lower correlation with momentum factors to effectively restore diversification between value and momentum. 20

6 Just buying a multiple of smart beta indices often leads to insufficient diversification. 21

7 STRATEGY 03 INVESTMENT PROCESS BEST STYLES Investment Style Research to earn the smart beta risk premiums of investment styles Best Styles Approach Allianz Global Investors Global Company Research to generate stock selection alpha within investment styles Source: AllianzGI, February BEST STYLES VS. MSCI SMART BETA INDICES Relative Performance of Best Styles Global vs MSCI Risk Premium ETFs Indices after Trading Costs Performance MSCI World 175 % 140% 175 % 150 % 120% 125 % Relative performance vs MSCI World 100 % 100% 75 % MSCI WORLD 50 % Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec % World quality World small cap World value weighted World growth World minimum volatility World momentum World high dividend MSCI quality mix Best Styles Source: AllianzGI, MSCI. This is for guidance only and not indicative of future allocation. The performance of Best Styles is represented by the composite SYSTEMATIC EQUITY GLOBAL BEST STYLES DEVELOPED COMP The other indices are MSCI World Risk Premium Indices, except the Momentum index where a MSCI World version is not available, and the relative performance of the MSCI AC World is shown instead. We applied transactions costs to the indices to proxy the performance of ETFs mimicking these indices. 22

8 Update I/2014 The AllianzGI Best Styles strategy is an active equity management approach built around the idea of harvesting smart betas or investment style risk premiums in a disciplined, systematic approach. In addition to this, an integrated portfolio solution not only achieves the proper diversification across multiple risk premiums, but also allows the successful mitigation of exposures to unwanted risk factors like macro-economic or interest rate sensitivities that stand in the way of harvesting the risk premiums in a stable way, i.e., largely independent from the economic or market environment. Smart beta investing, harvesting equity risk premiums and the Best Styles investment approach The AllianzGI Best Styles strategy is an active equity management approach built around the idea of harvesting smart betas or investment style risk premiums in a disciplined, systematic approach. Dr Klaus Teloeken is the Co-CIO of the Systematic Equity team. He joined Allianz Global Investors in 1996 as a quantitative analyst, and in 2001 he assumed the role of Head of Systematic Equity. He oversees more than EUR 17 billion of assets under management, and is responsible for the development and management of systematic investment strategies for equities. In this role Klaus has developed the team s Best Styles and High Dividend product line. He is also responsible for the management of the Best Styles Global and High Dividend Global product. Klaus studied mathematics and computer science in Dortmund, Germany. In the investment segment Best Styles, Dr Teloeken is supported by his colleague and Co-CIO Dr Benedikt Henne. The Best Styles approach, in a first layer, seeks to capture the risk premiums attached to investment styles like value and momentum. In a second layer, Best Styles also seeks to generate additional alpha within the investment style framework based on the AllianzGI bottom-up company research. (Chart 3) These two layers are combined with a diligent portfolio construction that implements a diversified investment style mix. In doing so, the Best Styles approach, in addition to harvesting investment style risk premiums, also provides the proper diversification across risk premiums. The individual MSCI Risk Premiums indices ETFs showed a rather unsteady performance over time and during the Great Financial Crisis while the Best Styles Global portfolios navigated quite steadily through the market turbulences of the last 10 years. (Chart 4) Dr Benedikt Henne works as Chief Investment Officer (CIO) Systematic Equity at Allianz Global Investors. He joined the company in 1998, and is responsible for the development and management of systematic equity products. In 2001 he was appointed Head of the Systematic Equity Team at Frankfurt. Dr Henne read mathematics in Paris and Bonn. He obtained a maîtrise from the Université Pierre et Marie Curie, Paris, and a mathematics degree and doctorate from the University of Bonn. He has held a CFA charter since