Scarcity of safe assets drives momentum for alternatively weighted risk premia indexes

Index providers and fund managers are seeing demand from investors for strategy indexes that focus on risk, as returns on risk-free assets fall far below historical norms. Magda Ali reports

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The scarcity of safe assets is likely to reflect equity risk-premiums, which have risen during the past year, and low risk-free bond yields, which have become negative in inflation-adjusted terms, warned Barclays Capital at the presentation of its latest annual Equity gilt study in London in February. As investors continue to scrutinise risky stocks, alternatively weighted risk premium indexes designed to outperform market-cap indexes by investing in the least volatile stocks have been attracting institutional investors.

In Demystifying equity risk-based strategies, a white paper published by BNP Paribas Investment Partners (BNPP IP) in December 2011, investors were urged to "to check carefully the correlation of their excess returns over the market-capped indexes, their overlap, and compare their factor exposures".

While stronger economic recovery and a restoration of confidence in eurozone sovereign debt would lift equity prices and reduce equity risk premiums, risk-free yields are likely to remain low and equity premiums elevated relative to historic norms for several years, according to Piero Ghezzi, head of research in economics and emerging markets at Barclay Capital in London, and co-author of the equity gilt study. "After 2008, availability of safe assets had declined significantly," says Ghezzi. "Returns on risk-free assets stand out as abnormally low as they are currently negative on an inflation-adjusted basis in nearly all cases."

The implication, he says, is that the difference between expected yields on equities and risk-free assets are likely to remain historically high, and that despite unusually high equity risk premiums, current valuations are not as cheap as they appear.

While their debt and deficits are of a similar size to eurozone counterparts such as Spain and Italy, the US, UK and Japan enjoy institutional advantages such as monetary sovereignty, flexible exchange rates and reserve currency status, which offer a degree of insulation from the corrosive market dynamics in the euro area.

Returns on risk-free assets stand out as abnormally low as they are currently negative on an inflation-adjusted basis in nearly all cases

However, these institutional advantages merely buy time, says the BarCap report. "These countries will have to take significant action over the next decade to ensure fiscal sustainability, or they will be subject to some combination of high inflation and economic distress," says Ghezzi.

Against this backdrop of turbulent markets and a shrinking universe of perceived safe havens, tail-risk hedging and capital preservation dominated 2011. There has been much debate over the most appropriate hedges and the ability to truly provide protection in a crisis. Barclays Capital has launched a series of risk-premium strategies across equities, foreign exchange and commodities designed to help investors position themselves for a heightened risk environment. When seeking low volatility or risk mitigation, alternative weighting can prove more sensitive to changes in the underlying market and offer tools to achieve capital protection through better diversification, as well as yield enhancement, according to Ghezzi.

The BNPP IP report notes that low-volatility stocks have outperformed high-volatility stocks since at least 1926, delivering positive alpha in all regions of the world. "Equity risk-based strategies outperform the market-capped index with lower risk on a medium- to long-term perspective," says Pierre Moulin, head of financial engineering at BNP Paribas in Paris. "A tilt towards low-risk stocks reduces the risk of the portfolio; this tilt is also responsible for a negative exposure to the market index."

A series of exchange-traded funds (ETFs) that use mean variance, minimum variance, equal- and value-weighted methods to adjust market weights are being or have been launched by Ossiam, Lyxor and Wisdom Tree. Last year, MSCI's alternatively weighted index series was used as the basis for a series of ETFs from issuers such as Blackrock and PowerShares.

In January, Wyoming Retirement System (WRS), a $6.5 billion pension plan, said it would restructure its passive equity portfolio to replicate a series of MSCI risk premium indexes. The pension fund is also tracking the newly launched MSCI Risk Weighted Index, designed to emphasise low-volatility stocks, and the MSCI Value Weighted Index, which is tilted towards stocks with value characteristics and lower valuations.

The realignment of WRS's passive equity portfolio is intended to lower volatility, improve risk-adjusted returns and decrease fees, says John Johnson, chief investment officer at the fund.

"Risk premium indexes are evolving rapidly and we have responded to demand from institutional investors for low-volatility strategy indexes," says Dimitris Melas, executive director and head of equity research for Europe, the Middle East and Africa at MSCI in London. "It is about lowering the volatility of the benchmark and combining stocks in a way that allows us to overweight stocks that are low in volatility."

Melas says institutional investors like this strategy because they want to gain equity exposure with an element of downside protection. In September 2011, MSCI launched its own white paper, Harvesting risk premium, which examined the historical characteristics of alternatively weighted strategies. The report's emphasis that systematic factors are drivers of long-term portfolio performance could lead to a redefinition of active management, and provide further justification and motivation for the adoption of risk-based asset allocation.

As of December 2011, the MSCI World Minimum Volatility Index was up nearly 14% against the benchmark market-capped MSCI World Index. "Strategy-based indexes are defensive in nature," says Melas. "We use our indexes to demonstrate how to outperform the market-capped indexes with lower risk."

Other risk-based strategies have performed similarly. BNPP IP's Equity World Low Volatility fund, for instance, has outperformed the market-capped benchmark index by 8.35% since inception. "This implies an alpha of 7.77%," says Gilles Guerin, Paris-based chief executive of Theam, BNPP IP's partner, which has more than €13 billion of assets under management. "It is clear that low-risk stocks have higher returns than expected from their level of risk."

"Investors are averse to losses and tend to prefer asymmetric profiles with downside protection," says Guerin. "They tend to monitor the markets closely and expect good performance in bull markets; the fund captures higher equity returns and delivers far better risk-return with substantially lower risk than capitalisation-weighted indexes."

BNP Paribas Investment Partners expects the approach to remain niche. "It will just take another fast rise in equity markets to erase memories and put the focus back on performance and forget risk," says William De Vijlder, chief investment officer at BNPP IP in Paris. "But the clever investors that persevere and invest in low-volatility stocks for the long-term should continue to sleep much better for many years to come."

 

Problems with alternative weighting

Increasingly, asset managers are approaching risk-control strategy indexes from a financial, rather than fundamentals, point of view, and are coming across some hurdles. Minimum variance, for instance, which exposes investors to the least volatile stocks, is said to have too much focus on reducing absolute risk, which creates a huge tracking error against the market-capped indexes. Meanwhile, the maximum diversification strategy, which invests in portfolios that maximise a diversification ratio, is said to be too sensitive to the risk model and is exposed to overcrowding.

Essentially exposed to smaller cap stocks, the equally weighted indexes also have higher transaction costs. "All alternatively weighted strategies are not equal," says Moulin. "The low-beta stock pricing anomaly, which forms the basis of alternatively weighted strategy indexes, is attributed to the fact that equity investors usually see higher returns, and therefore prefer riskier stocks, with higher beta, creating a demand imbalance."

Moulin predicts the market-capped indexes will remain the benchmark for investing in equities, with the largest capacity and lowest turnover.

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