Whither the Equity Risk Premium?

Coverage of the 2011 Investment Innovations Conference

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weather vaneAmidst roiling equity markets, many have said the days of the equity risk premium are over; however, according to our keynote speaker at Canadian Investment Review’s 2011 Investment Innovation Conference, it’s not only alive and well, but there are also new risk premia that investors must consider to capture opportunities in today’s markets.

In his keynote address, Roger Ibbotson, professor of finance at the Yale School of Management, presented research on how investors can and should use these differing risk premia to pick stocks. While Ibbotson believes the equity risk premium is still valid, he said investors must shift focus to other premia in the market—particularly liquidity, which according to Ibbotson can boost returns significantly over time while decreasing overall portfolio risk.

Ibbotson presented his own research findings, showing less liquid stocks outperforming over time because those same stocks tend to be valued at a “liquidity discount.” Stock pickers who focus on finding illiquid stocks can expect these stocks to excel as they return to normal trading volumes: “Stocks tend to migrate toward normal trading volume over time, increasing less liquid valuations while decreasing more liquid valuations,” Ibbotson concluded.

Liquidity, post-2008, is a risk that plan sponsors have been keenly aware of. And so is market volatility, which has taken its toll on the funded status of pension plans around the world. This has been pushing many plans to consider liability driven investment (LDI) strategies or other approaches to de-risking their plans to meet their liabilities over the long term.

Watch: Roger Ibbotson explains the liquidity premium

To address this, speaker Soami Kohly, vice-president and head of LDI with McLean Budden, discussed “dynamic de-risking”—a strategy that can help plan sponsors deal with market challenges—and the series of “perfect storms” that have gripped the investment landscape during the last decade.

Plan sponsors can use dynamic de-risking to adjust asset mix alongside the changing funded status of the plan. This type of approach is important in markets where stable, predictable returns are just not available.

In contrast to traditional LDI approaches, dynamic de-risking doesn’t require plan sponsors to make a one-time adjustment to their asset mix, explained Kohly. As an alternative to LDI, “dynamic de-risking gradually removes market-based risk from the pension plan based on the sponsor’s financial objectives and current market conditions,” Kohly said. “This gradual approach is more palatable because it provides a balanced approach, where investment returns and cash contributions are used to close the funding gap.”

Yes, de-risking is important, Kohly admitted, but the process needs to be affordable. Therefore, choosing the right moments is key. This can be done through a pre-approved asset mix schedule that allows an investment manager to alter the plan’s asset mix as the funded status of the plan changes—even on a daily basis.

Watch: Soami Kohly discusses dynamic de-risking

As plan sponsors de-risk to design stable return streams, other presenters looked at tools and strategies to generate consistent returns over the long term.

Roland Austrup, CEO and CIO with Integrated Managed Futures, presented on commodity trading advisors (CTAs), specifically on research showing how CTAs as a group have been able to generate stable predictable returns for a 30-year time period. In this talk, Austrup illustrated three main approaches for using CTAs to boost returns and manage portfolio volatility: diversification, quantitative asset allocation and active long/short investing.

The diversification strategy, said Austrup, is marked by the growing allocation to commodities, real estate and external managers that pursue a variety of absolute return strategies that are uncorrelated to underlying market returns.

The second strategy employed by CTAs is risk management based on quantitative asset allocation models focused on downside volatility and correlation—as opposed to dollar-based asset allocation.

Finally, Austrup discussed a third CTA strategy involving long/short investing to limit losses and maximize profits by investing on the right side of the market.

“Understanding the strategies employed by CTAs can offer valuable insight into available tools that generate stability and predictability in portfolio returns,” Austrup concluded.

Watch: Roland Austrup talks about managing volatility

The discussion of risk management and mounting liabilities continued with Damian Handzy, chair and CEO with Investor Analytics. His presentation, “Liabilities as Part of Risk Management,” focused on how risk management is undergoing a profound transformation, moving from a narrow focus on asset mix and relative risk to a new way of thinking about pension liabilities.

“Today, plan sponsors are taking lessons from the alternative space,” said Handzy, who pointed out that factors like absolute measures of risk, value at risk and stress testing are now being applied to better estimate pension liabilities.

Accurate data about those liabilities, he said, is fundamental to the health of pension plans. Even small mistakes in estimating the discount rate used can mean pension funds do not have a handle on how much they need to be fully funded for the long term.

Watch: Damian Handzy discusses liability risk and asset risk

Originally published on BenefitsCanada.com

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