When Markets Misprice Risk

Coverage of the 2011 Risk Management Conference.

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278204_objects_in_mirror_are_closer_tInvestors who take on risk generally expect to be paid for doing so: in the absence of an expectation of higher returns, investors would avoid the higher-risk asset. So one might expect that riskier stocks would command a risk premium, and that we should observe higher returns from them over the long run than those available from the broad market. On the contrary, there is a substantial body of evidence that no such risk premium exists.

Studies – some decades old, others more recent – have consistently found that this type of risk has not been rewarded. Some recent studies have even shown a negative correlation between returns and increasing risk across a wide range of markets. It seems to be a remarkably robust effect.

Moreover, this is a distinct effect from the value effect that investors have tracked for many years: price is not an input to the definition of a defensive stock and we observe within the defensive universe some traits that would more commonly be associated with growth stocks: a higher-than-average price-to-book ratio, for example; higher return on assets; and low leverage. So defensive is not a repackaging of value.

A possible explanation: benchmarking

Part of the explanation for the pattern of observed returns appears to lie in the almost universal use of market-relative benchmarking for mutual funds and institutional investment accounts. The objective to which these portfolios are managed is to beat the broad market. So even though the end investor would find lower risk stocks to be more attractive (if expected returns were equal), that is not taken into account at all in the way the objectives are set up. There is no incentive for the portfolio manager to favor low-risk over high-risk stocks, even though the end investor would benefit.

The investor’s response: time for a rethink?

This creates a need to reconsider the separation of asset allocation from implementation decisions, including the mandates and benchmarks that are given to investment managers and how we go about structuring equity portfolios.

There are a number of approaches that the concerned institution may take. The least disruptive is simply to be more deliberate in monitoring exposures: a minimum course of action would seem to be to check that there is no unintended bias in the equity portfolio. And more attention should be paid to risk when monitoring performance, while tracking error should be de-emphasized as a risk measure.

However, if the market is indeed mispricing risk, then that offers investors the prospect of creating a better asset allocation – one which can target the same expected return level with less risk.

The full version of this paper is available here.

Bob Collie, FIA, is Chief research strategist with Russell Investments; John Osborn, CFA, Director, Consulting, with Russell Investments.

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