Do smart beta risk premium exist?

September 2009

“Oh, if only it were so simple.”

The Holy grail?

Introduction

Definition of risk?

Beta or

Protecting capital & generating a real return over time

Smart beta implies capturing excess return above required return

This is credible and achievable

But how do you best capture it? The focus is on systematic risk

How do you best capture the stock specific excess return?

Many approaches to capturing excess returns – you decide?

How should you define risk?

First and foremost, managing downside risk must be embedded in your investment philosophy

Risk does not reside in price changes and cannot be summarized into a single number

In the world of investing risk translates into

A permanent loss of capital

Your savings not keeping up with inflation

This is reflected in the difference between the share price & intrinsic value

The pitfalls of “the market” - benchmark

Over allocation to large caps

BM’s are themselves inherently risky and result in a misallocation of capital. They are biased towards momentum

Do not make best use of portfolio managers’ skills

BM strategies may do proportionally better in bull markets, they also participate fully in the inevitable busts

Suffer from excessive levels of concentration

Active managers & smart beta managers aim to exploit this

Increasing the probability of out performance

Sector Allocations in a Market Capweighted Benchmark

Resources (18)44%

Financials (34)19%

Small Caps (69) 3%

Industrials (45)34%

Sector Allocations in an Equalweighted Benchmark

Small Caps (69) 42%

Resources (18)11%

Industrials (45)27%

Financials (34)20%

Source: SIM

Concentration and stock specific risk in the benchmark

A recent study has shown that the JSE All Share index performs similarly to an equal weighted portfolio of 16 stocks

(Kruger and van Rensburg, IAJ, Nov 2008)

BIL

AGL

SOL

MTN

SAB

SBKANGCFRIMP

GFI

FSR

OML

SLM

BVT

SHP

TBS

GRT

REI

MUR

SUIDSY

GNDKEH

How do we capture the stock specific alpha?

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The “value premia” – it does exist (SA context)

Source: SIM

Factor Quintile 12 24 36 48 60

Book to price Quintile 1Quintile 5

7.7%-6.7%

7.5%-7.2%

7.3%-6.9%

6.8%-7.0%

6.3%-7.8%

Dividend Yield Quintile 1Quintile 5

4.1%-3.7%

3.9%-4.4%

4.4%-4.8%

4.8%-4.5%

5.7%-4.0%

Earnings Yield Quintile 1Quintile 5

6.3%-4.3%

5.2%-4.3%

5.3%-4.7%

5.5%-4.7%

5.2%-4.7%

Normalised EY Quintile 1Quintile 5

7.5%-6.7%

7.6%-5.3%

6.5%-4.4%

6.1%-4.2%

5.4%-4.4%

Norm EY minus EY Quintile 1Quintile 5

4.3%3.6%

5.3%2.0%

5.5%2.3%

5.6%1.2%

5.7%0.6%

Norm ROE minus ROE Quintile 1Quintile 5

-2.6%-1.8%

-0.3%-2.6%

1.2%-1.7%

2.7%-2.1%

4.2%-2.5%

The link between business economics & value

Current ROE % 93% 93%

Current dividend cps 420 420

Current payout ratio % 63% 63%

Long term payout ratio % 60% 60%

Discount rate % 14% 14%

5 year average ROE (expected) % 50% 60%

Fade to long term ROE % 20% 20%

Fair intrinsic value cps 4600 5400

Current price cps 3770 3770

Upside to fair value % 22% 43%

Current market implied ROE % 36%

Implied PE ratio x 17 20

DDM Model

Great business economics

Business economics needs to be discussed, debated & rationalised – this is not a true Benjamin Graham investment

Source: SIM

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Best view investing

Exploit behavioural factors – fear & greed

Markets may be “efficient” in S-T, but

Market participants are often irrational in interpreting it!

Smart beta – can it capture this?

Mean reversion: returns & ratings mean revert!

How do you capture this in smart beta approach?

These two factors are timeless in nature

The “elusive” small cap premia

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Behavioral factors – fear & greed

Source: INet

● 97% value lost from peak to trough (1 yr)

● 40 years to recover (compounding @ 10%)

So markets are efficient?

Herd mentality – fat tail event

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Implied PE ratio Intrinsic value Grow th (g)

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Mean reversion

Source: SIM

PE = [(1+g)/(k-g)]* PR

where :g = growth, k = required return, PR = payout ratio Stock returns: dividends & future growth, not volatility!

Mean reversion : Growth rates & PE ratios

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Example – misinterpretation of value (Amplats)

Source: SIM, Thompsons, Barra

Returns were well above normalised, realistic levels How do you capture this in smart beta approach?

Not the time to have bought

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70%Current PE Current ROE

Challenges with smart beta

How do you leverage off active corporate governance? There are benefits to L-T responsible investing

Can you avoid bubbles & turning points? How do you avoid investing in potential bankruptcies? Do you maximise wealth over time relative to best

view investing? How are you managing risk – protecting loss of capital,

real returns? How do you fully capture irrationality in the market?

Benefits of “best view” investing

Benefit from active corporate governance & SRI

Avoid problems associated with “benchmarks”

More concentrated portfolios – benefit from best views

Move from market risk to manager risk

Risk defined as protecting capital & real returns (not volatility)

Conclusion

Do smart beta exist?

It does, but does it maximise wealth over time?

Can active management add incremental alpha?

Yes, optimal portfolio construction, fundamental overlay

Do opportunities exist to beat the market? Yes. Why?

Markets are irrational – driven by fear & greed

A value premia is evident

Small cap premia exist at times

Rational behaviour & patience pays off

Thank you

Tool box

How smart is beta?

Karl Popper – the best way to falsify a model: falsify its predictions

Beta: measuring risk i.t.o. variability of historical returns is bizarre

Example:

Consider a piece of land – price varies more than “the market”

It drops over three years by 90%, prime space, 15% yield

Beta = 1.5

Compared to land moving in line with market, beta 1, yield 3%

Which one is more “risky”?

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Beta – are you telling me that this stock is riskier?

Source: SIM, Thompson, Barra

AMS price dropped 70%, Platinum price dropped 63%, beta rises to 1.7

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Current Price Beta

Alpha – what do we mean by it?

Alpha represents stock specific returns in excess of the “market”

Is this only what investors want to achieve?

Do investors not want to maximise geometric wealth?

Or to protect capital & generate real returns?

Is “the market” a good proxy for achieving above?

Source: INet

Value & business economics

“Can anything be considered cheap in current market conditions

– Michael Coulsen, Finweek, 4/9/2008

“It may be best to hedge your bets in an unsettled world”

– Sharon Wood, FM 22/02/2002

Staff strike

Emerging market bond crisis

How do you capture good business economics & value

Diversification – not more stocks, but which stocks

Total Risk vs Num Stocks for Different Universes - Average of 1000 random Portfolios

25%

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40%

45%

50%

0 5 10 15 20 25 30 35 40

Average Stocks in Portfolio

Ave

rag

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l R

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J202

J200 J200 & J201 J203

J201 & J202

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Factor returns

Source: SIM,