Four major neglected findings of modern finance

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Here are four major neglected findings of modern finance. They have been proven effective in improving risk-adjusted investment returns, based on research results that different researchers have repeatedly confirmed over the years, but still need to find their way to the forefront of investor thinking. We believe that in current market conditions, they deserve greater prominence. 

Neglected finding 1: The equity premium

In the 19th century, it was commonly held that only fixed income was an investment, while equity investing was considered to be pure speculation. The recognition of accrued profits as a source of long-term increases in share value, distributed as dividends or retained as capitalised earnings, and at levels higher than interest rates, led to the concept of the ‘equity premium’: equities are riskier than bonds, yet on average they offer higher returns over the long term.

However, there are still many types of investors who remain reluctant to invest in equities – a phenomenon that could be explained by historical prejudices or restrictive regulations.

The two first columns of the table below show how costly it can be for an investor not to integrate this finding into their investment thinking.

Exhibit 1: Forward-looking expectations from various strategic asset allocations. Advanced equity strategies targeting, for example, stocks with a low volatility or using a factor-based stock selection process can earn a higher return relative to cash at reduced volatility levels and a higher Sharpe ratio.

forward looking expectations

Source: BNP Paribas Asset Management, Financial Engineering, March 2016

Neglected finding 2: The diversification effect

The benefit of diversification has been well known since portfolio theorist Harry Markowitz won the Nobel Prize in economic sciences in 1990: avoiding putting all your eggs (investments) in the same basket (e.g. asset class) can improve a portfolio’s average risk-adjusted performance. This finding holds true for all asset classes.

Still, the ‘home bias’, i.e. investors tend to be biased towards overweighting assets based in their home country or region, is proof that the allure of the familiar remains strong. The third column of the table illustrates the effect that avoiding this bias – by opting for a global asset allocation – can have for a European investor.

Neglected finding 3: The low-volatility anomaly

For over 50 years, researchers have noticed that within the equity asset class, low-volatility stocks have had more attractive risk-return profiles than stocks with an average volatility. Put simply, you can’t easily predict equity returns from past data, but you can predict risks, and thus you can reduce your risk and have the same or higher returns.

However, despite the recent development of smart-beta strategies, market capitalisation indexing remains the basis on which the vast majority of assets in our industry are invested. The fourth column of the table illustrates by how much an investor with a low-volatility focus can reduce risk to further improve the risk-adjusted return.

Neglected finding 4: The factorial explanation of active management

Since the work of Carhart in 1997 “On persistence in mutual fund performance”, it has become widely accepted that the greater part of excess return arises from factor exposures. Certain factors, for example value or size, have been further popularised by Nobel Prize winners such as Fama and French, while other factors remain the subject of debate among researchers.

More recently, the factor investing concept has been extended beyond equities to asset classes including fixed income. This is a trend we are involved in, with the result that we are now launching an innovative multi-factor, multi-asset strategy.

Allocating risk budgets to recognised factors of outperformance is a proven method for globally improving the risk-adjusted returns from a global portfolio. The fifth column in the table illustrates the effect of such an approach based on THEAM’s strategies in equities and fixed income.

Now is the time for recognition of the neglected findings of modern finance

The many potential benefits from this approach are all the more compelling given that interest rates have reached historical lows and may remain “lower for longer”. In a context of stretched traditional risk premiums, extending one’s investment territory is becoming pivotal to the successful generation of future returns. We are convinced that currently a multi-asset, multi-region, multi-factor strategy is the best way forward.

Such an approach would end the neglect of the equity premium, the diversification effect and the benefits of a low-volatility focus and a factor-based strategy. Progress at last.

 

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Etienne Vincent

Head of Global Quantitative Management, THEAM

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