Don’t Let Risk Eat Your Alpha

The market’s climb in recent years has claimed the lion’s share of investor attention, often at the expense of attention to risk. This is understandable—you can’t eat risk for breakfast. In fact, risk seems to have disappeared from the menu altogether of late—except in relatively rare moments such as December 2018, when a breathtaking correction came along to remind us that investing is not a one-way street, volatility seems pretty much to have taken a leave of absence. Cushioned by the extremely accommodative policies of the developed world’s central banks, the rolling three-year measure of market volatility is running a full standard deviation, or about two-thirds, below its long-term norm, encouraging a dangerous complacency about portfolio risk (Exhibit 1).

Exhibit 1: Smooth Sailing on Accommodative Seas

MSCI World Annualized Volatility

As of 30 September 2019
The one standard deviation below average volatility statistics were calculated by determining the volatility of the rolling 3-year rolling volatility statistics and subtracting the volatility from the average of the 3-year volatility numbers.
Source: Lazard, MSCI

If—or more likely when—volatility returns, we predict that measuring and controlling for risk will come back into fashion. That’s because in a more normal, more uncertain market environment, explicit risk controls can greatly improve the predictability of returns.

Under more normal conditions we expect portfolios constructed without any reference to the benchmark allocations or otherwise unconstrained by any diversification framework—so-called best ideas portfolios, for example—to have the highest exposure to risk and the least predictable returns. If a stock in such a concentrated portfolio blows up as a result of an unforeseen macro event, it can take down the entire portfolio. Methodical diversification can improve risk controls, but factor and style biases built inadvertently into such diversification can create unanticipated risks. More reliable and consistent return streams may flow from portfolios that distribute their assets among many different style baskets and across many different methodologies, avoiding excessive exposure in any one position to curb macro risk.

But even in truly well-diversified portfolios, investors can de-risk by giving serious consideration to environmental, social, and governance (ESG) externalities, an area of growing investor concern that is influencing stock returns and corporate strategies to an unprecedented and growing extent.

The Risks You Didn’t Mean to Take

The most prudent course would seem to be a portfolio that distributes risk—and return potential—across several factors: a multi-factor portfolio. If any one factor wobbles, the whole portfolio won’t go off track because it has sufficient uncorrelated exposures to steady it. That approach calls for a solid understanding of how each of the factors might react to changing markets. Take, for example, the two ways of evaluating earnings by their yield, the ratio of earnings per share to share price. Historical and projected earnings yield should be almost identical, but they aren’t. In more or less normal times going back to 1993, the correlations of the two to default risk returns measures closely tracked each other. The correlations diverged sharply during recent episodes of extreme volatility, however—the global financial crisis and the euro zone debt crisis. The correlation in the projected metric spiked while the historical metric turned negative. In other words, the former followed returns down, while the latter resisted the trend (Exhibit 2).

Exhibit 2: Correlations Can Crack under Stress

As of 31 March 2017
Correlations are calculated based on rolling periods of 3 years of monthly quintile spread returns for Return on Equity (ROE) and 3 years of monthly changes in US 10 year treasury yield.
Source: Lazard, FactSet

The preceding is an excerpt from our latest Lazard Insights, Don’t Let Risk Eat Your Alpha. Read the full paper to learn more about some key risks investors should be aware of, including unintended macro bets and ESG risks.

Important Information

Originally Published on 18 December 2019

Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.

The MSCI World Value Index captures large and mid cap securities exhibiting overall value style characteristics across 23 Developed Markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield. The index is unmanaged and has no fees. One cannot invest directly in an index.

The MSCI World Growth Index captures large and mid cap securities exhibiting overall growth style characteristics across 23 Developed Markets countries. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend. The index is unmanaged and has no fees. One cannot invest directly in an index.

The S&P Global BMI (Broad Market Index) is a free-float-adjusted market capitalization index that is designed to measure the performance of developed and emerging markets equities. The S&P Global BMI consists of 49 country indices comprising 25 developed and 24 emerging-market country indices. The index is unmanaged and has no fees. One cannot invest directly in an index.

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