1. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 1 How Useful are Risk Premia? A Practitioner’s Perspective... September 2009 Roland Rousseau Independent Consultant Quantitative Investment Strategy and Portfolio Construction Research

2. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 2 “Daddy, Where do Excess Returns Come from?” -> skill is the residual excess-return, after all RELEVANT beta excess-returns have been accounted for -> Excess returns come primarily from excess risk, not skill! -> Imagine a world without alpha. How would you invest?

3. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 3 Risk Premium vs Risk Factor Risk-Factor eg volatility, interest rates Return Quality, ability to ’predict/model’ Risk-Factors - Interest rates - Currency - Inflation - Volatility Risk-Premia - Equity, Bonds, Credit Risk - Event, Structural Risk - Liquidity Risk - Emerging Markets - Property, Art, Wine, Timber Accounting Risk-premia - Book-to-Market Ratio - Cash-Flow to Price Behavioural Risk-Premia - Momentum - Price Reversals - Earnings surprises/revisions Risk-Premium eg. value, momentum, emerging mkts, small caps Why is eg. Value considered a risk-premium?

4. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 4 How can we beat the following balanced-fund benchmark without skill: 60% Equity, 30% Bonds, 10% Cash? How can we beat the S&P 500 without skill? How can we beat the MSCI World Index without skill? Overweight value stocks or small caps – VRP 3-5%pa Overweight Emerging Markets – EMRP 2-5% pa Overweight Equities – ERP 3-6% pa Are We Using the Right Benchmarks? Is it Skill or just Excess Risk? Industry realisation: single-factor benchmarks like common indices (eg S&P 500, MSCI etc) are insufficient in a multi-factor world.

5. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 5 Portfolio Excess Return The New Industry Focus Excess Returns in addition to Alpha – Modular Portfolio Construction Scalability, transparency and lower cost are driving the interest in new types of beta risk premia Risk-Premium (long-only) -> Fama and French, Carhart 4-factor model, Barra  RP Primitive Trading Strategies - PTS (long-short) -> Merger Arbitrage, long/short equity, Man. Futures  Alt Alpha from long-only and long-short strategies  Asset Class/Risk Factor Betas (Long-only) -> emerging markets, bonds, commodities, property TT

6. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 6 Portable Beta Example (FTSE) Source: FTSE, CS Tremont, Roland Rousseau Using FTSE Value vs Growth Risk Premia… Risk premia are extremely valuable sources of excess return and don’t require any skill… The reliability of the value risk premium is high: “Value stocks have higher returns than growth stocks in markets around the world. For 1975-1995, the difference between average returns on global portfolios for high and low book-to-market stocks is 7.60% per year and value stocks outperform growth stocks in 12 of 13 major markets.” – Fama, French 1996 The reliability of the value risk premium is high: “Value stocks have higher returns than growth stocks in markets around the world. For 1975-1995, the difference between average returns on global portfolios for high and low book-to-market stocks is 7.60% per year and value stocks outperform growth stocks in 12 of 13 major markets.” – Fama, French 1996

7. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 7 ‘Predicting‘ the Behaviour of Asset Classes How Predictable is the FTSE All World Index? Source: FTSE, Roland Rousseau Correlation 0.03 Naive Test: Serial Correlation

8. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 8 ‘Predicting‘ the Behaviour of Risk Premia Source: FTSE, Roland Rousseau Correlation 0.20 How Predictable is Long FTSE World Value, Short FTSE World Growth? Information Coefficient = 0.20!

9. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 9 Example: The Legg Mason Primary Value Fund is one of the most successful active funds in the world and has outperformed the S&P500 for 13 years in a row. Dartmouth College lets its students, as part of their education, analyse how much the Legg Mason fund’s return variability comes from value, size and market risk. Their conclusion is: “The high returns are associated with the fund’s extreme exposure to small-cap and value risk rather than the skill of the manager. The three factors explain all but 8% of the variation in historical returns.” So 92% of the returns’ variability come from just 3 factors! It is not about replication. It is about risk management and smarter portfolio construction and benchmarking. Fung: Alternative Beta is the most appropriate way to benchmark alternative investments. Agarwal and Naik (2004) as well as Fung and Hsieh (2006) applied Sharpe’s style-based research to HF styles. They find that (small-cap – large-cap) + (credit spread) + long S&P 500 = 80% of aggregate long/short HF return variability Risk-Premia Drive Active Portfolios! Risk Factors and Premia drive the majority of active return variability

10. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 10 Historic breakdown of DOEQ returns using only few building blocks Out-of-sample Style Breakdown ACI Domestic Equity Funds 91% Allan Gray Equity Fund 87% Coronation Equity Fund 89% Investec Equity Fund 87% African Harvest Equity 89% Oasis Gen Equity Fund 82% OM Investors Fund 92% Prudential Equity Fund 85% Conclusion: only ±10% of the variability in portfolio returns is due to manager stock selection skill Source: Proprietary Research RESI INDI FINI Momentum Value and Small Caps Source: van Rensburg and Yu The DNA of Portfolio Returns Blending Risk Factors and Risk Premia Risk allocation drives portfolio returns, not skill. They are the DNA of portfolio returns.

11. Copyright reserved – Roland Rousseau – neobeta@neomail.co.za 11 Summary: The key uses of Risk Premia (RP) - Without RP, we cannot even benchmark alpha (both long-only and long-short)! traditional equity indices, cash, CPI+x% are inadequate benchmarks in a multi-factor world - Well-defined risk premia make excellent cheaper core-portfolio investments - RP are highly correlated to active portfolios and therefore provide new ways to construct portfolios in an ‘active-risk’ manner - RP are being listed and made tradable. They can be priced and hedged now! - Without RP, there would no point in investing! They are the DNA of portfolio returns - Investing is primarily about risk allocation, not finding alpha skill How Useful are Risk Premia? They are the DNA of all active portfolios