To be successful, a fund manager needs to understand why different assets have different returns.
More than 30 years of academic research have shown that risk is by far the most important determinant of return. In recent years, a good deal of progress has been made both in refining the concept of risk and in developing the tools necessary to control it.
All theories about risk and return share a number of simple principles. First, return is the reward for bearing risk. If an investor can invest in an asset with a certain return, such as a Treasury bill, then he or she will demand a risk premium as an inducement to investing in an asset with an uncertain or risky return. Secondly, the risk of a portfolio of different assets is lower than the sum of the risk of individual assets going into the portfolio. Diversification reduces risk. The risk that remains after a portfolio has been fully diversified is called systematic" because it has a predictable effect on the return of the portfolio.
Thirdly, not all forms of risk can command a risk premium. The reason is that portfolio diversification is relatively cheap to do. Cost considerations will therefore not force anyone to bear unsystematic risk. One should therefore not expect to be rewarded for bearing the risk of an undiversified portfolio. In other words, only undiversifiable or systematic risk contributes to expected return.
Finally, assets with the same risk should have the same return, and vice versa. These conditions must hold to prevent riskless arbitrage. If two assets are seen to have the same risk but provide a different return, then investors are better off selling the asset with the smaller return and buying the one with the larger return. Of course, buying and selling will put pressure on prices, a process which will continue until investors cannot be made better off by rebalancing their holdings. This will obviously be the case when the returns of the two assets are equal.
How can we measure systematic risk? According to Arbitrage Pricing Theory (APT), first proposed by Stephen Ross and developed together with Richard Roil into a portfolio management technique, the expected return on an asset depends on just two variables. The first is the exposure to systematic risk and the second the risk premium for bearing systematic risk. The product of these two variables determines expected return.
The sources of systematic risk are unexpected changes in fundamental economic factors. In practice five factors have been discounted - investor confidence, interest rates, business cycles, long-term and short-term inflation - which can account for 95% or more of the variation in returns. One interesting application is to use APT to outperform a benchmark. The example below uses stocks, but APT can be used equally well to manage bonds. Suppose a fund manager is asked to create a portfolio with the same level of risk as the S&P500, in which the largest 500 stocks quoted on the New York Stock Exchange are included according to their market capitalisation. Using capitalisation as a criterion for stock selection, however, does not necessarily lead to an efficient portfolio - that is, a portfolio which has the highest possible expected return given its level of risk.
In fact, research shows that value-weighted portfolios such as the S&P500 are rarely efficient and that one can form other portfolios with the same level of risk but a higher expected return. How does one find these more efficient portfolios?
This approach involves first measuring the exposures of the S&P500 to the underlying risk factors, then determining what the premium is for bearing the risk of each factor and, finally, selecting a more efficient portfolio by overweighting exposures to relatively attractive risk - ie, exposures to factors with a high ratio of expected return to risk
One can thus construct portfolios which will outperform a given benchmark by improving its efficiency. With the APT technique one can produce short/long portfolios and market-neutral style portfolios These closely track the risk of an index, but offer an additional return.
Roberto Wessels is managing director of Fortis Investments in the Netherlands"