Beyond the Equity Risk Premia

1© 2017 Windham Capital Management, LLC. All rights reserved.

Confidential. Not for redistribution.

January 2017 1

Portfolio Risk Deconstruction

Dr. Richard R. LindseyWindham Capital Management, LLC

Managing Partner & Head of Liquid Alternative Strategies


WHAT WILL WE COVER?

How to model portfolio returns?

What are risk premia?

What is the intuition behind risk premia and portfolio returns?

How can we decompose portfolio risk?

Are there other things we can do?


LET’S START WITH SOMEONE THING WE ALL LEARNED AS CHILDREN…

cos( ( ))

sin( ( ))

tan( ( ))

sin( ( ))

( )

bb

bb

b

a b b

bb

b

a b b bb

dxV t

dt

dyV t

dt

d Vt

dt L

y y L t

dyV

dt

d Vt

dt L

dy dy d dL V L

dt dt dt dt

q

q

qd

q

q

qd

q qq

=

= -

=

= -

» -

»

» - = - -

Key Idea: Similarly, we can capture how a portfolio behaves without knowing exactly what the portfolio holds.

Key Idea: You don’t need to know the math – you just need to act as if you do.


FOUR WAYS TO MODEL RETURNS

Factor Decomposition Principal Component Analysis Statistical Factor Analysis

Analysis using Tradable Assets / Pre-Specified Factors

Analysis using Tradable Assets and Trade Strategies

Analysis using Risk Premia

Problem: Results have no intuitive basis and are not guaranteed to be consistent through time.

Problem: Often relies on non-tradable factors, and does not capture the dynamics of actual trading strategies.


WHAT IS A RISK PREMIUM?

The amount by which the risky asset’s expected return exceeds the expected risk-free return such that the risky and risk-free assets are equally attractive

Risky ReturnRisk Free Return

Risk Premium



The amount by which the risky asset’s expected return exceeds the expected risk-free return such that the risky and risk-free assets are equally attractive

Risky ReturnRisk Free Return

Risk Premium

Simplified example: Credit risk premium

1. Assume: LIBOR yield = 0.77% & 10 year Greek government bond yield = 6.96%

2. Utility of risk-free rate (LIBOR) + Premium = Expected utility of uncertain return (10 year)

3. Utility of (0.77% + 6.19%) = Expected utility of uncertain return (10 year)

Risk Free Return

Risk Premium

Risk


THE EVOLUTIONARY UNDERSTANDING OF PORTFOLIO RETURNS

Active

Returns

Alpha

Market

Beta

Alpha

Market

Beta

Fama

French

Factors

Alpha

Risk

Premia

Market

Beta

MomentumSizeValueEmergingCreditCarryRoll YieldRelative Value

1970s 1980s 1990s Today



Risk Premia General Thesis

Equity Beta Global Systematic Non-Diversifiable Risk

Credit Fixed Income Default/Duration Risk

Equity Emerging Emerging vs Developed Market

Equity Size Small Cap vs Large Cap

Equity Value Value vs Growth

Commodity Value Backwardation

Rates Momentum Momentum in Interest Rates

Currency Momentum Momentum in FX Markets

Commodity Momentum Momentum in Commodities

Currency Carry Forward-Rate Bias

Commodity Roll Yield Forward Curve Bias


A DIFFERENT WAY OF LOOKING AT PORTFOLIO RISK

“Factor” Allocation

Fat 57%

Protein 25%

Carbohydrates 35%

50% of the “risk” from fat“Asset” Allocation

Bread 40%

Meat 10%

Vegetables 50%


MODELING A PORTFOLIO?

Investments Include:EquityFixed IncomeEmerging MarketsReal EstateCommoditiesHedge Funds



Note that the fit is approximately two years out of sample!



January 2000to

May 2014

Fitwith

Risk Premia

Mean 3.79% 4.90%

Volatility 15.83% 16.00%

MDD -49.87% -51.68%



Factor Loading

Intercept -0.0001

Equity Beta 0.9848

Commodity Roll Yield - 0.0678

Equity Emerging 0.1931

Equity Size 0.1965

Commodity Value 0.0612


HOW MANY DIFFERENT RISKS?


PROBABILITY OF LOSS?

Probability Loss Greater Than

10% -5.34%

5% -7.69%

1% -13.11%


WHAT DRIVES RETURNS?

One year Five years


FINAL THOUGHTS: LIVING WITH RISK

Sophisticated investors are increasingly looking beyond asset classes and strategies to

identify the true, underlying risks driving portfolio returns

In addition to helping identify the risks in the portfolio, this focuses thinking about the

function of each asset class or investment in the portfolio

Stocks for growth or value

Fixed income for credit or volatility

Alternatives for illiquidity or optionality

The most sophisticated investors accept that they do not get paid for investing in asset

classes – they get paid for investing in risk

The key is to choose which risks and how much of each risk to take


UPCOMING WINDHAM WEBINAR

Windham Software Overview

Tuesday, January 31 at 11am

Diversifying Away Equity Exposure

With Robert Bernstein

Wednesday, March 1st at 11am and 2pm EST

www.windhamlabs.com/webinars/

http://www.windhamlabs.com/webinars/


BIOGRAPHY

RICHARD LINDSEY, PhD is a Managing Partner of Windham Capital Management and Chief Investment Officer for Windham Liquid Alternatives. Previously, he served as the Chief Investment Strategist, Liquid Alternatives for Janus Capital. In this role he developed and co-managed the liquid alternative strategies and was also a member of the Janus Capital Group Global Allocation Committee. Prior to joining Janus in August 2012, Dr. Lindsey was a principal of the Callcott Group, LLC, a quantitative consulting group, where he was responsible for directing research activities and advisory services. For eight years Dr. Lindsey was president of Bear, Stearns Securities Corporation and a member of the Management Committee of The Bear Stearns Companies, Inc. Before joining Bear Stearns, Dr. Lindsey served as the Director of Market Regulation for the U.S. Securities and Exchange Commission and as the Chief Economist of the SEC. He was a finance professor at the Yale School of Management before joining the SEC. Dr. Lindsey has also served on several corporate boards including, The Investment Fund for Foundations (TIFF), the Options Clearing Corporation, the International Securities Exchange, and Strike Technologies. Dr. Lindsey has done extensive work in the areas of portfolio construction, risk management, and the trading of securities. He has held the positions of Visiting Academic at the Nikko Research Institute in Tokyo, Japan, and Visiting Economist at the New York Stock Exchange. He holds a bachelor of science degree in chemical engineering from Illinois Institute of Technology, an MS in chemical engineering from Berkeley, an MBA from the University of Dallas, and a Ph.D. in finance from the University of California, Berkeley. He is a Fellow of the Courant Institute, the Chairman of the International Association for Quantitative Finance as well as an Executive Vice President of the Quantitative Group for Finance.


CONTACT & DISCLOSURES

DISCLOSURES: The information contained in this presentation (the “Presentation”) is highly confidential and is not to be reproduced or

distributed to any other persons (other than professional advisors of the prospective investors receiving these materials). The Presentation is

intended solely for the use of the persons to whom it has been delivered. This Presentation has been prepared solely for informational

purposes. The Presentation is not intended to provide professional or investment advice, and you are advised to seek independent

professional advice prior to investing in any products or strategies described in the Presentation or recommended by Windham Capital

Management, LLC. In addition, this Presentation is neither an offer to buy or sell any securities, nor a solicitation of an offer to buy or sell

interests or shares in any fund or strategy.

Performance shown is simulated from January, 2000 – May, 2014. The returns presented as “Simulated” performance do not reflect actual

trading and they may not reflect the impact that material economic and other factors might have had on Windham’s decision-making if

Windham were actually managing money. Net performance is calculated by deducting a 1% management fee and trading costs. Simulated

results are derived from the performance of investment models created by Windham and applied to a hypothetical account.

Historical data and other information contained herein is believed to be reliable, but no representation is made as to its accuracy,

completeness, or suitability for any specific purpose. Windham accepts no liability (whether in tort or contract or otherwise) for any loss or

damage arising from any inaccuracies or omissions. Past performance figures, including any projection or forecast, are not necessarily

indicative of future or likely performance of any investment products. No assurance may be given that the strategies’ investment objectives will

be achieved. Investments are subject to investment risks including possible loss of principal amount invested.

Opinions expressed are current opinions as of the date appearing in this material only. References to market or composite indices,

benchmarks or other measures of relative market performance over a specified period of time are provided for your information only.

Reference to an index does not imply that the Windham portfolio will achieve returns, volatility or other results similar to the index. The

composition of a benchmark index may not reflect the manner in which a Windham portfolio is constructed in relation to expected or achieved

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which are subject to change over time.

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Beyond the Equity Risk Premia

Economy & Finance

Transcript of Beyond the Equity Risk Premia