By Samuel Lee
A version of this article was published in the May 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.
The potential for sleepless nights is why investments offer expected returns in excess of cash interest rates, so-called "risk premia." It really can't be any other way. High-return, low-risk opportunities attract mountains of capital as fresh meat attracts piranhas, and they're devoured just as rapidly. The result is a fairly efficient market. For the majority of investors, the only reliable way to obtain higher expected returns is to take on more risk.
But that doesn't mean every risk is rewarded. Idiosyncratic risk, the kind that can be eliminated through diversification, is not. Owning a single stock is a lot riskier than owning a portfolio of stocks, all else held equal, but your expected return isn't any higher for it. Diversification is called the only free lunch in investing for good reason.
Nondiversifiable or systematic risks are called risk factors, and they are critical to understanding portfolio behavior. The excess return that accrues to a factor is the risk premium. Your portfolio's behavior is largely set by its exposure to these factors. You get paid for bearing the unique kind of pain each factor risk represents.
There are three major risk factors, corresponding to different economic risks: growth, inflation, and liquidity. Pick any asset class, and you'll be able to attribute much of its returns to some combination of these three, plus the risk-free rate. However, the two major asset classes, stocks and bonds, have pronounced factor biases.
Stocks load up on growth risk because they're hurt when economic growth is unexpectedly poor. Bonds load up on inflation risk because they're hurt when inflation is unexpectedly high. I'm talking about unexpected changes. When the market fully anticipates a certain level of growth or inflation, and those expectations are realized, prices don't change.
Liquidity risk is a little esoteric, but it's the reason why seemingly unrelated strategies all suffer during bear markets. When there's a liquidity crisis, investors bunker in cash. Those squeezed for cash need to dispose of their assets, inducing fire sales. Illiquid asset classes experience the steepest losses. Junk bonds and preferred shares fell more sharply than equities during the financial crisis, even though they are senior to equities and therefore safer. However, even highly liquid strategies can suffer from liquidity risk when they require leverage. For example, merger arbitrage and currency carry are low-return, low-volatility strategies that require leverage to magnify returns to acceptable levels. In normal times, they're not correlated to either stocks or bonds. But during liquidity crises, lenders withdraw credit, forcing leveraged strategies to liquidate positions at the same time, exacerbating their losses.
Most investors don't realize that when they diversify, they're often merely reshaping their exposures to these factors, and often not by much. Junk bonds are a good example. Many junk-bond advocates (disingenuously or out of ignorance) point out that junk bonds have provided equity-market-like returns with lower volatility. The problem is junk bonds have earned returns from two sources: a credit premium that reflects a combination of growth and liquidity risk, and an interest-rate premium that reflects inflation risk. Adding junk bonds to a typical stock and bond portfolio doesn't provide a diversification boost of the magnitude that adding bonds to a stock portfolio does because junk bonds largely add redundant factor exposures.
Exhibit 1 shows the S&P 500's total return in excess of the 30-day Treasury bill compared with the total return of the Bank of America Merrill Lynch High Yield Master II Index minus equivalent-duration Treasuries, scaled to match the S&P 500's volatility. These adjustments allow an apples-to-apples comparison by stripping out the tailwind junk bonds have enjoyed from falling interest rates and by equalizing their volatilities.
Junk bonds' excess returns look like equity returns because they load up on the same factor risks. There are some notable points of divergence: Junk bonds were hurt badly in 2008 and 2011, when investors sold relatively illiquid junk bonds to raise cash.
In an ideal world, the "price" of gaining exposure to a factor should be identical, regardless of the asset class. However, at times certain asset classes will offer cheaper exposure to a factor. For instance, CCC and lower-rated bonds are trading at absurdly high valuations today, and they offer mostly exposure to economic growth risk, which can be accessed by owning equities. In this case, it's better to own equities and avoid CCC rated bonds. The intelligent, active asset-allocator is always looking to sell asset classes that are offering expensive factor exposures and replace them with cheaper ones. This is the approach I take.
Once you understand that factors are what drive returns, it's easy to see why so many investors mistakenly thought diversification failed during the financial crisis. Saying diversification failed is like saying math doesn't work. The problem was that while investors felt diversified by investing in many different types of bonds and equities, their portfolios were heavily reliant on economic growth and ample liquidity (that is, they were heavily loaded on the growth and liquidity risk). When the economy fell into a recession and the parlous state of the financial system spurred a flight to liquidity, conventional portfolios suffered. Most investors weren't diversified by the true drivers of returns: risk factors.
The factor approach to diversification can be generalized to include other assets, such as human capital, pensions, Social Security, and other sources of cash flow. Even if you ignore investment portfolios, individuals have different "native" factor exposures. Bankruptcy lawyers have arguably negative loading to growth risk, meaning they tend to earn more money when the economy (and stocks) do terribly. They can own more equities and fewer bonds and still maintain a truly diversified portfolio. Investment bankers, entrepreneurs, and CEOs are highly exposed to economic fluctuations, suggesting they should own more high-quality bonds to balance their overall factor exposures.
1) Investors earn excess returns, or risk premia, by bearing factor risk, which cannot be diversified away.
2) Risk factors are related to economic fundamentals. The three major factors are related to economic growth, inflation, and liquidity.
3) Most assets can be thought of as bundles of factors.
4) Different assets can offer exposure to the same factors, but at different prices. The goal of the active asset-allocator is to identify cheap factor exposures and sell expensive ones.
5) True diversification takes place at the risk factor level, not the asset class level.
6) Different investors have different native factor biases. These should be accounted for to construct portfolios that are better diversified.
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