The Equity Risk Premium: Applications for Investment Decision-Making

Professor Aswath Damodaran’s opening remarks at CFA Society Chicago’s Equity Risk Premium event on April 2, 2019 at the W Chicago City Center.

Aswath Damodaran, Kerschner Family Chair in Finance Education and a Professor of Finance at New York University Stern School of Business, is well known for his books and articles in the fields of valuation, corporate finance, and investment management, philosophies, and strategies. On April 2, he treated the CFA Society Chicago to a tour de force through the foundations of risk premia, the macroeconomic determinants of equity risk, and how the risk premium can me misused.

Damodaran’s talk was followed by a panel which included himself, Michele Gambera, co-head of Strategic Asset Allocation Modeling at UBS Asset Management, and Bryant Matthews, global director research at HOLT. The panel discussion was moderated by Patricia Halper, CFA, co-chief investment officer at Chicago Equity Partners.

Damodaran pointed out that while the risk-premium is referred to as one number, it contains several various risk factors, such as political and economic risks, information opacity, and liquidity risks. Despite the underlying complexity, a common way to derive the risk premium is from the average volatility of some historical period. This, Damodaran warns, is a dangerous approach. By using historical data you can derive any risk premium you want by using the time horizon of your choosing. When you look at historical averages, you are also searching for a number that nobody has ever experienced. And even if they did, you should not believe that history will simply repeat itself. And even if history did repeat itself, you are still estimating a number with large error margins. In the end, the exercise is just not useful.

Damodaran has done a lot of work determining equity risk premia for different countries and makes his data available on his homepage. His approach is to derive an implied risk premium based on consensus forecasts of earnings and adding country risk premia for different countries. He cautions that there is no pure national premium thanks to our integrated world. Much of S&P earnings, for instance, are derived from abroad, and this must be taken into account.

For a person who has devoted so much time to estimating risk premia, it may come as a surprise that Damodaran thinks people should spend less time on it. His approach is that once you observe the market-implied risk premium, you should use this in your valuation model and devote your attention to estimating cash-flows. Right now, too many people are wasting too much time on valuing companies through finding the perfect risk-premia when cash-flows are ultimately going to determine whether they will get valuations right. Academic finance is another culprit here, which spends too much research time on discount rates.

Ask yourself this, are you working on your model’s risk premia because that is where you have superior knowledge, or because it is your comfort zone?

Damodaran is also critical of the use of the price-to-earnings ratio to assess valuation, since it looks at earnings only for the current period. In the US market the ratio may look high, but the pictures very different for current implied risk premia. Since 2008, risk-free rates have come down while expected stock returns have remained roughly the same. This actually implies a higher risk premium.

 Michele Gambera shares Damodaran’s criticism of historically derived risk premia. He also pointed out that while the risk premium fluctuates a lot, we pretend in our models that it is constant. In effect, Gambera stressed, we are estimating a random-walk variable. A better approach for your valuations is to use a forward-looking covariance matrix with various factor loadings.

Should we therefore throw the historical data out the window? When asked the question, Bryant Matthews of HOLT pointed out that historical data are not all useless in a world where variables tend to mean-revert. But you may need to wait a long time for it to happen.

Is there a small-cap premium? Damodaran pointed out that if you estimate the historical premium since 1981, it is negative, which is clearly fictional. However, Matthews estimated a small cap premium of 0.6%, albeit with a standard error that makes it statistically zero. By slicing the equity market in other ways, he estimates that value stocks tend to have a 3.5% equity premium over growth stocks, while Fama and French’s quality stocks-factor enjoys a 2.1% premium over non-quality stocks.

Matthews has also calculated market implied risk premia for over 70 countries, and found it rising in the US from 0% in 2000 to 4% today. Such estimates, he pointed out, are often counterintuitive for clients. Surely, equities were riskier in 2000 when valuations were high. But precisely because valuations were so high, the implied risk premium, which was part of the discount rate, was low.

Can we make money by investing in high-risk premium stocks? After all, theory tells us returns are the reward for taking risk. Yet as Gambera pointed out, high-volatility stocks tend to be favored by investors in part as a way to leverage up according to the CAPM-models, as is done for instance in risk-parity models. At the same time, pointed out Matthews, low-volatility stocks are generally also high-quality stocks and therefore tend to have high return, despite their historically low risk.

Matthews argued that while profits are high for the US market as a whole, this really applies to only 100 companies. This concentration, he suggested, is due to lax regulations. Damodaran, however, suggested that antitrust measures cannot be relied on to change this fact. They may have been politically attractive in the time of Standard Oil, when that company’s dominated position allowed it to raise prices. The dominant firms of today are offering consumers very low prices. Break them apart and any politician will be met with discontent from voters.

Let us end with some historical perspective from Michele Gambera. Much of the early work on risk premia was made at a time of a very different market structure of industrialized countries. Steel and railroads ruled the day and many of today’s giants were not listed. The likes of Alphabet and Facebook pose new challenges in estimating risk premia. This suggests that now more than ever historical data will be misleading in estimating the risk premium, a modest number that means so much.

CFA Society Chicago 32nd Annual Dinner

The CFA Society Chicago Annual Dinner was an event devoted to honoring the 148 new CFA charterholders and the recipient of the Hortense Friedman, CFA, Award for Excellence.  The evening also featured Heather Brilliant, CFA, past chairman of CFA Society Chicago and Keynote Speaker Richard H. Thaler, 2017 Recipient of the Nobel Memorial Prize in Economic Sciences and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business.

The newest charterholders were congratulated for passing all three levels of the CFA exam, and having the required four years of relevant work experience required to qualify for the charter.  Honoring their commitment to completing the program, a crowd of 1,050 attendees gave them a standing ovation. It is estimated that preparation for the exams requires nearly 1,000 hours of study. The newest charterholders now hold a professional designation that is recognized worldwide as a symbol of excellence in their profession and a commitment to uphold the highest ethical standards.

Heather Brilliant, CFA is currently vice-chair of the CFA Institute Board of Governors and a managing director at First State Investments.  She addressed the “State of Disruption” in the financial services industry.  Brilliant identified two disruptors: the rise of passive investing and the increasing influence of technology.  She viewed both as positive developments that will in the long-term serve client interests.

The changes these disruptors cause will need to be harnessed by CFA’s.  Active managers will face more consolidation and robo-advice will be more prevalent.  However, it is difficult for machines to empathize with clients.  Brilliant stated that the CFA Institute will offer more continuing educations support and continue to advocate for fiduciary duty.

Brian Singer, CFA was honored as recipient of the Hortense Friedman, CFA, Award for Excellence.  The award honors a member of the Chicago-area investment community who has demonstrated initiative, leadership and a commitment to professional excellence. Singer is the head of William Blair’s Dynamic Allocation Strategies team, as well as its lead portfolio manager.  In expressing his thanks for the reward, Singer spoke of the great experiences he had earlier in his career in working with Gary Brinson and Gilbert Beebower.  They collaborated on a seminal article published in 1991 entitled: Determinants of Portfolio Performance II: An Update.

The keynote speech took the form of a question and answer session between Richard Thaler and Thomas Digenan, CFA, chairman of CFA Society Chicago. The questions from Dinegan covered a wide variety of topics and took advantage of Professor Thaler’s expertise in decision theory.  The Q & A unfolded as follows:

Guess a Number between 0 and 100
The number guessed must be the closest to two-thirds of the average guess of people attending this meeting. After some calculations, you arrive at a mean of 25.4, two-thirds of that mean is 16.93. Professor Thaler made an initial guess of 17 without having to go through the calculations. He was hopeful that charterholders would arrive at a number close to the correct answer.

Outlook for the Chicago Bears
Professor Thaler states the due to the NFL salary cap; successful team must have players that perform at a level greater than their salary. This favors teams with good draft picks and teams that find good players that other teams don’t want. The Bears were forced to pay defensive lineman Khalil Mack a market value salary for the next four years. This acquisition does not bode well for the Chicago Bears as Mr. Mack must be highly compensated.

Lottery Ticket Purchase?
Given the $1.6 billion payout, Professor Thaler would have purchased a ticket. He called it a “smart dream”. Interestingly, of 14 people asked to sell their machine number generated $2 ticket for $4, 11 would not do so. Once you have something, you don’t want to give it up.

Health Care Options for Employees and the Role of “Nudge”
Employees routinely make bad decisions with respect to which health care plan is best for them. These decisions include paying $2,800 for reducing your deductible by only $2,000. Professor Thaler characterized the desire to go to a smaller deductible as a “negative nudge”. He co-authored the global best-seller “Nudge” in 2008.

During open enrollment, there is no action required if you want to keep the same plan as the year before, however if you want to change you are forced start over (go to zero). This leads to what he termed “status quo bias”. Few employees understand their health care options, which can be a bigger decision than what type of 401K you have.

An Example of “Sludge”
People who sell things need to nudge. Bernie Madoff nudged, however he nudged people for evil. It must always be our intention to “nudge for good”.
When trying to access a review in a British journal, Professor Thaler ran into a paywall. The paywall asked for only one pound of payment to access the article; however he was required to give them his credit card. After an initial period you were automatically renewed at the market rate. To stop the subscription, you were required to give 2-weeks’ notice via telephone. This is a prime example of what Professor Thaler views as “Sludge” (making it difficult to get out)

What is Life Like after Winning a Nobel Prize?
Professor Thaler has noted that he has encountered more “Sludge”. He is the third recipient of the Nobel Prize on the floor he works on at the University of Chicago, so after about a week everything returned to normal.

Thoughts on “Surge Pricing”?
Professor Thaler warned that surge pricing can be a huge blunder. This is especially true when it becomes too prevalent. Most customers are resentful when a hardware store raises the price of snow shovels during a snowstorm. During a snow storm in New York, Uber commenced surge pricing. He noted that Home Depot does not raise the price of plywood after a hurricane. Home Depot, by not implementing surge pricing, is promoting a long-term relationship with their customers.

How do you guard against over-confidence?
It is important to eliminate hindsight bias. You must distinguish between bad decisions and bad outcomes. In a football analogy, Professor Thaler stated that attempting to score a touchdown on fourth down with one yard to go for a touchdown early in a football game is a smart decision. If you are not successful, you give the ball over with no points scored. However this is not a case of overconfidence by the head coach. This is an example of good decision with a bad outcome. It is difficult to do, however it is better to evaluate the decision, not the outcome.

In his concluding remarks, Professor Thaler criticized point forecasts by analysts and advocated confidence limits. A $2.34 point forecast can be contained in $2.15-$2.50 confidence limit. It is also critical to be able to look back at forecasts to track errors. Forecasting is an important part of what people do and the more feedback you have the more you will learn.

 

CFA Society Chicago would like to thank the following organizations for helping to make the 2018 Annual Dinner a success!

PREMIER SPONSORS
Northern Trust
UBS Asset Management
William Blair

PLATINUM SPONSORS
First Trust Portfolios, L.P.
Mesirow Financial
Nuveen

Thank you to all our Gold, Silver and Bronze sponsors as well!

The Active vs. Passive Debate

 

 

 

 

 

 

 

 

 

 

 

 

On Tuesday, June 13, approximately 400 people gathered at the Standard Club to attend CFA Society Chicago’s forum on trends, insights and case studies about active vs. passive investment strategies. An additional 200 joined the event via webcast. All of the participants agreed that the terms active and passive represent a spectrum. Nat Kellog, CFA, director of research at Marquette Associates, moderated the first debate.

 TRENDS & INSIGHTS

Joel Dickson, Ph.D., global head of investment research and development with Vanguard, began the conversation by stating Vanguard’s objective to generate market performance at the lowest cost. He noted that if one group has a persistent information advantage than another must be disadvantaged because the aggregate investment results represent a zero sum game. The discussion then focused on whether or not empirical data suggests that the winners can be identified in advance.

Brett Hammond, research leader at the Capital Group stated the firm’s strategy of increasing the number of analyst visits with company management to make superior qualitative decisions about business strategy and execution. Hammond estimated that 1,600 domestic mutual funds employ a factor based approach to quantitatively structuring portfolios. He notes that these strategies represent a form of active management. He also believes that they create opportunities for investment management firms with a long term perspective and superior fundamental analysis.

Aye Soe, CFA, managing director, Global Research & Design at S&P Dow Jones Indices, noted that Paul Samuelson’s 1974 article Challenge to Judgement, promoted the idea of a portfolio that tracks the S&P 500.

Since then, indexes and index funds have evolved to tilt toward factors in an attempt to enhance returns. This evolution moves the objective from market returns to alpha, which is the goal of active management. Soe suggested that the nature of the bond market and bench mark indexes provide more opportunity for deviations (i.e. exclude Treasury bonds) from the market to enhance returns.

The conversation addressed the impact of the rise of index funds on the price discovery role of the securities markets. The Bernstein article- Why Passive Investing is Worse than Marxism may overstate the impact. Although index funds now own approximately 25% of US equity capitalization, they only represent about 5% of trading.

KEYNOTE INTERVIEW

Bob Litterman then interviewed Eugene F. Fama, 2013 Nobel laureate in economic sciences and Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, to learn about the evolution of his thoughts over the past 50 years. Dr. Fama drew a distinction between active and passive approaches to factor tilts in portfolios. An attempt to time factor premiums or add an additional level of analysis produces an active approach.

Fama acknowledged the impact of micro-cap stocks noted in a May 2017 paper titled Replicating Anomalies. This paper concludes that the excess returns identified for most factor based strategies disappears when you adjust for the outsized impact of extremely small companies. Fama emphasized the need to adjust for this impact, a sound basis in financial economics and persistency in the results across markets and time. He noted the robustness of the value factor and the more limited effect of the size factor on portfolio returns. Momentum represents a factor that is evident in the data, but hard to exploit because of the extreme overweight required in illiquid, micro-cap stocks. Fama noted that momentum represents “the biggest embarrassment to the efficient market hypothesis” because it does not fit well into financial theory.

One trend identified over the past 50 years is the growth in the study of financial economics. In the 1960s, MIT and the University of Chicago dominated this area of study. Now, every major university devotes resources to data analysis for market anomalies.

Firms like Dimensional Fund Advisors and Vanguard devote substantial resources to fulfill their corporate governance responsibilities as shareholders. The firms also employ sophisticated trading strategies to obtain best execution. Fama noted that active managers who add value deserve to earn a return on their human capital. As a result, the excess return generally flows to the manager, not the investor in the fund.

The conversation concluded with comments about the future direction of the investment advisory industry. The movement from investment managers to financial advisors to wealth management may move the compensation model from a percentage of assets under management to an hourly or fee for service basis. The growth of “robo advisors” may create another tool for wealth managers to serve clients, versus a replacement for the advisor. The role of the advisor may shift toward a focus on the distribution of possible outcomes and the incorporation of uncertainty in financial plans.

CASE STUDIES

Lisa Haag, CFA, director of investment strategy with The Boeing Company, presented the case for active management of defined benefit and defined contribution retirement plan assets. The Boeing Company’s defined benefit plan has 25% of its assets invested in publicly traded equities with only 5% employing passive strategies. The remainder of the plan’s assets is invested in long duration bonds and alternative investments.

Jason Laurie, CFA, of Altair works with near 300 high net worth family groups. Passive strategies represent 10% to 15% of assets. Laurie noted the firm’s size provides them with the opportunity to negotiate low fees for clients. He emphasized the importance of patience with active managers by noting that over 90% of top managers periodically experience one to three years of sub-par performance.

Marc Levinson, chair of the Illinois State Board of Investments, outlined the transition from active management toward passive management of the State’s pension assets since September 2015. The $4 billion of defined contribution assets moved from 75% active to all passive. The $17 billion defined benefit assets moved to 70% passive. The state moved from near 100 managers to less than 20. Levinson lead the Board from the political nature of “who are you going to replace my guy with” to a market approach that did not require hiring a manager with a sponsor.

In conclusion, two of the three entities continue a commitment to selecting managers who can beat the market after fees. In contrast, two of the first three panelists and Fama presented a case that the financial markets efficient from a beat the market after fees perspective. The debate goes on.