Strategy

Best Styles:
Harvesting Risk Premium
in Equity Investing
Harvesting risk premiums is a common investment strategy
in fixed income or foreign exchange investing.
In equity investing it is still rather new, but well-rewarded.

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Update I/2014

17
 STRATEGY

AUTHOR: DR KLAUS TELOEKEN

For institutional investors, harvesting risk premiums is a common Implicitly, the performance of equity managers is to a large extent
investment strategy. In asset classes like fixed income or explained by their exposures to a few equity risk premiums
currencies, it is straightforward for investors to think of investing anyway – and this is true irrespective of whether the manager is
in terms of harvesting risk premiums like the term premium or aware of this investment style exposure or not. (Chart 1)
the credit premium in fixed income, or the carry premium in “FX”
(foreign exchange) trading. As the performance decomposition based on Mercer’s GIMD
database shows, there can be no doubt that investment style risk
Fixed income investors extend the duration of portfolios to premiums are the true drivers of active equity returns.
capture the term premium in fixed income, or add to corporates
and high yields to earn the credit premium. Index providers have reacted, and have recently launched a whole
series of indices that target these risk premiums – under a variety
FX investors exploit the FX carry premium by going long in high- of different labels like smart beta indices, alternative beta indices
yielding currencies, and shorting low-yielding currencies. or risk premium indices.

In all these examples, investors take extra risks (duration risk, As we are proponents of the idea of harvesting risk premiums, we
credit risk, currency risk) and expect to be compensated for this think these indices are a good start.
extra risk by means of an extra return – the risk premium.

For equity investors, however, thinking in terms of equity risk UNDE R S T A ND. A C T .
premiums is still rather new. But risk premiums also exist here.
Examples include the value premium, the small cap premium · Harvesting risk premiums is a proven successful
or the momentum premium. Value stocks, e.g. stocks with a low investment strategy across asset classes
price/book-ratio, are usually more risky, as value stocks are typically · This concept is also well-rewarded in equity markets
less profitable, more leveraged and more cyclical than other stocks. · Index providers have started to offer a variety of risk
premium strategies under labels like smart beta,
The existence of all these risk premiums is well documented in alternative beta or risk premium indices
the academic literature. For instance, Basu (1977)1 discovered that · These smart beta indices are an easy-to-grasp index
stock with a low Price/Earnings ratio led stocks with a higher Price/ methodology, but in our view they fail to efficiently earn
Earnings ratio on the NYSE. Banz (1981)2 described the size effect the risk premiums of investment styles in a stable way
– small cap stocks outperform large cap names. Titman (1993)3 · AllianzGI Best Styles is a distinctive active equity
found the momentum anomaly – stocks that led the market over management approach to harvest investment style risk
the last six to twelve months have a tendency to continue to lead premiums in a stable way across time
markets. · Best Styles implements a diversified mix of long-term
investment style winners, manages risk factors within
The existence of these risk premiums is documented for all major investment styles, and also uses bottom-up alpha sources
investment regions, and over extended time spans. And, based on · The Best Styles products have outperformed in 13 out of
our experience, there are not too many patterns in investing that 15 years since inception, largely independent from the
are as persistent as these risk premiums. Therefore, it does make economic or the market cycle.
sense to explicitly build a portfolio around the idea of harvesting
these equity risk premiums.

But we think investors can do better when it comes to harvesting

individual risk premiums than just buying individual smart beta
1
Basu, S. (1977) Investment Performance of Common Stocks in Relation to their Price-
Earnings Ratios, Journal of Finance indices. Typical smart beta indices are not designed to harvest
2
Rolf W. Banz (1981), The Relationship Between Market Value and Return of Common the equity risk premiums in the most efficient way for a client
Stocks, Journal of Financial Economics
3
Jegadeesh, N. and Titman (1993), Returns to Buying Winners and Selling Losers:
portfolio, but are more designed as an easy-to-grasp index
Implications for Stock Market Efficiency, Journal of Finance methodology.

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 Update I/2014

01 WHERE DOES OUTPERFORMANCE COME FROM? EMPIRICAL EVIDENCE

Active return decomposition of global equity managers (1990–2013)

2.5%
RESIDUAL

2.0%

VALUE

1.5%
Active
Returns MOMENTUM 1.0%

REVISIONS 0.5%

GROWTH / SIZE / QUALITY

0%
RISK

Source: AllianzGI, 31 July 2013

For example, simple value indices like the Research Affiliates The reason is that just buying a multiple of smart beta indices
Fundamental Indices (RAFI) or the MSCI value weighted indices often leads to insufficient diversification. However, diversification
are biased towards companies in financial disarray, but the value across multiple risk premiums is warranted. Many risk factors like
premium can be earned more efficiently by avoiding these value or momentum have been very successful over the longer
companies. Minimum volatility indices like the MSCI minimum term, but have also experienced significant short-term
volatility index, while targeting the low volatility premium, leave drawdowns. For example, the value investor had to endure a sharp
the exposure to other risk premiums like value or momentum decline in the run-up to the TMT bubble, or as the financial crisis
largely unmanaged, which can result in adverse exposures to unfolded in 2007. Similarly, the momentum investor suffered
these risk factors. from a painful setback after the burst of the TMT bubble, or during
the market recovery in 2009.
These examples demonstrate that, while smart beta investing is a
good starting point, investors can do better in terms of capturing A diversified blend of the value and momentum investment styles
individual risk premiums like value or low volatility. And investors has earned the risk premiums attached to these investment styles
can also do better in terms of capturing multiple risk premiums in a much more stable way than each of the individual investment
than just buying a multiple of smart beta indices. styles. (Chart 2)

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 STRATEGY

02 INVESTMENT STYLE DIVERSIFICATION IS KEY TO STABLE OUTPERFORMANCE

Relative performance of investment styles for a global universe

120%

Diversified Style Mix Value

100%

80%

60%

40%
Momentum

20%

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: AllianzGI, February 2014

Historic simulation Dec 1989 – Dec 2012: quarterly rebalancing, performance after (estimated) transaction costs. Assumptions of the backtest: since no comparable fund existed in the period under
consideration, assumptions were made in order to illustrate past performance as realistically as possible.The model portfolios use a similar breadth of investment opportunities as existing global funds.
The performance figures are before taxes and after transactions costs of 50bps, dividends are reinvested. The model portfolio comprises approx. 300 stocks, all overweights in the portfolio are of equal size,
underweights relative to the benchmark are restricted to 1%. No constraints are in place with respect to sector or country deviations from the benchmark. The strategy is rebalanced semi-annually, on
average 50% half turn portfolio changes p.a. The relative performance of the strategy is shown relative to a global investment universe that represents the liquid investment opportunities over time. The
performance of this investment universe may differ from the performance of a benchmark like the MSCI World index. Unless otherwise noted, performance results and valuation presented are in US Dollars.

Diversification is key However, for investors in these two MSCI risk premium indices
The chart underpins the fact that harvesting risk premiums there was nothing that could be done to restore diversification;
diversification across multiple risk factors has been key to stable investors just had to accept the loss of diversification. Smart beta
outperformance. But investors can do better in terms of indices like the MSCI risk premium indices are simply not designed
diversification across multiple risk factors than just buying a with a view to a diversified combination with other smart beta
multiple of smart beta indices. Typical smart beta indices have indices, but are designed as stand-alone products.
varying exposures to risk factors – to the targeted risk factors, and
also to non-targeted risk factors where exposures are unmanaged. A portfolio manager in an integrated portfolio solution, though, can
This makes correlations between smart beta indices rather provide the proper diversification across multiple risk premiums by
unstable, and hence renders an efficient diversification impossible. structuring the individual risk premium portfolios with a view towards
the subsequent diversification across multiple risk premiums.
For example, the correlation between the MSCI risk premium
indices for value and momentum shifts over time. Most of the To do so, the portfolio manager should manage the composition
time, like today, the correlation of relative returns is negative, of the individual risk premium portfolios in a way that allows stable
hence there is a substantial diversification advantage from mutual correlations, and hence effective diversification. For
blending value with momentum. example, if the correlations between value and momentum are
becoming too high the portfolio manager will:
However, in prolonged cyclical value rallies like the one from 2003
to 2007, value and momentum typically go hand in hand, and · put more weight on those value stocks that are not also
hence there is no diversification advantage left from blending momentum stocks
value with momentum. But diversification was badly needed at · put more weight on those valuation criteria that will have a
the end of the value rally in 2008, as both value and momentum lower correlation with momentum factors
stocks tanked as the global economy grinded to a halt after the
Lehman collapse. to effectively restore diversification between value and momentum.

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“Just buying a multiple of smart beta indices
often leads to insufficient diversification.”

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 STRATEGY

03 INVESTMENT PROCESS BEST STYLES

Investment Style Allianz Global Investors

Research to earn Global Company
the smart beta Best Styles Research to generate
risk premiums of Approach stock selection alpha
investment styles within investment styles

Source: AllianzGI, February 2014

04 BEST STYLES VS. MSCI SMART BETA INDICES

Relative Performance of Best Styles Global vs MSCI Risk Premium ETFs Indices after Trading Costs

140%
Performance MSCI World

175 %

Relative performance vs MSCI World

175 %

150 % 120%

125 %

100 % 100%

75 %

MSCI WORLD

50 % 80%
Dec. 2003 Dec. 2004 Dec. 2005 Dec. 2006 Dec. 2007 Dec. 2008 Dec. 2009 Dec. 2010 Dec. 2011 Dec. 2012 Dec. 2013

World quality World growth World high dividend

World small cap World minimum volatility MSCI quality mix
World value weighted World momentum Best Styles

Source: AllianzGI, MSCI. This is for guidance only and not indicative of future allocation.
The performance of Best Styles is represented by the composite SYSTEMATIC EQUITY GLOBAL BEST STYLES DEVELOPED – COMP 0189.
The other indices are MSCI World Risk Premium Indices, except the Momentum index where a MSCI World version is not available, and the relative performance of the MSCI AC World
is shown instead. We applied transactions costs to the indices to proxy the performance of ETFs mimicking these indices.

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 Update I/2014

“The AllianzGI ‘Best Styles’ strategy is an active

equity management approach built around the
idea of harvesting smart betas – or investment
style risk premiums – in a disciplined, systematic
approach.”

In addition to this, an integrated portfolio solution not only Dr Klaus Teloeken is the Co-CIO of the Systematic Equity team. He
achieves the proper diversification across multiple risk premiums, joined Allianz Global Investors in 1996 as a quantitative analyst,
but also allows the successful mitigation of exposures to and in 2001 he assumed the role of Head of Systematic Equity. He
unwanted risk factors like macro-economic or interest rate oversees more than EUR 17 billion of assets under management,
sensitivities that stand in the way of harvesting the risk premiums and is responsible for the development and management of
in a stable way, i.e., largely independent from the economic or systematic investment strategies for equities. In this role Klaus has
market environment. developed the team’s Best Styles and High Dividend product line.
He is also responsible for the management of the Best Styles
Smart beta investing, harvesting equity risk premiums and Global and High Dividend Global product. Klaus studied
the Best Styles investment approach mathematics and computer science in Dortmund, Germany.
The AllianzGI “Best Styles” strategy is an active equity In the investment segment Best Styles, Dr Teloeken is supported
management approach built around the idea of harvesting smart by his colleague and Co-CIO Dr Benedikt Henne.
betas – or investment style risk premiums – in a disciplined,
systematic approach.

· The Best Styles approach, in a first layer, seeks to capture the

risk premiums attached to investment styles like value and
momentum.
· In a second layer, Best Styles also seeks to generate additional
alpha within the investment style framework based on the
AllianzGI bottom-up company research. (Chart 3)

These two layers are combined with a diligent portfolio Dr Benedikt Henne works as Chief Investment Officer (CIO)
construction that implements a diversified investment style mix. Systematic Equity at Allianz Global Investors. He joined the
In doing so, the Best Styles approach, in addition to harvesting company in 1998, and is responsible for the development and
investment style risk premiums, also provides the proper management of systematic equity products. In 2001 he was
diversification across risk premiums. The individual MSCI Risk appointed Head of the Systematic Equity Team at Frankfurt.
Premiums indices ETFs showed a rather unsteady performance Dr Henne read mathematics in Paris and Bonn. He obtained
over time – and during the Great Financial Crisis – while the Best a maîtrise from the Université Pierre et Marie Curie, Paris, and
Styles Global portfolios navigated quite steadily through the a mathematics degree and doctorate from the University of Bonn.
market turbulences of the last 10 years. (Chart 4) He has held a CFA charter since 2001.

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