July 16, 2023 – Across the globe, the colossal sum of approximately $50 trillion is spent by consumers each year.
As global wealth and GDP per capita increase, those consumers reaching the upper echelon of affluence have made premium goods more popular than ever. Whether it be premium fashion brands, premium alcoholic beverages, premium watches, or premium automobiles, these wealthy shoppers are focused on items above the norm.
In markets, intelligent investors focus on a different type of premium – the equity risk premium and credit risk premium are essential concepts that relate to the compensation investors receive for taking on certain types of risk. These premia are to incentivize investors to take on risks above the norm.
Specifically, the equity risk premium represents the excess return investors expect to earn investing in stocks compared to risk-free investments such as government bonds. It represents the additional compensation investors demand for bearing the inherent risks and volatility associated with equity investments. The equity risk premium is typically measured as the difference between the expected return on equities and the risk-free rate of return, represented by government bonds or other low-risk instruments. A higher equity risk premium suggests a greater potential for return but also a higher level of risk. Historically, the equity risk premium for developed markets has hovered around 5.0%, meaning if government bonds offered a 3.0% return, then equity investors would demand an 8.0% return to justify the additional risk of allocating to stocks.
The credit risk premium refers to the additional yield investors require for holding debt instruments with a higher level of credit risk, compensating investors for the possibility of default by the borrower. When investing in fixed-income securities, investors typically demand a higher yield for taking on greater credit risk. The credit risk premium reflects the compensation investors receive above the risk-free rate to account for the likelihood of default, a downgrade in credit rating, or other credit-related events.
Risk premia play an essential role for investors as they assist in determining the appropriate expected return of an investment given its associated risks. By considering risk premia, investors can make more informed asset allocation decisions. Here’s why risk premia are important:
- Pricing risk: Risk premia help price assets and financial instruments accurately. By quantifying the additional compensation required for holding riskier assets, investors can assess the attractiveness of an investment opportunity and make comparisons across different asset classes.
- Risk-return tradeoff: Risk premia allow investors to evaluate the tradeoff between risk and return. Investments with higher risk premia offer the potential for higher returns, but they also come with increased uncertainty. Understanding the relationship between risk premia and potential returns assists investors in managing their risk exposure and optimizing their investment portfolios based on their risk tolerance and return expectations.
- Portfolio diversification: Risk premia enable investors to diversify their portfolios effectively. By considering the risk premia of different asset classes, investors can construct portfolios that minimize risks and optimize returns. Diversification helps reduce portfolio risk by spreading investments across assets with varying risk profiles, correlations, and return potential.
- Risk management: Risk premia provide investors with insights into the risks they are exposed to and facilitate risk management strategies. By understanding the compensation associated with different risks, investors can implement risk mitigation techniques, such as hedging or employing risk-adjusted return measures, to manage their overall risk exposure. Alternatively, risk premia may guide the magnitude of leverage that an investor employs.
The equity and credit risk premia form the bedrock of the traditional stock and bond portfolio, guiding how investors allocate between asset classes.
As equities are riskier than bonds, given their subordinated position in the capital stack, stock investors should require a higher return than fixed income. Similarly, given corporate bonds are riskier than government bonds due to their propensity for default, investors should demand a greater investment return on corporate bonds compared to risk-free Treasurys.
The risk premia governing investor decisions are more akin to rules of thumb as opposed to laws carved in stone. In fact, risk premia can ebb and flow, presenting rich and poor opportunities for capital allocators.
That brings us to today, in which the risk-free U.S Treasury bills, U.S. investment grade corporate bonds, and U.S. large-cap equities all yield around 5.5%.
Ten years ago, equity investors earned a risk premium of 7.0%, while bond investors earned a risk premium of 3.0%.
Now, both the equity risk premium and the credit risk premium have collapsed to zero.
While equity investors once could expect a premium return for taking on more risk than risk-free Treasury bills, it is no longer the case – ditto for fixed-income investors. The capital markets line, which illustrates the relationship between risk and return for a portfolio consisting of a risk-free asset and a risky asset, has gone from upward sloping to flat.
Whether one allocates to Treasury bills, corporate bonds, or stocks, all three asset classes offer the same expected return of approximately 5.5%. Currently, investors are not compensated for the additional risks inherent within traditional asset classes.
The equity risk premium and credit risk premium are crucial components in investment analysis. They provide investors with a framework to evaluate the compensation they require for taking on the risks associated with equity investments and credit exposure. By considering risk premia, investors can make informed decisions, manage their risk exposure, and aim for a balance between risk and return in their investment portfolios.
While consumer demand for premium goods has never been higher, investor demand for equity and credit risk premia has rarely been lower.
What is an investor to do?
Just as a bargain hunter seeks a good deal on premium goods, an enterprising investor may pursue alternative risk premia in the market. Investors do not have to accept the status quo of zero risk premia in traditional asset classes or plow all of their capital strictly into Treasury bills. Specifically, many alternative asset classes still offer a premium return, given the accompanying risk.
Accelerate manages four alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): Cash Plus
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Portfolio Protector
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Portfolio Stabilizer
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50
ARB gained 0.8% in June, matching the monthly return of the benchmark S&P Merger Arbitrage Index. Over the first half of the year, ARB is up 2.0%, while the benchmark is down -1.2%.
During the month, nine merger positions closed, including many of the Fund’s biotech M&A investments. Fifteen public M&A deals were announced in June, and the Fund invested in two, including one subscription receipt arbitrage. The Fund had nine SPACs mature and invested in one new blank check IPO while trading actively in the secondary market.
Currently, the Fund is allocated 63% to SPAC arbitrage and 37% to merger arbitrage. The portfolio has gross exposure (long plus shorts) of 152%, with holdings of 18 merger arbitrage investments and 94 SPAC arbitrage investments.
HDGE gained 4.6% in a month in which long-short factor portfolio performance was mixed, however, positive.
The long U.S. multifactor portfolio outperformed the short U.S. multifactor portfolio by 1.3% as the top-decile longs rallied 10.7% while the bottom-decile shorts gained 9.4%. Given the Fund’s 60% net long exposure (110% long and 50% short), its 4.6% monthly return exceeded that of the dollar-neutral long-short multifactor portfolio.
Regarding individual factor portfolios, the U.S. long-short value portfolio returned 0.7% in June while the long-short operating momentum portfolio led the pack with a 2.8% increase. The U.S. market-neutral value portfolio was roughly flat, whereas price momentum and trend portfolios dropped -2.8% and -3.4%, respectively.
ONEC gained 0.4% in June and is up 3.7% year-to-date.
Key contributors to the month’s positive performance include alternative equity, up 5.2%, and absolute return, up 4.6%.
Real assets contributed positively, with infrastructure gaining 3.0% and real estate generating a 0.9% return.
The global macro bucket also performed well, with managed futures rising 3.3% and risk parity adding 2.2%.
The performance of the Fund’s private credit allocations was mixed in June. The leveraged loan portfolio was up 2.3% and the mortgage book lost -0.4%.
Continuing with positive hedge fund performance contributions was arbitrage with a 0.8% gain. The primary detractors for the month were commodities, which fell -2.5%, and gold, which dropped -2.7%.
During the month, ATSX gained 5.2% while its benchmark, the TSX 60, rose 3.6%. Year-to-date, ATSX is up 4.1% and its benchmark increased 5.7%.
The Fund’s long-short overlay portfolio added 1.6% of alpha, given the overall positive performance of Canadian long-short factor portfolios.
The Canadian multifactor portfolio generated a positive performance of 1.9% in June, led by long-short quality with a 2.8% gain and long-short momentum with a 1.1% increase. The market-neutral value and trend portfolios were down for the month, losing -2.7% and -1.8%, respectively, while the operating momentum portfolio was approximately flat.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
