Presentation to: The Bloggers from Hell

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Do smart beta risk premium exist? September 2009
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Oh, if only it were so simple.
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The Holy grail?
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Introduction

• Definition of risk?
• Beta or
• Protecting capital generating a real return
  over time
• Smart beta implies capturing excess return above
  required return
• This is credible and achievable
• But how do you best capture it? The focus is on
  systematic risk
• How do you best capture the stock specific excess
  return?
• Many approaches to capturing excess returns you
  decide?

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How should you define risk?

• First and foremost, managing downside risk must
  be embedded in your investment philosophy
• Risk does not reside in price changes and cannot
  be summarized into a single number
• In the world of investing risk translates into
• A permanent loss of capital
• Your savings not keeping up with inflation
• This is reflected in the difference between the
  share price intrinsic value

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The pitfalls of the market - benchmark

• Over allocation to large caps
• BMs are themselves inherently risky and result
  in a misallocation of capital. They are biased
  towards momentum
• Do not make best use of portfolio managers
  skills
• BM strategies may do proportionally better in
  bull markets, they also participate fully in the
  inevitable busts
• Suffer from excessive levels of concentration
• Active managers smart beta managers aim to
  exploit this

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Increasing the probability of out performance
Sector Allocations in a Market Cap weighted
Benchmark
Sector Allocations in an Equal weighted Benchmark
Source SIM
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Concentration and stock specific risk in the
benchmark
How do we capture the stock specific alpha?
A recent study has shown that the JSE All Share
index performs similarly to an equal weighted
portfolio of 16 stocks
(Kruger and van Rensburg, IAJ, Nov 2008)
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The value premia it does exist (SA context)
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Source SIM
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The link between business economics value
DDM Model
Business economics needs to be discussed, debated
rationalised this is not a true Benjamin
Graham investment
Source SIM
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Best view investing
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• Exploit behavioural factors fear greed
• Markets may be efficient in S-T, but
• Market participants are often irrational in
  interpreting it!
• Smart beta can it capture this?
• Mean reversion returns ratings mean revert!
• How do you capture this in smart beta approach?
• These two factors are timeless in nature
• The elusive small cap premia

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Behavioral factors fear greed
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• 97 value lost from peak to trough (1 yr)
• 40 years to recover (compounding _at_ 10)

Herd mentality fat tail event
So markets are efficient?
Source INet
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Mean reversion
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Mean reversion Growth rates PE ratios

• PE (1g)/(k-g) PR
• where g growth, k required return, PR
  payout ratio
• Stock returns dividends future growth, not
  volatility!

Source SIM
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Example misinterpretation of value (Amplats)
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• Returns were well above normalised, realistic
  levels
• How do you capture this in smart beta approach?

Source SIM, Thompsons, Barra
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Challenges with smart beta

• How do you leverage off active corporate
  governance?
• There are benefits to L-T responsible investing
• Can you avoid bubbles turning points?
• How do you avoid investing in potential
  bankruptcies?
• Do you maximise wealth over time relative to best
  view investing?
• How are you managing risk protecting loss of
  capital, real returns?
• How do you fully capture irrationality in the
  market?

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Benefits of best view investing

• Benefit from active corporate governance SRI
• Avoid problems associated with benchmarks
• More concentrated portfolios benefit from best
  views
• Move from market risk to manager risk
• Risk defined as protecting capital real returns
  (not volatility)

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Conclusion

• Do smart beta exist?
• It does, but does it maximise wealth over time?
• Can active management add incremental alpha?
• Yes, optimal portfolio construction, fundamental
  overlay
• Do opportunities exist to beat the market? Yes.
  Why?
• Markets are irrational driven by fear greed
• A value premia is evident
• Small cap premia exist at times
• Rational behaviour patience pays off

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• Thank you

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• Tool box

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How smart is beta?

• Karl Popper the best way to falsify a model
  falsify its predictions
• Beta measuring risk i.t.o. variability of
  historical returns is bizarre
• Example
• Consider a piece of land price varies more than
  the market
• It drops over three years by 90, prime space,
  15 yield
• Beta 1.5
• Compared to land moving in line with market, beta
  1, yield 3
• Which one is more risky?

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Beta are you telling me that this stock is
riskier?
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AMS price dropped 70, Platinum price dropped
63, beta rises to 1.7
Source SIM, Thompson, Barra
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Alpha what do we mean by it?

• Alpha represents stock specific returns in excess
  of the market
• Is this only what investors want to achieve?
• Do investors not want to maximise geometric
  wealth?
• Or to protect capital generate real returns?
• Is the market a good proxy for achieving above?

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Value business economics
How do you capture good business economics value
Source INet
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Diversification not more stocks, but which
stocks
Total Risk vs Num Stocks for Different Universes
- Average of 1000 random Portfolios
50
45
40
Average Total Risk
35
30
25
0
5
10
15
20
25
30
35
40
Average Stocks in Portfolio
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Factor returns
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Source SIM,