Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

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Utilities Sector as Stock Market Tell

Does the the utilities sector exhibit a useful lead-lag relationship with the broad stock market? In their January 2014 paper entitled “An Intermarket Approach to Beta Rotation: The Strategy, Signal and Power of Utilities”, Charles Bilello and Michael Gayed test a simple strategy that holds either the U.S. utilities sector or the broad U.S. stock market based on their past relative strength. Specifically, when utilities are relatively stronger (weaker) than the market based on total return over the last four weeks, hold utilities (the market) the following week. They call this strategy the Beta Rotation Strategy (BRS) because it seeks to rotate into utilities (the market) when the investing environment favors low-beta (high-beta) stocks. They perform both an ideal (frictionless) long-term test and a short-term net performance test using exchange-traded funds (ETF). Using weekly total returns for the Fama-French utilities sector and broad market since July 1926 and for the Utilities Select Sector SPDR (XLU) and Vanguard Total Stock Market (VTI) since July 2001, all through July 2013, they find that: Keep Reading

Measuring the Stock Illiquidity Premium

How big is the return premium associated with stock illiquidity? In his March 2014 paper entitled “The Pricing of the Illiquidity Factor’s Systematic Risk”, Yakov Amihud specifies and measures an illiquidity premium. He defines illiquidity as the average daily ratio of absolute return to dollar volume over the past three months. He specifies the illiquidity premium as the average four-factor (market, size, book-to-market, momentum) alpha on a set of hedge portfolios that are long (short) the stocks that are most (least) illiquid. Specifically, each month he:

  • Sorts stocks on illiquidity and deletes the 1% with highest illiquidities as unreliable.
  • Ranks surviving stocks on standard deviation of daily returns (volatility) over the last three months into three segments (terciles).
  • To avoid confounding volatility and illiquidity, ranks stocks within each volatility tercile into illiquidity quintiles (creating 15 volatility-illiquidity portfolios). This step effectively controls for size, which relates negatively to volatility.
  • Skips two months (avoiding reversal/momentum effects) and calculates value-weighted returns for the 15 portfolios during the third month after formation based on market capitalizations at the end of the prior month.
  • Calculates the monthly illiquidity return as the average difference in returns between highest and lowest illiquidity portfolios across the three volatility groups.
  • Calculates illiquidity alpha by controlling monthly illiquidity returns for market, size, book-to-market and momentum factors over the past 36 months.

Using daily and monthly data for all NYSE and AMEX common stocks and monthly factor returns during 1950 through 2012, he finds that: Keep Reading

Equity Risk Premium Model Consensus

What is the consensus of the different approaches to modeling the U.S. equity risk premium (ERP)? In their October 2013 paper entitled “The Equity Risk Premium: A Consensus of Models”, Fernando Duarte and Carlo Rosa estimate the ERP by combining outputs of 20 models prominently used by practitioners and featured in the academic literature. They define the ERP as the compensation investors require to make them indifferent between holding the equity market portfolio (proxied by the S&P 500 Index) and a risk-free bond (proxied by nominal or real U.S. Treasury instruments). They categorize the 20 ERP models into five groups: (1) historical mean returns, (2) discounted dividends, (3) cross-sectional regressions, (4) time-series regressions and (5) surveys. They measure the success of each model as the R-squared statistic for a regression of realized excess returns on ERP model outputs. They calculate the consensus of all models in real time via a single principal component. This approach reduces noise but puts some weight on non-optimal models. Using monthly data as available from widely used academic and government sources during January 1960 through July 2013, they find that: Keep Reading

Practically Beating a Market-weighted Stock Index?

Is there a simple compromise between easy-to-implement market weights and more diversified equal sector and equal stock weights? In their December 2013 paper entitled “A Simple Diversified Portfolio Strategy”, Bernd Hanke and Garrett Quigley present a stock portfolio construction approach that blends market weights, equal stock weights and equal sector weights. The objectives of the approach (relative to market weights) are: (1) higher returns (by capturing more of the diversification premium); (2) lower risk (via increased diversification); and, (3) competitive capacity and rebalancing frictions (by limiting the tilt toward small, illiquid stocks). In testing this approach, they form and rebalance annually regional (U.S., European and Japanese) portfolios of relatively liquid stocks. They ignore rebalancing frictions. They define sectors via the broadest Global Industry Classification Standard level (ten sectors). Using total (dividend-reinvested) returns, market capitalizations and sector memberships for a broad sample of relatively liquid stocks during January 1992 through March 2013, they find that: Keep Reading

Emerging Markets Developed Yet?

Do emerging markets still deserve their reputation as a portfolio-diversifying asset class? In the October 2013 version of their paper entitled “Emerging Equity Markets in a Globalizing World”, Geert Bekaert and Campbell Harvey examine whether, given the dramatic globalization of the past 20 years, it still make sense to classify country equity markets as “developed” or “emerging.” Using monthly returns as available for developed and emerging equity markets mostly during January 1988 through August 2013, they conclude that: Keep Reading

Optimal Allocation to Equities Versus Investment Horizon

Are stocks so attractive over the long run that they crowd bonds and cash out of the optimal portfolio? In their September 2013 paper entitled “Optimal Portfolios for the Long Run”, David Blanchett, Michael Finke and Wade Pfau relate optimal portfolio equity allocation to investment horizon worldwide to determine whether stocks universally exhibit time diversification (whereby mean reversion of returns causes equity risk to decrease as investment horizon lengthens). In calculating optimal equity allocation, they employ a utility function to model how investors feel about the risk of good and bad outcomes (not volatility as measured by standard deviation of returns). They consider different levels of investor risk aversion on a scale of 1 to 20, with 20 extremely risk averse. They measure returns for both overlapping and independent investment intervals of 1 to 20 years. They constrain portfolios to long-only positions in three assets: government bills (cash), government bonds and stock indexes. Using annual real returns to local investors in bills, bonds and stock indexes for 20 countries during 1900 through 2012, they find that: Keep Reading

2013 Country Equity Risk Premiums from Academia and Practitioners

What are the current academic and practitioner estimates of risk-free rates and of annual premiums over the risk-free rate demanded in each country by equity investors? In their June 2013 paper entitled “Market Risk Premium and Risk Free Rate Used for 51 Countries in 2013: A Survey with 6.237 Answers”, Pablo Fernandez, Javier Aguirreamalloa and Pablo Linares summarize the results of a May-June 2013 email survey “about the Market Risk Premium (MRP or Equity Premium) and Risk Free Rate that companies, analysts and professors use to calculate the required return on equity in different countries.” Based on 1,553/2,205/1,443 specific responses to the question from professors/analysts and financial companies/non-financial companies, respectively, around the world, they find that: Keep Reading

Safe Retirement Portfolio Withdrawal Rate as of April 2013

What initial retirement portfolio withdrawal rate is sustainable over long horizons when, as currently, bond yields are well below and stock market valuations well above historical averages? In their June 2013 paper entitled “Asset Valuations and Safe Portfolio Withdrawal Rates”, David Blanchett, Michael Finke and Wade Pfau apply predictions of bond yields and stock market returns to estimate whether various initial withdrawal rates succeed over different retirement periods. They define initial withdrawal rate as a percentage of portfolio balance at retirement, escalated by inflation each year thereafter. They simulate future bond yield as a linear function of current bond yield with noise, assuming a long-term average of 5% and bounds of 1% and 10%. They simulate future U.S. stock mark return as a linear function of Cyclically Adjusted Price-to-Earnings ratio (CAPE, or P/E10), the ratio of current stock market level to average earnings over the last ten years, assuming P/E10 has a long-term average of 16.4 with noise (implying average annual return 10% with standard deviation 20%). They simulate inflation as a function of bond yield, change in bond yield, P/E10 and change in P/E10 with noise. They assume an annual portfolio management fee of 0.5%. They run 10,000 Monte Carlo simulations for each of many initial withdrawal rate scenarios, with probability of success defined as the percentage of runs not exhausting the portfolio before the end of a specified retirement period. Using initial conditions of a government bond yield of 2% and a P/E10 of 22 as of mid-April 2013, they find that: Keep Reading

The “Best” Equity Risk Premium

What are the different ways of estimating the equity risk premium, and which one is the best? In the March 2013 update of his paper entitled “Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2013 Edition”, Aswath Damodaran offers a comprehensive overview of equity risk premium estimation and application. Using data from multiple countries (but focusing on the U.S.) over long periods, he concludes that: Keep Reading

Country Stock Market Return-Risk Relationship

Do returns for country stock markets vary systematically with the return volatilities of those markets? In their December 2012 paper entitled “Are Investors Compensated for Bearing Market Volatility in a Country?”, Samuel Liang and John Wei investigate the relationships between monthly returns and both total and idiosyncratic volatilities for country stock markets. They measure total market volatility as the standard deviation of country market daily returns over the past month. They measure idiosyncratic market volatility in two ways: (1) standard deviation of three-factor (global market, size, book-to-market ratio) model monthly country stock market return residuals over the past three years; and, (2) standard deviation of one-factor (global market) model country stock market return residuals over the past month. They then relate monthly country market raw return, global one-factor alpha and global three-factor alpha to prior-month country market volatility. Using monthly returns and characteristics for 21 developed country stock markets (indexes) and the individual stocks within those markets, and contemporaneous global equity market risk factors, during 1975 through 2010, they find that: Keep Reading

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