Sunday, September 25, 2016
If you focus on risk premiums, you should be following the skew
Risk and return. The drumbeat that excess return or a risk premium is received in exchange for taking on risk as measured by volatility is relentlessly driven into the minds of all investors, but what if this trade-off is not as strong as the rhetoric? New research in QuantitativeFinance, "Risk Premia: Asymmetric Tail Risks and Excess Returns" by the folks at Capital Fund Management focuses on skew as one of the key risks. In fact, the authors of some new research make a strong case for risk premiums being more closely related to skew. In particular, the downside risk of negative skew may be more important at explaining excess returns than volatility which can lead to either upside or downside.
The authors find that risk premiums, excess returns versus 10-year government yields are strongly correlated with tail risk not volatility. This relationship exists across countries, asset classes, and strategies. The authors examine equities, bonds, credit, commodities, and FX through carry along with well-known strategies. This universal relationship is both intuitive and actually easy to measure. Investors need to be paid for tail risk exposure.
This relationship actually goes back to some of the original work by Markowitz who discussed downside risk in his path-breaking monograph. Unfortunately, while intuitive, most research and teaching as focused on risk through measures of volatility. While research has been done on skew, not enough focus has been placed on the impact of tail risks.
Interestingly, the authors find that trend-following strategies have positive excess return and positive skew. You can get paid a premium and receive skew. To a lesser extend this is also found with value investing. These are exceptions to the risk premia relationship across other strategies and asset classes.