Equity risk premium change with "good" and "bad" times

 

The macro market regime can be classified as risk tolerance, macro outlook, macro stability, and risk-on conditions. Each of these regimes can be either in a good or bad state. A set of macro state variables like the short rate, term spread, credit spread, dividend yield, effective spread, price impact and systematic volatility can be used to define these regime states.

The size of the equity risk premium will differ based on the market regime state. Conditioning on the market regime can create higher performing risk premium portfolios relative to any unconditional portfolio. See "Macroeconomic Risks in Equity Factor Investing: Part 2/2"

Factor risk premium can have low unconditional correlation but in reality have high sensitivity in different regimes. Momentum and high profitability are highly sensitive to the risk tolerance regime. These two risk premium have correlated regime sensitivity. What is surprising is that the size premium seems to be independent of macro regimes and hence will be a good diversifier in all states. Also surprising is the fact that the low volatility risk premium has high sensitivities to many market regimes. Low volatility is not a strategy for protecting a portfolio given this high regime sensitivities.

Understand your market regime and realize that equity risk premiums are regime sensitivity.  An unconditional correlation may not tell us about the true risk between equity risk premiums. 

Macroeconomic surprises impact equity risk premium

Macro risks impact equity factor investing. Equity factors (value, momentum, size, low risk, high profitability, and low investment) show cyclicality associated with some macro variables. Bundling risk factors together unconditionally will add value when forming a portfolio; however, accounting for macro risk surprises will provide further insights on the spread or sensitivity of these premium. Looking at short rates, the term premium, the credit premium, dividend yields, and market illiquidity can all provide better insights on the conditional movement in equity risk factors and are easily employed in any model of risk premium. See "Macroeconomic Risks in Equity Factor Investing". 

All the primary risk factors show a systematic relationship to one or more macro variables.  Short rates and the term premium seem to be the most important macro variables. Clearly, they represent changes in the economy and monetary policy.  Increases in short rates will negatively affect size, volatility, and the investment premium. Increases in the term premium will have a strong negative impact on momentum, profitability, and investments, but will have a positive impact on value. Default or credit spread will have a positive impact on profitability. 

The macro regime matters on equity factor risk premium. This has been known for some time. This papers quantifies the impact of macro surprises on various risk factors. If you don't account for where you are in the economic cycle, you factor exposures will harm your portfolio return. Of course, the problem is now determining what economic regime you are in or where you are headed. 

Skewness across asset classes - It can be exploited

 

There is a unique risk premium associated with skew and it exists to varying degrees across all asset classes, equities, bonds, commodities, and currencies. Creating rank weighted asset class portfolios that are long negative skew and short positive skew and bundled equally across all four asset classes can generate a portfolio that has a Sharpe of .72 over the period from 1990-2017.  The value of skew is shown in the paper, "Cross-Asset Skew" which creates a global skewness factor. 

The value of skew can be seen using several different statistical measures and is robust across different data sub-samples. The value of skew cannot be explained by other factors like momentum, carry or value. It is unique. Additionally, the skew risk premium seen in one asset class is not correlated with the skew in other asset classes.  Investors need to be compensated for the risk of negative skew and investors overpay for the lottery ticket embedded in a positive skewed asset. The combination of going long (short) skew and negative (positive) skew is pervasive Except for currencies across all asset classes. Even though asset classes may have most markets negatively skewed, the rank ordering shows the pervasive benefit from buying the lowest ranked skewed markets and selling the highest rank. 

Forming mean variance efficient multi-factor portfolios, the researchers find skewness is given a positive weight. Holding the skew factor is relevant for improving the efficient frontier especially at lower volatility. 

Different measures of skew which may have better intuition

Skew can be thought of as one side of the distribution being stretched to reflect the greater likelihood of events in either the left or right tail of the distribution. It is a distribution asymmetry. It is the third movement of the distribution and usually is measured as: 

However, the measure of skew as a difference cubed does not have immediate intuitive sense. You can measure it as either being positive or negative, and give it a level of intensity, but it does not have a good feel for most users. Investors will like positive skew, but it must be thought of in the context of price. How much do I have to pay for the skew I may like. 

Other alternatives to the traditional measure of skew that are easy to calculate for return include: 

Low moment skew which is the scaled difference between the sample mean and median.

Spread between the up and down semi-variances which is easy to calculate and has good intuition.

The high minus low measure which is the spread of absolute value of  the max and min scaled by the standard deviation.

All can be calculated on a rolling basis to provide insight on the changing skew of any asset.