Important legal information

The content displayed on this website is exclusively directed at qualified investors, as defined in the swiss collective investment schemes act of 23 june 2006 ("cisa") and its implementing ordinance, or at “independent asset managers” which meet additional requirements as set out below. Qualified investors are in particular regulated financial intermediaries such as banks, securities dealers, fund management companies and asset managers of collective investment schemes and central banks, regulated insurance companies, public entities and retirement benefits institutions with professional treasury or companies with professional treasury.

The contents, however, are not intended for non-qualified investors. By clicking "I agree" below, you confirm and acknowledge that you act in your capacity as qualified investor pursuant to CISA or as an “independent asset manager” who meets the additional requirements set out hereafter. In the event that you are an "independent asset manager" who meets all the requirements set out in Art. 3 para. 2 let. c) CISA in conjunction with Art. 3 CISO, by clicking "I Agree" below you confirm that you will use the content of this website only for those of your clients which are qualified investors pursuant to CISA.

Representative in Switzerland of the foreign funds registered with the Swiss Financial Market Supervisory Authority ("FINMA") for distribution in or from Switzerland to non-qualified investors is Robeco Switzerland AG, Josefstrasse 218, 8005 Zürich, and the paying agent is UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich. Please consult www.finma.ch for a list of FINMA registered funds.

Neither information nor any opinion expressed on the website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco/Robeco Switzerland product should only be made after reading the related legal documents such as management regulations, articles of association, prospectuses, key investor information documents and annual and semi-annual reports, which can be all be obtained free of charge at this website, at the registered seat of the representative in Switzerland, as well as at the Robeco/Robeco Switzerland offices in each country where Robeco has a presence. In respect of the funds distributed in Switzerland, the place of performance and jurisdiction is the registered office of the representative in Switzerland.

This website is not directed to any person in any jurisdiction where, by reason of that person's nationality, residence or otherwise, the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website.

I Disagree
The risk premium is practically zero

The risk premium is practically zero

15-10-2010 | Insight

The risk premium does not exist and the scope of its failure is wide, says, Eric Falkenstein, Ph.D. and low volatility investing expert.

  • Eric Falkenstein
    Eric
    Falkenstein
    Quantitative Equity Strategist at Pine River Capital Management

“I want to convince you that there is no risk premium,” said Eric Falkenstein, Ph.D., quantitative modeling expert and former hedge fund manager. “There are no intuitive metrics of risk that are robustly correlated with returns.” Proving this point was the basis for his recently published book, Finding Alpha: the Search for Alpha when Risk and Return Break Down, and the subject of his talk at the Robeco Minimum Volatility Investing seminar.

No relation between risk and return

His argument that there is no relationship between high-risk stocks and higher return is based on a mountain of empirical research, his own as well as by other practitioners and academics. It all began with a study by the well-known financial economists, Eugene Fama and Kenneth French.

As Falkenstein described in his talk at Robeco, Fama and French published research as early as 1992 that rebutted the capital asset pricing model and showed a flat relationship between volatility and return.  In an interview with the New York Times when the research was published, Fama said, "Beta as the sole variable explaining returns on stocks is dead."

This was a complete about-face for one of the original proponents of the capital asset pricing model, which fundamentally states that higher risk stocks can be expected to produce better returns than lower risk stocks.

Falkenstein, however, goes one step further from Fama's finding of a flat relationship between risk and return, and instead asserts "the real relationship is actually negative." This is visible when the performance of US equity high-beta and low-beta portfolios are compared against the S&P 500 Index. (The data for such a comparison is available on Falkenstein's web site.) Over a period of more than 50 years, low-beta stocks clearly outperformed both the market and high-beta stocks, with high-beta stocks turning in the worst performance of the three portfolios.

Risk premium absent across many investment types

Falkenstein's extensive research reveals the lack of a connection between high-risk securities and high returns across a variety of investment categories, including equities, currencies, commodities, corporate bonds, private equity and even film investing and horse racing. While it is human nature to bet on long-shots at the race track, the higher risk bet is seldom rewarded, and the actual relationship between risk and return in horse racing is overwhelmingly negative.

"The best evidence against the risk premium is not one test," he says, "it is the scope of the failure. There are 20 asset classes where the risk premium fails to occur."

Falkenstein does note a positive association between risk and return in a few investment niches, including the short end of the yield curve and the spread between BBB-AAA corporate bonds. Efficient equity investing, such as indexing, should also yield a positive risk premium, he says, "But the average equity investor does not get the equity risk premium because of problems with taxes and expenses."

Equity risk is not rewarded

He points out that his back-tests of minimum variance portfolios, derived from a range of indexes, including the FTSE, MSCI Europe, Nikkei and S&P 500, have all outperformed the relevant index. "In every case, volatility is 30% lower and returns are 2-3% higher."

For Falkenstein, the take-away from this research is clear cut. "If risk and return are empirically uncorrelated, low-volatility investing is a rather straightforward normative implication of what a rational investor should do." In short, for equity investors, risk is not rewarded. Hence the rising popularity and success of low-volatility strategies.

1 Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” Journal of Finance,  47 (June 1992).

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe
Subjects related to this article are: