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A Profile of 10 Return Premiums
(This post stems from my interview with Antti Ilmanen, author of Expected Returns. Feel free to check out part one and part two of my Q&A with Antti.)
 
My interview with Antti Ilmanen covered a number of different topics, but there are three big picture elements that stand out to me:
  • The explosion in unique, systematic strategies for generating investment returns within the world’s financial markets that the last 15-20 years of academic and practitioner research has uncovered
  • The debate about whether these factors can be captured, will persist and are mostly reward for bearing risk or the result of market inefficiencies
  • The potential for better portfolio diversification by framing diversification explicitly in terms of exposure to each known source of expected return
Generating Investment Returns
By my count, financial research has documented at least 10 distinct, systematic strategies for generating investment returns. These are frequently referred to as return premiums.
 
Equity Premium
By far the most well-known, this premium is the reward investors have historically earned for owning a diversified portfolio of equities instead of safe fixed income. This premium has averaged about 8.0 percent per year in the U.S. over the period of 1927–2010.
 
Equity Size Premium
The size premium is the difference in the returns of small-cap stocks and large-cap stocks. In the U.S., this premium has averaged 3.8 percent per year over the period of 1927–2010.
 
Equity Value Premium
The value premium is the difference in the returns of value stocks (stocks with low prices relative to earnings) and growth stocks (stocks with high prices relative to earnings). In the U.S., this premium has averaged 4.9 percent per year over the period of 1927–2010.
 
Equity Momentum Premium
The momentum premium (or “effect”) is the tendency for stocks that have done relatively well to continue to do well and vice versa. In the U.S., this premium has averaged 9.7 percent per year over the period of 1927–2010. While most of the research on momentum has involved the equity market, it has been discovered in other markets (such as commodities) as well.
 
Term Premium
The term or maturity premium is the additional return that investors have earned from buying longer maturity bonds instead of shorter maturity bonds. In the U.S., this premium has averaged 2.2 percent per year over the period of 1927–2010.
 
Default Premium
The default premium is the additional compensation investors have received from investing in risky bonds instead of risk-free bonds. In the U.S., this premium has averaged about 0.3 percent per year over the period of 1927–2010.
 
Currency Carry Premium
High interest rate currencies tend to earn higher returns than low interest rate currencies. Currently, the developed-markets version of this strategy would be buying short-term Australian dollar debt (among others), because its interest rates are relatively high compared to other developed market currencies. Over the period of 1983–2009, the currency carry premium was about 6.1 percent per year.
 
Volatility Selling Premium
A strategy of selling volatility — which means it will do poorly when volatility unexpectedly increases and well when volatility is less than expected — has generated a historical premium of 3.7 percent over the period of 1989–2009.
 
Merger Arbitrage Premium
Once mergers are announced the price of the target company (i.e., the company that will be acquired) does not immediately jump to the deal or acquisition price. Therefore, a strategy of buying companies after mergers are announced has historically earned a premium of about 4 percent per year (per the 2001 study "
Characteristics of Risk and Return in Risk Arbitrage") because most mergers do indeed happen.
 
Low Volatility Premium
Historically, stocks with low past volatility have outperformed stocks with past high volatility. In the U.S., this premium has averaged about 12 percent per year over the period of 1963–2000.
 
I plan to profile each of these return premiums with a specific focus on the research that has validated them and why the premiums are thought to exist.
 
Copyright © 2011, Buckingham Family of Financial Services. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

Comments

Director of Wealth Management

Very helpful and interesting.
at 11/17/2011 10:50 AM

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