As a scheduled speaker at this fall’s Investment Innovation Conference in Bermuda (November 16 – 18), Roger Ibbotson, Professor of Finance at the Yale School of Management, will be sharing his views on the risk premiums that exist in today’s markets. In advance of the conference, we asked him a few questions about the evolution and structure of these premiums. To find out more about Roger’s presentation and the Investment Innovation Conference, click here.
Q: How important is the equity risk premium? In the past decade it’s been very low.
A: It’s been almost zero. The thing is you’ve got to expect that once in awhile. One of the words in the equity risk premium is risk. So it’s not a sure thing. You have to anticipate that there are going to be some years, and even some decades, when you don’t get it. You didn’t get a positive return in the 1930s.You didn’t really get it in the last decade. You get it in most decades, though.
On a go-forward basis, you have to presume that in most decades you’re going to get this. And actually it’s a positive return in about 70% of the individual years. So maybe it won’t be 70%, but I would say two-thirds of the years you’re going to have up markets. So it’s not something to be ignored.
Do you have a prospective estimate of the equity risk premium? Where will it be in the next decade?
I’ve often dismissed the historical way of doing it – particularly in the early 2000s – when we were all thinking that it might be dangerous to extrapolate. I came out with a paper, “Long-Run Stock Returns: Participating in the Real Economy.” We looked at alternative ways to measure the premium. At the time, we got a substantially lower estimate of the premium [than the historical rate]. Let me say that after the drops in the market, the historical rate isn’t that bad of an estimate today. Through 2010, if I go from 1926 to 2010, the stock market had a 9.9% compound return and government bonds had a 5.5% return. If you look at that difference, it’s 4.4%, and that’s not an unreasonable estimate of the premium in today’s market. It may have been unreasonable in 2000 because the spreads would have been bigger at that time. But now after the drops in the market, I think that’s not an unreasonable estimate.
Over the past decade, you and others have discovered new premiums, like the liquidity premium. What does that involve?
I’m actually just looking at publicly traded stocks and buying the less liquidly traded public stocks. There is a surprisingly high premium associated with buying the less-liquid stocks.
Are those small caps or just the bottom end of the S&P 500?
You’ll find this premium in small caps and large caps, in value and in growth. You’ll find it any different part of the market. It’s basically something that’s additive to any other premium you might find. If you look at the less liquid value stocks versus the most liquid value stocks, you’ll find a very substantial premium. Actually, you’ll find that the premium has compounded at much as 8% per year, for value stocks or growth stocks.
How long does it take to realize that premium?
It’s on average every year. But it’s like all of these premiums, like the equity risk premium. You don’t realize it every year or every decade. But you realize it most of the time. So it’s not so much how long — you get it pretty much all along the way — but in order to be sure that you’re going to get it, you may have to wait a decade. And even a decade doesn’t guarantee it, just like the equity risk premium, as we’ve just seen.
Where do the size, value and momentum premiums stand today?
I believe that all the premiums will continue to exist. The one that is most shaky is the momentum premium, because that has the least economic foundation to it. It’s almost more of an alpha then a beta play, whereas the others are more beta-oriented. The reason why there are premiums in the market is because they’re basically paying people to do something they don’t want to do. You don’t want to buy stocks when they’re risky, you’d rather buy bonds. You don’t want to buy distressed value companies when could buy the exciting growth companies, and you don’t want to buy small caps when it’s so much easier to buy large caps. And you don’t want to buy the less liquid stocks; you’d rather buy the most liquid stocks. The crux of this in every case is that you, as an investor, are being paid to do something that you don’t want to do. That’s why these premiums don’t go away.
With bonds, you look at horizon and default premiums. What are these?
The horizon premium is no more than an interest-rate premium — it’s the premium you get for buying longer-horizon bonds rather than shorter-horizon bonds. You’re locking in an interest rate over the period. That means the bond investor has a lot of price fluctuations on the bond. There’s an imbalance here, essentially because most investors would prefer to buy shorter-term bonds, but issuers want to issue long-term bonds. Here again, it’s the same kind of concept as with all these premiums. What do you do when the issuers want to issue long-term and the investors want to buy short-term. The only way this works is if issuers, in this case, offer a higher yield, a higher expected return for investing in long-term bonds. That’s the horizon premium. The default premium is the same thing because we don’t want to buy these bonds that have higher default risk. Again, it’s getting the investors to buy the things that they wouldn’t have wanted to buy and inducing that with an extra return.
To learn more about the Investment Innovation Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Garth Thomas to be considered, as limited space available.