Sources of Reward
There must be the possibility of a return to entice investors to take risks and finance new and existing ventures.
The sources of return can be categorized broadly as a form of compensation. We find that the potential return corresponds to the level of risk taken.
A company can be financed by a mix of debt or equity shares. We can use that idea to demonstrate a taxonomy of risk and return.
Fixed income risk
Debt or bond investors lend a company or government money in exchange for interest payments and the eventual return of their principal.
The primary risks:
- interest rate/inflation If interest rates rise than the present value of the fixed interest stream you expect to receive is worth less. Therefore the value of the bond or loan that the investor owns falls. This risk is similarly tied to inflation. Even if interest rates don’t rise but inflation increases, that fixed stream of interest payment buys less goods and services.
- default risk Bonds can be collateralized by a company’s general credit or specific assets. In the event of a default where a company cannot make an interest payment the investor would have a pro-rata claim on the relevant assets. In the case of governments, the credit rests on its ability to tax citizens or create money.
Equity risk
Investors in equity or common shares are subordinate in a company’s capital structure. They do not have any claim to the assets. It is common for the shares of a company to exceed its book value (net assets minus net liabilities) because the company has earnings power.
If you start a lemonade stand, it could be worth more than the pitchers and lemons you have on hand because when combined with your labor and management skills there’s an expectation that you will generate profits. The shareholders own the profits remaining after any senior claims (lenders or preferred shareholders) have been paid.
If the company cannot generate profits, the equity owners are wiped out first even though lenders may be able to recover value of the remaining assets in bankruptcy.
The shareholder must weigh the potential for unbounded profit (as opposed to fixed interest payments) against 100% loss in bankruptcy.
The shareholder gets higher reward potential in exchange for bankruptcy risk.
Real Estate
We see these same concepts in real estate investing. A bank acts as a lender by offering mortgages while real estate investors and developers borrow money to combine with the equity they bring to a deal.
Likewise, a syndicate can raise equity capital from multiple investors. These limited partners are analogous to shareholders in a corporation.
There is a 3rd category of potential risk and reward that exist besides typical stock and bond markets. It is compensation for providing liquidity.
Liquidity provision
This is the domain of commodity futures and currencies. If an oil producer wants to finance a new drilling project, it is typical that they will sell oil futures expiring in multiple years. By locking in a price for the anticipated production they can lock in a profit margin without worrying about the the price of oil in the interim.
A speculator who buys the oil future is providing liquidity to a hedger.
Now imagine a Chinese refiner that imports oil to produce gasoline. The refiner faces multiple risks:
- The price of oil, its input, skyrocketing
- The price of gasoline, its output, plummeting
- The US dollar appreciating against the yuan since oil is priced in USD
- And if the refiner exports to say Japan, it is worried about the value of the yen, the demand currency, falling
Currency and commodity markets are risk transfer markets where businesses go to insure against adverse price movements. They are the “willing losers” who see the cost to hedge or forgone profits as the cost to smooth their revenue.
Speculators and investors have excess savings and patience to accept the risks the hedgers don’t want in hopes of earning a return.
The asset management world refers to sources of return as risk premia.
Returns are compensation for accepting these risks. While it's possible to subdivide these risk premia into finer distinctions, the broad sources of return are compensation for:
- inflation/interest rate risk (fixed income)
- default risk (fixed income)
- bankruptcy risk (equity)
- liquidity risk (general price transfer)
Why do “markets go up?”
Commodity futures markets usually don’t just go up. That they don’t just go up is not so much a law as it is an observation. Commodities do not represent ownership of things that generate cash flow. They are instead consumed and produced. They can be both outputs or inputs. Technology increases our capacity to produce more output with same work. This is the definition of productivity in fact.
Currency pairs do not just go up. The reciprocal of a currency is just another currency. They are relative constructs.
When people observe that markets go up over time they usually mean a stock index representing a basket of shares in economically relevant corporations which is periodically modified to maintain the continuity of relevance.
For clarity, we can edit the observation to say the value of the top corporations in the US, whoever they may be, has increased over time. Since a share of stock is a fractional ownership in a company, stock investors have enjoyed positive returns over time in excess of inflation.
Rather than “markets go up” we can ask why have corporations increased in value.
(again “corporation” is like a variable name — the exact companies they point to have changed over time. Netflix exists, Blockbuster does not)
The answer:
The growth of corporate earnings
As the population grows, GDP grows. Even better, when technology increases productivity, GDP per capita grows. We become wealthier. We have more income to buy more stuff and more savings to re-invest in the capacity to supply more stuff.
Every share of this mythical corporation we own is a claim to larger profits and therefore grows alongside the economy.
The growth doesn’t need to be exactly in lockstep along the way. An industry that once led can later lag and the composition of our holdings might be out of step with such changes or the price we pay for the projected earnings can be too optimistic.
This is where it’s insightful to consider the components of return:
- Earnings
If a company earns 10% net profit on its capital that’s earnings.
- Re-investment
If there’s potential to grow its market or market share it can choose to plow the profit in the business to earn 10% on the newly reinvested capital or it could give it back to shareholders (either via dividends or buying back its outstanding shares). The shareholders can themselves reinvest the dividends back into the company or to another company. Or they can spend the profit (which will show up as profit to whomever they bought goods/services from).
- Re-rating
The amount investors are willing to pay for the stream of future earnings is known as a multiple. This amount depends on the demand to invest (aggregate savings), the supply of available investments, and the general level of optimism/pessimism.
The value of corporate shares reflect a forward-looking claim on aggregate profits.
If the economy grows, this will be mirrored in the general trend of share prices and therefore returns. Greed and fear lead to extrapolation and discounting ensuring prices will overshoot and undershoot interim time horizons.
It is a sober reminder that not every country’s share returns have been “up and to the right”.
The primary source of investor returns is underwriting the risk of broad economic growth.
Learn More
These are terrific references decomposing sources of return and providing historical attributions.
My top takeaway is that the longer your time horizon the less the price you pay matters if the business is actually compounding (ie re-investing at attractive rates of return). Mathematically, it’s because the amount of total return attributed to the change in multiple is effectively amortized over the holding period.
If you are a short-term investor all you care about is the multiple changing. If you are a long-term investor then you hope the business has room to recycle its own profits back into its market profitably.
- Why Do Markets Go Up? (Factor Investor)
- Why Time Horizon Works (Morgan Housel)
- Importance of ROIC — The Math of Compounding (Saber Capital)
- Return: Where Does It Come From? (Prof Kevin Bracker)
- Risk and Returns Before and After The Fact (Byrne Hobart)
Deeper learning
While the sources of risk premia described earlier are the broadest categories, there are finer ways to chop them up. For example, politics in a country with a shaky rule of law or risk of nationalization can create a substantial enticement in the form of seemingly fat risk premiums (ahem, Argentian bonds).
Illiquidity itself can be a form of risk premium. Closed-end funds, A/B shares, on-the-run vs off-the-run treasuries may all include relative discounts. Insurance policies or annuities can offer higher returns than long-term bonds but they are box you can’t open for decades without risking penalties.
Finally, the very distribution of returns can cause particular assets or strategies to offer a higher return for the intrepid investor. For example, carry trades which are characterized by small steady profits dotted with periods of substantial drawdowns. This is called risk premia as compensation for skewness.
Similarly, there’s research suggesting that low-return strategies with a high Sharpe ratio persist because investors are “leverage averse” — they are unwilling to lever up the low-return strategy despite its more attractive risk/reward.
- Tail Risk Premium vs Pure Alpha (paper)
- Risk Premium Investing: A Tale of 2 Tails (paper)
Excerpts
we summarize the case of US short dated government paper exhibiting a positive skewness meaning it is not a risk premium strategy, while longer dated government bonds and, certainly, corporate bonds stand-out as clear risk premium strategies
Measuring the skew of this strategy shows that the factor exhibits negative skewness. What is interesting, however, is that the large downside moves come from upside moves in the index. Despite the fact, therefore, that the strategy has negative skewness, it is a true diversifier in the sense that the negative skewness comes from risk-on environments occurring at times unrelated to the drawdowns of other risk premium strategies
We find in this case that HML exhibits a positive skewness. A positive Sharpe ratio strategy with positive skewness is rare indeed. Our claim in this short note is that positively skewed, positive Sharpe ratio strategies do not come from the family of risk premia, but rather generate returns by exploiting some form of market anomaly. The case of the HML factor is curious, however, and not easily explained. The skewness of the strategy turns negative when using monthly data, adding to the confusion, and necessitating further work.
This ‘long volatility’ component of trend fol lowing is what gives us a positive skew and was the reason for its success through the 2008 global financial crisis. We would argue that the trend is in fact not a risk premium strategy, but rather a genuine market anomaly arising out of the extrapolative tendencies of investors
It seems, therefore, that one is able to improve the Sharpe ratio/negative 7 It is easier to understand how Tail Risk combines in the case of two portfol ios rather than the more compl icated and involved calculations necessary when talking about skewness skewness characteristics of risk premium investing through diversification. The idea of non-diversifiable or incompressible risk, that we al luded to earlier in this paper, does not preclude us from improving the characteristics of the investment and, therefore, we favor this approach in building our portfolio.
The observation that the risk premium is proportional to the level of risk as measured by negative skew is crucial in building a portfolio of such strategies. For example, one may be inclined to run an optimization scheme to build a portfolio based on Sharpe ratios from backtested ideas and strategies. This may prove to be a dangerous approach, knowing that higher levels of Sharpe ratio are purely as a result of a higher level of risk reflected in the negative skew of the return stream. With this in mind a more stable robust portfolio is constructed by instead al locating equal ly to sources of risk premium
- The skewness of commodity futures returns (paper)
Abstract
"A trading strategy that takes long positions in commodity futures with the most negative skew and shorts those with the most positive skew generates significant excess returns that remain after controlling for exposure to well-known risk factors. A tradeable skewness factor explains the cross-section of commodity futures returns beyond exposures to standard risk premia. The impact that skewness has on future returns is explained by investors’ preferences for skewness under cumulative prospect theory and selective hedging practices."