Falling equity risk premiums:
There are alternatives again
Falling equity risk premiums: There are alternatives again
Interest rates are back, to the delight of all bond investors. “There is no alternative” was the bulls’ argument on the stock market for a long time. Dividend stocks were considered to have no alternative because no significant interest could be earned with savings accounts, time deposits and bonds. In the meantime, the picture has changed:
Interest rates are back and so is the valuation view on equity investments.
Chart 1: Plot of the equity risk premium of the S&P 500 since 2008. The equity risk premium is the difference between the expected return of the S&P500 index and the yield of a 10-year U.S. government bond
The barometer for the attractiveness of equities compared to bonds is at its lowest level in more than 10 years. The so-called equity risk premium, i.e. the excess return investors demand for an investment above the risk-free rate of return, has fallen well below two percent (see chart 1).
Even before the Corona crisis, the equity risk premium was declining. Investors were positive about the future prospects for the economy and the stock market, which led to rising stock prices and thus a decline in the equity risk premium. Now, however, things are different. The risk-free interest rate has risen, while the return on equities has remained constant.
The decline in the equity risk premium now poses a challenge for equities. In the long term, equities must promise a higher return than bonds. Otherwise, the safety of government bonds would outweigh the risk of equities losing some, if not all, of investors’ money.
The appeal of equities has waned as bond yields have skyrocketed.
The equity risk premium is an important concept in financial and investment management because it helps investors and analysts evaluate the expected returns of various investment opportunities and make informed investment decisions.
In addition to the equity risk premium, there are other risk premiums that reward investors for taking on different types of risk. Examples include the credit risk premium and the volatility risk premium.
The latter has remained constant despite the new interest rate environment and is therefore a very good alternative to equity risk premiums.
The volatility risk premium reflects the remuneration investors receive for providing insurance against market losses. It exists geographically in all countries and in many asset classes for the same reason as any insurance premium: investors seek protection against adverse events.
And because market participants tend to be risk-averse and tend to overestimate the likelihood of extreme market events, the volatility risk premium is abundant in almost any market environment – regardless of the current level of interest rates.
In the long term, the volatility risk premium is thus much more stable than the equity risk premium and offers a higher probability of profit (see chart 2).
Chart 2: Comparison of the equity risk premium (left) versus the volatility risk premium (right) of the DJ EuroStoxx 50 based on monthly data since 2000.As an equity investor, the equity risk premium is collected through a LONG position. The volatility risk premium is collected through a SHORT position.
Options are a type of insurance in finance, providing access to the volatility risk premium. The objective of an option buyer is generally to hedge an asset against losses. The goal of an option seller, on the other hand, is generally to profit from the sale of an option. The option buyer pays in advance the so-called option premium, which is collected by the seller. Similar to most insurance contracts, the option premium is a premium that the seller receives as compensation for assuming a loss event.
Chart 3: Increase in expected return of short volatility funds due to increase in base yield in bond portfolio.
In the case of so-called short volatility funds, which therefore collect the volatility risk premium by selling options, only a small amount of cash is required due to the derivative implementation. The majority of the fund volume (>90%) is therefore invested in a bond portfolio (base portfolio). The bond portfolio serves as collateral for the derivative transactions vis-à-vis the respective counterparty.
Until recently, this base portfolio did not earn interest, and even generated mostly negative interest rates. Thanks to the new interest rate environment, the expected return of such short volatility funds has now increased significantly (see chart 3). The base portfolio alone delivers approx. 3% return p.a. more than a few years ago.
On top of this comes the volatility risk premium, which remains attractive in the current interest rate environment. The recent market turmoil has even made this risk premium more attractive.
From a return perspective, short volatility funds have become more of a real alternative in a mixed portfolio than ever before due to the combination of a bond portfolio and a derivatives portfolio.