Some Thoughts On Risk In a World of Low Returns

This article was originally published on my LinkedIn page on November 2016.

In this memo, I seek to explain what investment “risk” is and to describe the relationship between risk and reward in the context of financial assets.

I address why a risk-conscious investor should only accept purchasing a financial asset if its expected return will compensate him or her for the risk associated with it. I will also address why many market participants today are buying into assets with unfavorable risk-reward characteristics. Also discussed in the memo are the negative consequences of a lack of risk consciousness by market participants on a macroeconomic level.

Today, few investors realize that the low returns they are experiencing comes with a disproportionately larger level of risk. That is, the arena for marketable securities is plagued with low risk-adjusted returns. Excess liquidity within financial markets is bringing down prospective yields, and prompts market participants to search for higher returns irrespective of the associated risk. This phenomenon can set the wheels of the last stage of a market cycle in motion.

In financial theory, it is assumed that a security (financial asset) is priced so that its return compensates investors for the riskiness of the underlying asset. In reality, markets are not perfectly efficient, and there are times when an asset (or assets) is not priced in a way to compensate an investor for the risk he or she takes.

This can be good or bad for an investor, depending on whether the risk and reward dynamics of an asset are skewed in a favorable or unfavorable way. If a security does not compensate an investor for the risk that he assumes when purchasing it, it means that the security has a low risk-adjusted return. Similarly, there may be situations where an asset’s risk and reward are out of balance, yet provides more return for the amount of assumed risk; in this case, an investor has generated higher risk-adjusted returns.

In academia, finance professors define risk as volatility, which refers to how much a security’s price fluctuates. The definition that is used in this memo takes on a slightly different connotation. Here, the risk is the probability of permanent loss.

Risk and return come hand in hand, and in many cases, securities offer sufficient returns to compensate for that risk.

For example, if U.S. Treasuries yielded 6% (a distant memory) and a public equity type investment offered the same prospective returns, the market would ensure that the public equity investment would experience a decrease in its price so that its yield increases in order to maintain a healthy spread between the yields of both assets to compensate for the risk.

Asset prices are constantly in flux and undergo changes in yields to a level sufficient to compensate for the risk taken. This shows that for any given financial asset, the relationship between risk and reward are linked by its price.

The level of risk an investor adopts when purchasing a security comes in two forms: The first form of risk comes from the quality of the underlying asset. U.S Treasury bonds are said to be risk free as there is no default risk- all other assets should theoretically yield more. The second form of risk comes with the price paid for the asset. A Treasury bondholder can lose money if they purchase the security now (at all time highs), and sells it when interest rates move upwards in the future, which causes a decline in its price. Similarly, shares of a good company purchased at ten times earnings can be a compelling investment, whereas the same stock purchased at 28 times earnings may be very risky.

It is important to understand how an investor determines the riskiness of an asset. Investors typically price risk by applying a risk premium over and above the risk-free rate, which is often the 10-Year U.S Treasury rate.

One reason why security prices are as high as they are is because of a monetary policy tool used by the Federal Reserve, known as Quantitative Easing (QE). This policy aims to increase the money supply by purchasing U.S Treasuries from financial institutions. Purchasing these Treasuries bids the prices of these securities up, and reduces their yield.

The current yield on the 10-Year U.S Treasury is around 1.8%, and the riskiness of other assets are determined by adding on a risk premium over the U.S Treasury’s risk-free rate. The ultra-low returns that U.S Treasuries currently offer brings down benchmarks to which risk premiums are linked to, resulting in lower yields (returns).

As the market as a whole begins to experience increasingly higher prices, and thus lower yields, participants start to become less risk conscious and move to riskier asset classes in search of higher yield.

Those assets then begin to experience reductions in yields too, because their price is being bid up which entices market participants to obtain even higher returns by buying into yet riskier asset classes.

A ‘peak’ in a security such as a stock, or in a market index such as the S&P 500, occurs when the last market participant who has been holding out decides to invest. From that point, there are only two things that can happen; the prices of securities either remain relatively stagnant, or they fall. As the market approaches this level, the marginal increase (or rate of growth) in securities’ prices falls, leading to lower future returns. By this point, many participants who entered the market in the latter portion of the cycle did so because prices kept going up (rather investing for cash yield); once this slows down, the market becomes much less attractive to those very buyers.

Debt plays a vital role in how it affects asset prices. If market participants have more money available to purchase securities (because of the availability of debt), they will bid the prices of those assets up with their broader capital base.

The increasing availability of credit seduces market participants into using margin debt to obtain higher returns. As mentioned earlier, the market eventually saturates when most willing and able participants are invested.

The immediate movement following that point is not necessarily a market price collapse, but the use of leverage can introduce a disproportionately high level of risk because lenders can demand their money back if investments fail to deliver on contractual value tests. In this instance, the debt-ridden market participants will collectively have to sell their holdings to repay lenders; on a macroeconomic level, this would depress the level of liquidity and security prices. This process reflects the end of a short-term credit cycle.

A lack of risk consciousness can lead to investors moving into riskier asset classes, regardless of price. This means that these market participants would be buying into assets that have a high probability of loss, and because of its high price, a non-compensatory level of return.

In a recent article in Barron’s, titled, ‘Seeking Yield? Try Insured Munis,’ the author attempted to make the case for buying insured bonds of financially impaired Puerto Rico: all for a yield of 4.5% (or for just over 7% given specific tax considerations). The Alpine High Yield Managed Duration Municipal funds owns Puerto Rico bonds maturing in 2020, for a yield of about 4%, meaning that the risk premium implied here is a meager 2.5%.

There is more evidence to suggest that market participants are assuming higher levels of risk that can lead to lower future returns. Analysts at Wells Fargo Securities wrote that “Despite projections for continued economic growth in 2016…corporate credit fundamentals continue to erode.” Default rates have risen to 6.6% from 3.9% last October, and even though most of these defaults are from energy companies that face low oil prices, this could lead to banks calling in on loans, and commencing the final stage of the credit cycle. The SPDR Barclays High Yield Bond ETF achieved a modest 5-year return of 4.30%, suggesting that junk bonds are being heavily bought into.

Furthermore, most of the debt that has been amassed is being used to bid up prices of financial assets through share repurchases and acquisitions, and not on capital expenditures for plant and equipment. This suggests that companies are using debt to bid up the prices of their own securities, and not reinvesting as much into building up their asset base and improving its fundamentals. (The long-term capital expenditure rate from 1951 to 2013, measured as a percentage of profits, is 88%; this fell to 53% as of December 2012).

A good indicator of the price level of the market as a whole is the Shiller P/E (CAPE) ratio, which is a cyclically adjusted price-to-earnings ratio for the S&P 500. (A price to earnings ratio is a measure of how expensive the price of a security is relative to its earnings).

A lower than average figure for this ratio suggests above-average returns in the future, and above average results for this ratio suggests lower than average returns in the future. According to Robert Shiller’s website, as of August 2016, the CAPE ratio was at 27.27 which implies an earnings yield of around 3.7%. This low yield on equities suggests two things: Since prices are already high, there is less potential for price appreciation, and there is no sufficient cushion to protect investors should any surprises happen. Investors should tread carefully to avoid buying into overpriced securities, especially when they are purchased with borrowed money.