It is generally assumed (some might say intuitively) that investors expect higher returns from investing in riskier assets. This is also true within a single geography, where investors expect higher returns from investments made into equities than they would from a government bond.
Active investment managers, like Ashburton Investments, therefore invest with the objective of maximising risk-adjusted returns, taking care to ensure that the risks taken on in portfolios are justified by the returns expected.
To get a bit more theoretical, the value of an asset today is the sum of all the future cash flows that the asset is expected to generate, but discounted to reflect future inflation and risks. It is this discount factor or rate which is highly debated and the main source of the value an active manager can add. When most investors are pricing in more risk (i.e. using a higher discount rate, which will reduce the value of the asset today) than the manager thinks there really is, there is the potential for the asset to provide additional return to the portfolio if the manager is proved right.
When investing in emerging or frontier market equities, there are a number of components of risk to consider.
Firstly, there is the relevant country risk that encompasses both the economic and political environment. Bond investors typically look at the ‘spread’ or difference in yield in a country over US bonds as an indicator of the extra return that they expect to get for the additional country risk they are taking. Equity investors have to consider additional risks, especially the uncertainty of future cash flows. This additional risk over bonds is usually termed the ‘equity risk premium’. Many studies have shown that investors in equities typically expect to get between 4% and 6% higher returns from taking the additional risk over simply buying government bonds.
Another way to explain the equity risk premium is the volatility or variability of the earnings and therefore the cash flows of companies compared to the almost certain and predictable cash flows received from a government bond.
Liquidity in smaller markets, Africa for example, may be quite low and therefore this is typically built into the current price (i.e. the discount rate is higher because the equity risk premium used by investors is higher).
A good example of mispriced risk can be illustrated by an investment we made in an Egyptian company last year. At the time, investors were pricing in a very high premium for Egyptian shares, but this had been applied across the market. Certain companies did not face the same risks and we were able to purchase shares in a carpet manufacturer, Oriental Weavers, at what it considered a significant discount. While the market has rallied 50% since then, as risks in Egypt have reduced, shares in Oriental Weavers have more than doubled; indicating how this mispriced risk has subsequently unwound to the benefit of investors.
Many retirement savers or retirees do not realise that they are taking an implicit view on the equity risk premium that constantly occupies the thoughts of active equity investment managers. If you were to overestimate the equity risk premium for example, you might save too little or invest in assets that are too risky.
At Ashburton Investments, our investment professionals, especially our emerging and frontier market specialists, are constantly considering the appropriate equity risk premiums to enable them to select shares with the suitable risk adjusted returns for their mandates.