Research by Thanos Verousis, senior lecturer in accounting and finance at Newcastle University Business School, has identified an asset premium on exposure to idiosyncratic risk, in turn leading him to suggest that investors reduce exposure to businesses with high exposure to European markets.
The research has been focused on investors failing to diversify portfolios away from company-specific risk and thereby missing out on returns. Verousis found an aggregate idiosyncratic risk associated with a negative risk premium of -1.32% annually – after controlling for systemic factors including industry groupings, stock characteristics and market conditions.
Verousis utilised two model portfolios for the research; the first took long positions in the bottom 20% of stocks with low idiosyncratic risk and a short position in the top 20% of stocks with high idiosyncratic risk; the second set the ratio at 50% of top and bottom stocks according to idiosyncratic risk.
The conclusion is that investors should increase their exposure to companies with the lowest idiosyncratic risk and sell those with the highest such risk to benefit from the 1.32% improvement. (See further details in the box below.)
Verousis said: “It is now accepted that investors are not perfectly rational, machine-like beings who fully diversify their portfolios to get the best possible returns. However, until now, we haven’t been able to put a figure on the potential returns investors are missing out on by not considering their exposure to idiosyncratic, or firm-specific, risk.”
“This research shows that, contrary to popular belief, assets with high firm-specific risk are not the ones that bring the best returns. Instead, investors should be selling these stocks and investing in firms with low idiosyncratic risk. This will bring an average return of 1.32%, a significant boost given current market conditions.”
It is this conclusion that leads Verousis to suggest that investors avoid companies that have higher exposure to the Europe ex-UK market.
“While Brexit could be seen as a systemic event, the idiosyncratic risk for companies with high exposure to the European market, such as airlines, as substantially increased. Diversifying away from idiosyncratic risk is even more difficult in volatile markets, so it is vital that investors review their portfolios regularly over the coming days and weeks.”
“But our research also shows that there is a clear opportunity for investors to profit from Brexit. They need to exploit the increase in idiosyncratic risk of companies that are heavily exposed to the European markets. They can increase their profits by selling these shares and investing in firms that are expected to benefit from Brexit, for instance tobacco, metal and media companies that export outside the EU.”
The research findings are set to be presented at the Financial Management Association’s Annual Meeting in Las Vegas in October.
|Idiosyncratic risk visualised
(Source: Thanos Verousis, Newcastle University Business School)
The plot above shows the monthly returns of portfolios that have been formed according to their exposure to aggregate idiosyncratic risk (pre-formation betas). Stocks in the first quintile, which have the lowest pre-formation betas (-6.85 on average), offer a mean monthly return of 1.37%. At the other end, the highest-beta stocks in the fifth quintile (average beta is 6.71) offer the lowest mean return of 0.43% per month. More importantly, mean returns decrease monotonically with the level of past dispersion betas as we move from the first to the fifth quintile portfolio. The simple strategy of going long in the lowest-betas stocks and short in the highest-beta ones is found to offer a mean return of 0.94% per month. Overall, the fact that portfolio returns are decreasing monotonically with the level of their concurrent sensitivity to changes in aggregate idiosyncratic risk is consistent with the existence of a negative dispersion premium.
Our results clearly show that after accounting for systematic risk factors, a zero-cost spread portfolio that is long in stocks with low idiosyncratic risk and short in stocks with high idiosyncratic risk is found to offer adjusted returns of 11.3% per annum. These results suggest that the high returns offered by the portfolio are not simply compensation for exposure to well-known systematic risk factors. In this respect, the traditional assumption that investors are not compensated for idiosyncratic risk as they have the ability to fully diversify by investing in the market portfolio, is particularly restrictive and highly unlikely to describe the way in which investors actually construct portfolios.