An anatomy of global risk premiums

Abstract

Long-term investors are attuned to the thought that risk is rewarded. By making an investment with more potential variation in returns, investors demand a risk premium – the expected return in excess of a comparatively risk-less investment. This is particularly espoused in the long-term investments of pension funds, yet is a reductive view of financial markets. We investigate the realized risk premiums in a global, multi-asset portfolio of a typical pension fund between 1999–2015, and relate the variation of the realized risk premiums to macroeconomic fluctuations. Owing to the coincident relation between the realized risk premiums and the economic cycle, under the prevailing economic condition, the Sharpe ratios of portfolios constructed ex post to capitalize on risk premiums are appallingly low (between −1 and 0.2). Therefore, despite the heartening corroboration of risk premiums’ existence, investors are susceptible to their time variation.