Investment performance can be described as coming from six sources:
1 Treasury bill yield. The short term (less than one year, and typically 1-6 months) risk-free rate of interest.
2 Inflation-indexed government bond yield. The long-term inflation-risk-free rate of interest. It is unclear whether these inflation-indexed bonds need to offer a premium return over Treasury bills, but they probably will.
3 Conventional Treasury bond yield. The long-term nominal risk-free rate of interest. This rate of interest is subject to the risk of unexpectedly high inflation. It will include a premium over inflation-linked bonds to compensate for expected inflation, and probably also a margin above this for the uncertainty of that inflation (see below).
4 Market risk premium. The compensation that any rational saver should seek in return for putting money or future income at risk of loss. The market provides this reward for bearing "market risk". This is most obviously reflected in the equity risk premium (the amount by which equities are expected to outperform bonds or cash) and the credit risk premium (the extra yield paid on corporate bonds to compensate for the risk that a company might default). Less obviously, market risk premiums appear systematically to be offered in return for accepting various types of insurance risk and for different types of equity risk (for example, small company risk separately from equity market risk). These last two are discussed in Chapter 7 (equity investing), Chapter 9 (hedge funds) and Chapter 11 (real estate).
5 Investment manager skill. Generates investment performance (or alpha) that is separate from the performance of the market (or beta). Frequently, investment performance that managers attribute to their skill (which is an expensive, scarce commodity) gets jumbled up with different aspects of market investment performance (which can normally be accessed easily and inexpensively). One example is where managers who are responsible for asset allocation between stocks and bonds might normally overweight equities, because equities are expected to outperform bonds. This, though, is a reward for greater risk-taking, not a reward for skill.
6 Noise. What unskilful managers introduce to the performance of investors' portfolios. Noise is often described as "alpha" when it is positive. (Sceptics have described alpha as "the average error term".) Distinguishing noise from skill is one of the most difficult tasks for investors. There are always likely to be more unskilled "noise" managers with marketable track records than skilled managers who, in addition to being skilled, also have a marketable record at any point in time. Noise will normally bring some extra volatility; it will also incur fees and distract investors, wasting their valuable time.
The first three sources can be accessed easily and inexpensively by anyone, through direct holdings of government securities. Equity market risk can be accessed inexpensively through index funds or exchange traded funds. Some investment markets and some aspects of market risk premiums (for example, private equity) can be accessed only if the investor is willing to take a view on investment manager skill. The sources of hedge fund performance are discussed in Chapter 9.
The pattern of returns from exposure to market risk can also be re-engineered through "structured products" which contain combinations of embedded options with exposure to particular markets. These do not generate performance, but they can provide insurance against the risk of disappointing outcomes in ways which may suit the investors.
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