Beyond the Equity Risk Premia

1© 2017 Windham Capital Management, LLC. All rights reserved.
Confidential. Not for redistribution.
January 2017 1
Portfolio Risk Deconstruction
Dr. Richard R. Lindsey
Windham Capital Management, LLC
Managing Partner & Head of Liquid Alternative Strategies

WHAT WILL WE COVER?
 How to model portfolio returns?
 What are risk premia?
 What is the intuition behind risk premia and portfolio returns?
 How can we decompose portfolio risk?
 Are there other things we can do?

LET’S START WITH SOMEONE THING WE ALL LEARNED AS CHILDREN…
cos( ( ))
sin( ( ))
tan( ( ))
sin( ( ))
( )
b
b
b
b
b
a b b
b
b
b
a b b b
b
dx
V t
dt
dy
V t
dt
d V
t
dt L
y y L t
dy
V
dt
d V
t
dt L
dy dy d d
L V L
dt dt dt dt
q
q
q
d
q
q
q
d
q q
q
=
= -
=
= -
» -
»
» - = - -
Key Idea: Similarly, we can
capture how a portfolio
behaves without knowing
exactly what the portfolio
holds.
Key Idea: You don’t need
to know the math – you
just need to act as if you
do.

FOUR WAYS TO MODEL RETURNS
 Factor Decomposition
 Principal Component Analysis
 Statistical Factor Analysis
 Analysis using Tradable Assets / Pre-Specified
Factors
 Analysis using Tradable Assets and Trade
Strategies
 Analysis using Risk Premia
Problem: Results have no intuitive basis and are
not guaranteed to be consistent through time.
Problem: Often relies on non-tradable factors,
and does not capture the dynamics of actual
trading strategies.

WHAT IS A RISK PREMIUM?
The amount by which the risky asset’s expected return exceeds the expected risk-free return
such that the risky and risk-free assets are equally attractive
Risky Return
Risk Free Return
Risk Premium

The amount by which the risky asset’s expected return exceeds the expected risk-free return
such that the risky and risk-free assets are equally attractive
Risky Return
Risk Free Return
Risk Premium
Simplified example: Credit risk premium
1. Assume: LIBOR yield = 0.77% & 10 year Greek government bond yield = 6.96%
2. Utility of risk-free rate (LIBOR) + Premium = Expected utility of uncertain return (10 year)
3. Utility of (0.77% + 6.19%) = Expected utility of uncertain return (10 year)
Risk Free Return
Risk Premium
Risk

THE EVOLUTIONARY UNDERSTANDING OF PORTFOLIO RETURNS
Active
Returns
Alpha
Market
Beta
Alpha
Market
Beta
Fama
French
Factors
Alpha
Risk
Premia
Market
Beta
Momentum
Size
Value
Emerging
Credit
Carry
Roll Yield
Relative Value
1970s 1980s 1990s Today

Risk Premia General Thesis
Equity Beta Global Systematic Non-Diversifiable Risk
Credit Fixed Income Default/Duration Risk
Equity Emerging Emerging vs Developed Market
Equity Size Small Cap vs Large Cap
Equity Value Value vs Growth
Commodity Value Backwardation
Rates Momentum Momentum in Interest Rates
Currency Momentum Momentum in FX Markets
Commodity Momentum Momentum in Commodities
Currency Carry Forward-Rate Bias
Commodity Roll Yield Forward Curve Bias

A DIFFERENT WAY OF LOOKING AT PORTFOLIO RISK
“Factor” Allocation
Fat 57%
Protein 25%
Carbohydrates 35%
50% of the “risk” from fat
“Asset” Allocation
Bread 40%
Meat 10%
Vegetables 50%

MODELING A PORTFOLIO?
Investments Include:
Equity
Fixed Income
Emerging Markets
Real Estate
Commodities
Hedge Funds

Note that the fit is
approximately two
years out of sample!

January 2000
to
May 2014
Fit
with
Risk Premia
Mean 3.79% 4.90%
Volatility 15.83% 16.00%
MDD -49.87% -51.68%

Factor Loading
Intercept -0.0001
Equity Beta 0.9848
Commodity Roll Yield - 0.0678
Equity Emerging 0.1931
Equity Size 0.1965
Commodity Value 0.0612

HOW MANY DIFFERENT RISKS?

PROBABILITY OF LOSS?
Probability Loss Greater Than
10% -5.34%
5% -7.69%
1% -13.11%

WHAT DRIVES RETURNS?
One year Five years

FINAL THOUGHTS: LIVING WITH RISK
 Sophisticated investors are increasingly looking beyond asset classes and strategies to
identify the true, underlying risks driving portfolio returns
 In addition to helping identify the risks in the portfolio, this focuses thinking about the
function of each asset class or investment in the portfolio
 Stocks for growth or value
 Fixed income for credit or volatility
 Alternatives for illiquidity or optionality
 The most sophisticated investors accept that they do not get paid for investing in asset
classes – they get paid for investing in risk
 The key is to choose which risks and how much of each risk to take

UPCOMING WINDHAM WEBINAR
Windham Software Overview
Tuesday, January 31 at 11am
Diversifying Away Equity Exposure
With Robert Bernstein
Wednesday, March 1st at 11am and 2pm EST
www.windhamlabs.com/webinars/

BIOGRAPHY
RICHARD LINDSEY, PhD is a Managing Partner of Windham Capital Management and
Chief Investment Officer for Windham Liquid Alternatives. Previously, he served as the Chief
Investment Strategist, Liquid Alternatives for Janus Capital. In this role he developed and co-managed
the liquid alternative strategies and was also a member of the Janus Capital Group Global Allocation
Committee. Prior to joining Janus in August 2012, Dr. Lindsey was a principal of the Callcott Group,
LLC, a quantitative consulting group, where he was responsible for directing research activities and
advisory services. For eight years Dr. Lindsey was president of Bear, Stearns Securities Corporation
and a member of the Management Committee of The Bear Stearns Companies, Inc. Before joining
Bear Stearns, Dr. Lindsey served as the Director of Market Regulation for the U.S. Securities and
Exchange Commission and as the Chief Economist of the SEC. He was a finance professor at the Yale
School of Management before joining the SEC. Dr. Lindsey has also served on several corporate
boards including, The Investment Fund for Foundations (TIFF), the Options Clearing Corporation, the
International Securities Exchange, and Strike Technologies. Dr. Lindsey has done extensive work in the
areas of portfolio construction, risk management, and the trading of securities. He has held the
positions of Visiting Academic at the Nikko Research Institute in Tokyo, Japan, and Visiting Economist
at the New York Stock Exchange. He holds a bachelor of science degree in chemical engineering from
Illinois Institute of Technology, an MS in chemical engineering from Berkeley, an MBA from the
University of Dallas, and a Ph.D. in finance from the University of California, Berkeley. He is a Fellow
of the Courant Institute, the Chairman of the International Association for Quantitative Finance as
well as an Executive Vice President of the Quantitative Group for Finance.

CONTACT & DISCLOSURES
DISCLOSURES: The information contained in this presentation (the “Presentation”) is highly confidential and is not to be reproduced or
distributed to any other persons (other than professional advisors of the prospective investors receiving these materials). The Presentation is
intended solely for the use of the persons to whom it has been delivered. This Presentation has been prepared solely for informational
purposes. The Presentation is not intended to provide professional or investment advice, and you are advised to seek independent
professional advice prior to investing in any products or strategies described in the Presentation or recommended by Windham Capital
Management, LLC. In addition, this Presentation is neither an offer to buy or sell any securities, nor a solicitation of an offer to buy or sell
interests or shares in any fund or strategy.
Performance shown is simulated from January, 2000 – May, 2014. The returns presented as “Simulated” performance do not reflect actual
trading and they may not reflect the impact that material economic and other factors might have had on Windham’s decision-making if
Windham were actually managing money. Net performance is calculated by deducting a 1% management fee and trading costs. Simulated
results are derived from the performance of investment models created by Windham and applied to a hypothetical account.
Historical data and other information contained herein is believed to be reliable, but no representation is made as to its accuracy,
completeness, or suitability for any specific purpose. Windham accepts no liability (whether in tort or contract or otherwise) for any loss or
damage arising from any inaccuracies or omissions. Past performance figures, including any projection or forecast, are not necessarily
indicative of future or likely performance of any investment products. No assurance may be given that the strategies’ investment objectives will
be achieved. Investments are subject to investment risks including possible loss of principal amount invested.
Opinions expressed are current opinions as of the date appearing in this material only. References to market or composite indices,
benchmarks or other measures of relative market performance over a specified period of time are provided for your information only.
Reference to an index does not imply that the Windham portfolio will achieve returns, volatility or other results similar to the index. The
composition of a benchmark index may not reflect the manner in which a Windham portfolio is constructed in relation to expected or achieved
returns, investment holdings, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of
which are subject to change over time.
Windham Capital Management, LLC owns trademark and other intellectual property rights contained in this Presentation. You are prohibited
from copying, reproducing, modifying, or distributing in any way the contents or any part of this Presentation for any purpose without our prior
written consent.
Windham Capital Management, LLC does not intend for the information contained in this Presentation to be distributed to, or used by, any
person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation or would subject Windham
to any registration requirement within such jurisdiction or country.
Additional information is available upon request. Windham Capital Management, LLC and its owners disclaim any and all liability relating to
this Presentation, including without limitation any express or implied representations or warranties for statements contained in, and omissions
from, this information. Windham’s Investment Solution products are offered exclusively by Windham and not as part of its collaboration with
State Street Associates.

Beyond the Equity Risk Premia

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