Wednesday, January 24, 2007

Thinking about risk premiums

I was perusing this post at All About Alpha again when it occurred to me that if long only large cap mutual funds, and long only strategies in general, depend on risk premium (e.g. that's what encompasses the majority of their returns and thus should be used as the basis for compensating their managers). If that IS the case, markets would appear to be in for a bumpy ride in the near future. Risk premiums have been compressing and are fairly low among a range of asset classes these days (leading to levering up of bets and further afield searches for untapped asset classes). So if the risk premiums are dropping while the risks themselves are staying constant or increasing, at some point, the music has to stop and the situation normalizes. That sounds like a fairly painful event for someone. (Maybe you? Maybe me? Maybe we?)

Now, maybe I'm just thinking about this too simplistically. This just happened upon me while I was catching up on my reading. Fascinating stuff to consider though, and simultaneously very scary. I'll be mulling this over for a little while longer.

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