market-implied cost of equity (mice) · 2020. 5. 11. · cheapness of a stock or equity market, is...

Market-Implied Cost of Equity (MICE): Quantification and Implications for Asset Allocation Strategy

AN ORIGINAL CONCEPT

BY KEVIN YULIANTO, FRM, CAIA, PFM

C O N TA C T: K E V I N @ P U TA M E N C A P I TA L .C O M

May 2020

PUTAMENCAPITAL.COM

Table of Content

Introduction to MICE...............................................................................3

MICE in Asset Allocation Strategy............................................................4

Quantification of MICE............................................................................7

MICE and 5-Year Return Expectation: Sector...........................................8

MICE and 5-Year Return Expectation: Country.......................................14

Putamen Capital ERP Quant Strategy......................................................39

Putamen Capital Long/Short (Pure Alpha) ERP Quant Strategy..............43

Conclusion...............................................................................................45

PUTAMENCAPITAL.COM 2

Introduction to MICEThe market has a mean-reverting characteristic across the cycle, highlightedby increasing risk premium during period of risk aversion, and vice versa.Valuation ratio, such as P/E or P/B ratio, although useful to gauge thecheapness of a stock or equity market, is a poor market timing tool. This isbecause valuation ratios capture not only the cost of equity implied by themarket, but also changing growth expectation, profitability, and payout ratio.

Cheaper stocks could always go cheaper when earnings collapse orexpectation of future growth decline. Expensive stocks, such as FAANG, couldalso become more expensive when the long-term growth outlook improves.Hence, a better indicator needs to be developed for investors to be able toquantify the pure risk premium embedded in the stock prices.

After months of brainstorming and research session, Putamen Capitalproudly introduce our effort to quantify the Market-Implied Cost of Equity(MICE), a proprietary indicator calculated by our in-house team. MICE aim togive investors a pure market-timing tools with regards to global equity.Investors should buy equities when its MICE is higher than its historicalaverage and is going downward. We also build a systematic trading strategybased on this concept and the result is very encouraging; more on this underthe ERP Quant Strategy section.

During highly competitive environment today when every edge could makeor break an active fund performance, we believe this indicator will help ourfund generate positive absolute return across the cycle. In the next fewmonths, we will be incorporating the MICE indicator into a new quantitativeequity strategy model, aside our currently running Global Equity Strategy(GES) and Global Equity Relative Strategy (GERS) model.


MICE in Asset Allocation StrategyPortfolio managers have largely relied on bits of information to gauge thegrowth expectation and risk premium for a stock. Many of this information ishighly subjective and not quantifiable, which result in a sub-optimal portfolioallocation. MICE attempt to quantify both factors and provide a framework ofthinking for fundamental managers. For quantitative funds, engineers coulduse MICE as a valuable input to model’s allocation decision. For the laterapproach, at Putamen Capital we build a portfolio strategy based mainly onEquity Risk Premium (ERP) input of our MICE model, whose performanceturned out to be much better than we expect.

Several implementations of MICE for a fund manager:

• Top down equity allocation based on growth attractiveness, risk, and return

MICE and our measure of Long-Term Growth (LTG) expectation help manager toclassify sector and country profile into four quadrants based on risk (cost of equity)and growth. For growth-oriented manager, this means focusing on the top rightcorner of Chart 1, which includes the high-growth IT sector and several EmergingMarket equities. On the other side, energy sector, currently with a negative LTGexpectation should be treated closer to a REITS or a fixed-income security. With lowoil price and hence lower capex in recent years, energy firms have already paid out90% of its profit as dividends. This means that energy stock is more akin to a floating-rate bond with the yield fluctuating based on oil prices.

• Return Expectation in Portfolio Construction

In the fourth and fifth section of this report, we provide historical charts of stockprices, ERP, LTG, and 5-year return expectation of each country and sector in ourequity universe. By studying historical events since 1990’s, on the following pages weshow the annualized 5-year return for every level of ERP that investors shouldexpect. Currently, for most country, ERP is higher than historical average, meaningthat investors would be well rewarded by investing in global equities. Our researchshows that for today’s ERP level of global equities at 8.1%, investor could expect 6%to 13% annualized return in the following 5 years.


• Sector and country rotationAs the economic cycle turned from bust to boom, portfolio managers wouldgenerally shift its allocation weight from defensive to cyclical. By observingMICE, comparing it to history and across other sectors, managers are able toestimate the depth of a cycle and impending turning point.

• Gauging the extremeness of market movementOur MICE indicator helps manager to get a sense of bullish/bearish sentimentof the market and its turning point. For example, in the current cycle theturning point of global equity was not just prior to COVID-19 rout but rather inlate 2018 when ERP is at post-crisis low (Chart 2). Had managers notice the factthat despite stock had been rebounding strongly after the late 2018 correction,ERP has been widening, (s)he would have realized that the peak of marketbullish sentiment is turning and allocate more to a defensive strategy.

Chart 1. Country and Sector Market-Implied Cost of Equity and Long-Term Growth Expectation


Fixed-Income Characteristics

High Growth Potential

What to buy?1) Bet on improving

profit and growth2) Bet on declining

Cost of Equity

• Equity movement attribution analysisOur proprietary calculation decomposes price movement into several factors, withequity risk premium and growth expectation as the major components. Byobserving the trend in LTG and ERP, investors could quantify the economic cycle inevery country in a direct manner and implement a portfolio strategy based oncycle turning points.

• Contrarian market indicatorAt Putamen Capital, we monitor 42 countries/regions and 11 equity sectors. OurERP quant model gives a daily investment recommendation on whether we shouldbe invested in certain countries. By counting the number of country the modelrecommends, we have an indicator that gauge the bullish/bearish magnitude inthe market. Currently, the model recommends investing in over 95% of ourcountry/region universe, implying a very bearish market stance, which fromcontrarian point of view means a perfect time to invest more in risky assets.

1,600

1,400

1,200

1,000

800

600

400

1,600

1,400

1,200

1,000

800

600

400

All World:

Stock Prices in US$ Terms

2

4

6

8

105

6

7

8

9

10

04 06 08 10 12 14 16 18 20

Equity Risk Premium* (inverted; ls)

Long-term Nominal Growth Expectation (rs)

% %

• Screening for equity investment opportunities

We build ERP with the goal ofbuilding a systematic tradingstrategy based on the indicator.However, for fundamentalinvestors, ERP is useful forscreening opportunities acrossequity market based on thedeviation of current ERP from itshistorical average. An ERP close toits historical low warrants cautionand vice versa.

Chart 2. Global Stocks’ Equity Risk Premium


Quantification of MICEAlthough MICE indicator are based on proprietary quantitative method,there are several underlying economic theories that underlie the model’sdecisions. First, the growth of a company/country/sector depends on theamount of investment it made and the return of that investment. The higherthe part of profit a company pays to its shareholder, the less it is able tospend for capital expenditures that are important for long-term earningsgrowth.

Countries such as Australia, Canada, Chile, South Africa, all of which has alarge commodity dependence has seen a rising payout ratio this decade,mainly attributable to the declining commodity prices and hence lowerinvestment in the industry. Consequently, we saw the long-term earningsgrowth of these countries also declining in the past decade. Meanwhile,countries with higher growth and more investment opportunities, such asTurkey, Philippines, India, and China, have seen much lower payout ratio anda relatively higher growth expectation.

The second point is that as a global investor with no capital flow restriction,MICE reflect the cost of equity associated with investing in that country. Thisincludes political, geopolitical, and other risk that commonly affect earningsexpectation and/or return required by investors. For most countries, ERP hasbeen fluctuating between 4% to 10% in the past two decades. Note that themuch lower U.S. Treasury yield currently means that earnings multiple has tobe much higher than it was for equity risk premium to go back to pre-crisislevel.


10

20

30

40

50

60

70

80

90

10

20

30

40

50

60

70

80

90

Con

sum

er D

iscr

etiona

ry

Finan

cials

Indu

stria

ls

Info

rmat

ion

Techn

olog

y

Com

mun

icat

ion

Service

s

Hea

lth C

are

Mat

erials

Con

sum

er S

taples

Utilities

Rea

l Estat

e

Energ

y

% %World Sector Dividend Payout Ratio

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

Ene

rgy

Rea

l Estat

e

Utilities

Finan

cials

Com

mun

icat

ion

Ser

vice

s

Mat

erials

Con

sum

er S

taples

Hea

lth C

are

Indu

stria

ls

Con

sum

er D

iscr

etiona

ry

Info

rmat

ion

Techn

olog

y

% %

Long-term Growth Expectation

2

4

6

8

10

12

14

16

2

4

6

8

10

12

14

16

Ene

rgy

Rea

l Estat

e

Utilities

Com

mun

icat

ion

Ser

vice

s

Finan

cials

Mat

erials

Con

sum

er S

taples

Indu

stria

ls

Hea

lth C

are

Con

sum

er D

iscr

etiona

ry

Info

rmat

ion

Techn

olog

y

% %

World Sector:

Market-Implied Cost of Equity

MICE and 5-Year Return Expectation: Sector

In this section and the following, weprovide data, as of April 2020, on thelatest reading of sector and countrypayout ratio, Market-Implied Cost ofEquity (MICE) and Long-Term Growth(LTG) expectation.

In the next several pages, we showcharts on global sector and country’shistorical stock price, ERP and LTG forreader to digest the correlation betweenthese moving variables.

On the top panel of each pages, we ploteach sector/country historical ERP andthe subsequent 5-year return, which wehope help investors gauge the risk/returnprofile of each equity market.


300

250

200

150

100

50

300

250

200

150

100

50

Consumer Staples:


7

8

9

10

11 7

8

9

10

11

12

04 06 08 10 12 14 16 18 20


Long-term Nominal Growth Expectation (rs)% %

*Cost of Equity Minus U.S. 10-Year Government Bond Yield

300

250

200

150

100

50

300

250

200

150

100

50

Consumer Discretionary:


0

4

8

124

6

8

10

12

04 06 08 10 12 14 16 18 20




0

1

2

3

4

5

6

7

8

9

10

11

0

1

2

3

4

5

6

7

8

9

10

11

-10 0 10 20 30

-10 0 10 20 30

Subsequent 5-Year Annualized Return in US$ Terms

Eq

uit

y R

isk P

rem

ium

% %Consumer Discretionary:

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

-4 0 4 8 12 16 20

-4 0 4 8 12 16 20


Equity R

isk P

rem

ium

% %Consumer Staples:


90

80

70

60

50

40

90

80

70

60

50

40

Communication Services:


-8

-4

0

4

8-8

-4

0

4

04 06 08 10 12 14 16 18 20




400

300

200

100

400

300

200

100

Energy:


-5

0

5

10

15-10

0

10

20

04 06 08 10 12 14 16 18 20



% %


-12

-8

-4

0

4

8

12

-12

-8

-4

0

4

8

12

-8 -4 0 4 8 12

-8 -4 0 4 8 12


Eq

uit

y R

isk P

rem

ium

% %Communication Services:

6

8

10

12

14

16

18

20

6

8

10

12

14

16

18

20

-20 -10 0 10 20 30

-20 -10 0 10 20 30

Subsequent 5-Year Annualized Return in US$ TermsE

qu

ity R

isk P

rem

ium

% %Energy:


200

160

120

80

40

200

160

120

80

40

Financials:


-5

0

5

10

15

2

4

6

8

10

12

04 06 08 10 12 14 16 18 20




300

250

200

150

100

50

300

250

200

150

100

50

Health Care:


8

10

12

8

10

12

14

04 06 08 10 12 14 16 18 20



% %


2

4

6

8

10

12

14

16

18

2

4

6

8

10

12

14

16

18

-20 -10 0 10 20

-20 -10 0 10 20


Eq

uit

y R

isk P

rem

ium

% %Financials:

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

-5 0 5 10 15 20

-5 0 5 10 15 20


Equity R

isk P

rem

ium

% %Health Care:


300

250

200

150

100

50

300

250

200

150

100

50

Industrials:


4

6

8

106

7

8

9

10

04 06 08 10 12 14 16 18 20




400

320

240

200

160

120

80

40

400

320

240

200

160

120

80

40

Info Tech:


0

4

8

12

16

4

8

12

16

04 06 08 10 12 14 16 18 20




3

4

5

6

7

8

9

10

11

12

3

4

5

6

7

8

9

10

11

12

-10 -5 0 5 10 15 20 25

-10 -5 0 5 10 15 20 25


Eq

uit

y R

isk P

rem

ium

% %Industrials:

0

2

4

6

8

10

12

14

16

0

2

4

6

8

10

12

14

16

-10 -5 0 5 10 15 20 25

-10 -5 0 5 10 15 20 25


Eq

uit

y R

isk P

rem

ium

% %Info Tech:


350

300

250

200

150

100

350

300

250

200

150

100

Materials:


0

4

8

124

6

8

10

12

04 06 08 10 12 14 16 18 20



% %


200

160

120

80

200

160

120

80

Utilities:


2

4

6

8

101

2

3

4

5

6

04 06 08 10 12 14 16 18 20



% %


0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

-10 0 10 20 30

-10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %Materials:

2

3

4

5

6

7

8

9

10

11

2

3

4

5

6

7

8

9

10

11

-10 -5 0 5 10 15 20

-10 -5 0 5 10 15 20


Eq

uit

y R

isk P

rem

ium

% %Utilities:


MICE and 5-Year Return Expectation: Country



Investment opportunities are found mostly in EM countries

European countries are mostly in the low growth, low cost environment

1,600

1,400

1,200

1,000

800

600

400

1,600

1,400

1,200

1,000

800

600

400

All World:


2

4

6

8

105

6

7

8

9

10

04 06 08 10 12 14 16 18 20



% %

1,600

1,200

800

400

1,600

1,200

800

400

Developed Markets:


2

4

6

8

105

6

7

8

9

10

04 06 08 10 12 14 16 18 20



1

2

3

4

5

6

7

8

9

10

11

12

1

2

3

4

5

6

7

8

9

10

11

12

-10 -5 0 5 10 15 20

-10 -5 0 5 10 15 20


Eq

uit

y R

isk P

rem

ium

% %All World:

1

2

3

4

5

6

7

8

9

10

11

1

2

3

4

5

6

7

8

9

10

11

-10 -5 0 5 10 15 20

-10 -5 0 5 10 15 20


Eq

uit

y R

isk P

rem

ium

% %Developed Markets:


1,400

1,200

1,000

800

600

400

200

1,400

1,200

1,000

800

600

400

200

Emerging Markets:


6

8

10

12

7

8

9

10

04 06 08 10 12 14 16 18 20



1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Austria:


0

4

8

12

16

2

4

6

8

04 06 08 10 12 14 16 18 20



% %

1

2

3

4

5

6

7

8

9

10

11

12

13

1

2

3

4

5

6

7

8

9

10

11

12

13

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Emerging Markets:

0

2

4

6

8

10

12

14

16

18

0

2

4

6

8

10

12

14

16

18

-30 -20 -10 0 10 20 30 40

-30 -20 -10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Austria:


1,400

1,200

1,000

800

600

400

1,400

1,200

1,000

800

600

400

Australia:


2

4

6

8

10 2

3

4

5

6

04 06 08 10 12 14 16 18 20



% %

2,000

1,000

800

600

400

300

200

100

2,000

1,000

800

600

400

300

200

100

Brazil:


4

8

12

164

6

8

10

12

04 06 08 10 12 14 16 18 20



% %

0

1

2

3

4

5

6

7

8

9

10

11

12

0

1

2

3

4

5

6

7

8

9

10

11

12

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Australia:

2

4

6

8

10

12

14

16

2

4

6

8

10

12

14

16

-40 -20 0 20 40 60 80

-40 -20 0 20 40 60 80


Eq

uit

y R

isk P

rem

ium

% %Brazil:


1,200

1,000

800

600

400

1,200

1,000

800

600

400

Canada:


2

4

6

8

104

6

8

10

04 06 08 10 12 14 16 18 20



1,600

1,200

800

400

1,600

1,200

800

400

Switzerland:


4

6

8

10

12

144

6

8

10

04 06 08 10 12 14 16 18 20



0

1

2

3

4

5

6

7

8

9

10

11

0

1

2

3

4

5

6

7

8

9

10

11

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Canada:

2

4

6

8

10

12

14

16

2

4

6

8

10

12

14

16

-10 -5 0 5 10 15 20 25

-10 -5 0 5 10 15 20 25


Eq

uit

y R

isk P

rem

ium

% %Switzerland:


2,000

1,600

1,200

1,000

800

600

400

200

2,000

1,600

1,200

1,000

800

600

400

200

Chile:


0

2

4

6

8

10 3

4

5

6

7

8

04 06 08 10 12 14 16 18 20



% %

2,000

1,600

1,200

1,000

800

600

400

200

2,000

1,600

1,200

1,000

800

600

400

200

China:


6

8

10

12

8

9

10

04 06 08 10 12 14 16 18 20



0

4

8

12

16

20

24

0

4

8

12

16

20

24

-20 -10 0 10 20 30 40

-20 -10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Chile:

0

1

2

3

4

5

6

7

8

9

10

11

12

0

1

2

3

4

5

6

7

8

9

10

11

12

-20 -10 0 10 20 30 40 50

-20 -10 0 10 20 30 40 50


Eq

uit

y R

isk P

rem

ium

% %China:


3,000

2,000

1,000

700

500

300

200

100

3,000

2,000

1,000

700

500

300

200

100

Colombia:


0

4

8

2

3

4

5

6

04 06 08 10 12 14 16 18 20



2,000

1,000

800

600

400

300

200

100

2,000

1,000

800

600

400

300

200

100

Czech Republic:


0

4

8

12 0

2

4

6

8

04 06 08 10 12 14 16 18 20



% %

-20

-15

-10

-5

0

5

10

15

20

-20

-15

-10

-5

0

5

10

15

20

-20 -10 0 10 20 30 40 50 60 70

-20 -10 0 10 20 30 40 50 60 70


Eq

uit

y R

isk P

rem

ium

% %Colombia:

-4

-2

0

2

4

6

8

10

12

14

-4

-2

0

2

4

6

8

10

12

14

-20 -10 0 10 20 30 40 50 60

-20 -10 0 10 20 30 40 50 60


Eq

uit

y R

isk P

rem

ium

% %Czech Republic:


1,200

1,000

800

600

400

1,200

1,000

800

600

400

Germany:


0

4

8

12

4

6

8

04 06 08 10 12 14 16 18 20



% %

2,000

1,600

1,400

1,200

1,000

800

600

400

2,000

1,600

1,400

1,200

1,000

800

600

400

Denmark:


6

8

10

126

7

8

9

10

11

04 06 08 10 12 14 16 18 20



0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Germany:

3

4

5

6

7

8

9

10

11

12

3

4

5

6

7

8

9

10

11

12

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Denmark:


1,200

1,000

800

600

400

1,200

1,000

800

600

400

Spain:


5

10

15

200

2

4

6

8

10

04 06 08 10 12 14 16 18 20



1,400

1,200

1,000

800

600

400

1,400

1,200

1,000

800

600

400

Finland:


2

4

6

8

10

122

4

6

8

10

04 06 08 10 12 14 16 18 20



% %

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

-20 -10 0 10 20 30 40

-20 -10 0 10 20 30 40


Equity R

isk P

rem

ium

% %Spain:

2

3

4

5

6

7

8

9

10

11

12

13

2

3

4

5

6

7

8

9

10

11

12

13

-20 -10 0 10 20 30

-20 -10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %Finland:


1,200

1,000

800

600

400

1,200

1,000

800

600

400

France:


0

4

8

120

2

4

6

8

10

04 06 08 10 12 14 16 18 20



1,200

1,000

800

600

400

1,200

1,000

800

600

400

U.K.:


4

6

8

10

12 4

6

8

10

12

04 06 08 10 12 14 16 18 20



-4

-2

0

2

4

6

8

10

12

14

-4

-2

0

2

4

6

8

10

12

14

-20 -10 0 10 20 30

-20 -10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %France:

2

3

4

5

6

7

8

9

10

11

12

13

14

2

3

4

5

6

7

8

9

10

11

12

13

14

-10 -5 0 5 10 15 20

-10 -5 0 5 10 15 20


Eq

uit

y R

isk P

rem

ium

% %U.K.:


1,600

1,200

800

400

1,600

1,200

800

400

Hong Kong:


2

4

6

84

5

6

04 06 08 10 12 14 16 18 20



% %

1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Hungary:


4

8

12

16 4

8

12

16

04 06 08 10 12 14 16 18 20



% %

0

1

2

3

4

5

6

7

8

9

0

1

2

3

4

5

6

7

8

9

-5 0 5 10 15 20 25 30

-5 0 5 10 15 20 25 30


Eq

uit

y R

isk P

rem

ium

% %Hong Kong:

4

6

8

10

12

14

16

18

20

4

6

8

10

12

14

16

18

20

-20 -10 0 10 20 30 40 50

-20 -10 0 10 20 30 40 50


Eq

uit

y R

isk P

rem

ium

% %Hungary:


2,000

1,600

1,200

1,000

800

600

400

200

2,000

1,600

1,200

1,000

800

600

400

200

Indonesia:


8

10

12

14

16

10

12

14

04 06 08 10 12 14 16 18 20



2,000

1,000

800

600

400

300

200

100

2,000

1,000

800

600

400

300

200

100

Ireland:


-5

0

5

10

15 -10

-5

0

5

10

04 06 08 10 12 14 16 18 20



% %

-8

-4

0

4

8

12

16

20

-8

-4

0

4

8

12

16

20

-20 -10 0 10 20 30 40 50 60

-20 -10 0 10 20 30 40 50 60


Eq

uit

y R

isk P

rem

ium

% %Indonesia:

-15

-10

-5

0

5

10

15

20

25

-15

-10

-5

0

5

10

15

20

25

-30 -20 -10 0 10 20 30

-30 -20 -10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %Ireland:


1,800

1,400

1,000

800

600

400

200

1,800

1,400

1,000

800

600

400

200

India:


8

10

12

14 10

12

14

16

04 06 08 10 12 14 16 18 20



1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Italy:


4

8

12

0

1

2

3

4

5

04 06 08 10 12 14 16 18 20



5

6

7

8

9

10

11

12

13

14

15

16

5

6

7

8

9

10

11

12

13

14

15

16

-10 0 10 20 30 40 50 60

-10 0 10 20 30 40 50 60


Eq

uit

y R

isk P

rem

ium

% %India:

-2

0

2

4

6

8

10

12

-2

0

2

4

6

8

10

12

-30 -20 -10 0 10 20 30

-30 -20 -10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %Italy:


1,400

1,200

1,000

800

600

400

1,400

1,200

1,000

800

600

400

Japan:


-2.5

0.0

2.5

5.0

7.5 3

4

5

6

7

04 06 08 10 12 14 16 18 20



1,600

1,200

800

400

1,600

1,200

800

400

South Korea:


5

6

7

8

9

107

8

9

10

11

04 06 08 10 12 14 16 18 20



-8

-6

-4

-2

0

2

4

6

8

-8

-6

-4

-2

0

2

4

6

8

-10 -5 0 5 10 15 20

-10 -5 0 5 10 15 20


Eq

uit

y R

isk P

rem

ium

% %Japan:

-6

-4

-2

0

2

4

6

8

10

12

-6

-4

-2

0

2

4

6

8

10

12

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %South Korea:


1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Mexico:


6

8

10

12

14

16 6

8

10

12

14

16

04 06 08 10 12 14 16 18 20



1,600

1,400

1,200

1,000

800

600

400

1,600

1,400

1,200

1,000

800

600

400

Malaysia:


4

6

8

4

5

6

7

8

04 06 08 10 12 14 16 18 20



% %

4

6

8

10

12

14

16

18

4

6

8

10

12

14

16

18

-20 -10 0 10 20 30 40

-20 -10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Mexico:

-4

-2

0

2

4

6

8

10

-4

-2

0

2

4

6

8

10

-10 -5 0 5 10 15 20 25

-10 -5 0 5 10 15 20 25


Eq

uit

y R

isk P

rem

ium

% %Malaysia:


1,400

1,200

1,000

800

600

400

1,400

1,200

1,000

800

600

400

Netherlands:


5

10

15

204

6

8

10

12

04 06 08 10 12 14 16 18 20



1,600

1,200

800

400

1,600

1,200

800

400

New Zealand:


-2.5

0.0

2.5

5.0

7.5 -4

-2

0

2

4

04 06 08 10 12 14 16 18 20



2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

-20 -10 0 10 20 30

-20 -10 0 10 20 30


Equity R

isk P

rem

ium

% %Netherlands:

-5

0

5

10

15

20

25

30

35

40

-5

0

5

10

15

20

25

30

35

40

-20 -10 0 10 20 30

-20 -10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %New Zealand:


2,000

1,600

1,200

1,000

800

600

400

200

2,000

1,600

1,200

1,000

800

600

400

200

Peru:


5

10

15

208

12

16

04 06 08 10 12 14 16 18 20



4,000

2,000

1,600

1,200

800

600

400

200

4,000

2,000

1,600

1,200

800

600

400

200

Philippines:


0

4

8

122

4

6

8

10

04 06 08 10 12 14 16 18 20



2

4

6

8

10

12

14

16

18

20

22

24

2

4

6

8

10

12

14

16

18

20

22

24

-20 -10 0 10 20 30 40 50 60

-20 -10 0 10 20 30 40 50 60


Eq

uit

y R

isk P

rem

ium

% %Peru:

-2

0

2

4

6

8

10

12

14

-2

0

2

4

6

8

10

12

14

-20 -10 0 10 20 30 40

-20 -10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Philippines:


1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Poland:


0

4

8

12

4

6

8

10

04 06 08 10 12 14 16 18 20



1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Portugal:


0

5

10 -5

0

5

10

04 06 08 10 12 14 16 18 20



0

5

10

15

20

25

0

5

10

15

20

25

-20 -10 0 10 20 30 40 50

-20 -10 0 10 20 30 40 50


Eq

uit

y R

isk P

rem

ium

% %Poland:

-5

0

5

10

15

20

25

-5

0

5

10

15

20

25

-30 -20 -10 0 10 20 30

-30 -20 -10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %Portugal:


2,000

1,600

1,200

1,000

800

600

400

200

2,000

1,600

1,200

1,000

800

600

400

200

Russia:


8

12

16

6

8

10

12

14

16

04 06 08 10 12 14 16 18 20



% %

1,200

1,000

800

600

400

200

1,200

1,000

800

600

400

200

Sweden:


0

4

8

12

2

4

6

8

10

04 06 08 10 12 14 16 18 20



-4

0

4

8

12

16

20

-4

0

4

8

12

16

20

-20 -10 0 10 20 30 40 50 60

-20 -10 0 10 20 30 40 50 60


Eq

uit

y R

isk P

rem

ium

% %Russia:

0

2

4

6

8

10

12

14

16

0

2

4

6

8

10

12

14

16

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Sweden:


1,200

1,000

800

600

400

1,200

1,000

800

600

400

Singapore:


2

4

6

8

104

5

6

7

8

9

04 06 08 10 12 14 16 18 20



4,000

2,000

1,600

1,200

800

600

400

200

4,000

2,000

1,600

1,200

800

600

400

200

Thailand:


4

8

12

16

8

12

16

04 06 08 10 12 14 16 18 20



% %

-1

0

1

2

3

4

5

6

7

8

9

10

-1

0

1

2

3

4

5

6

7

8

9

10

-10 0 10 20 30

-10 0 10 20 30


Eq

uit

y R

isk P

rem

ium

% %Singapore:

-15

-10

-5

0

5

10

15

-15

-10

-5

0

5

10

15

-10 0 10 20 30 40

-10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %Thailand:


1,400

1,200

1,000

800

600

400

200

1,400

1,200

1,000

800

600

400

200

Turkey:


6

8

10

12

149

10

11

12

04 06 08 10 12 14 16 18 20



% %

1,600

1,200

800

400

1,600

1,200

800

400

Taiwan:


0

2

4

6

8 2

3

4

5

6

04 06 08 10 12 14 16 18 20



6

8

10

12

14

16

18

20

6

8

10

12

14

16

18

20

-20 -10 0 10 20 30 40 50 60

-20 -10 0 10 20 30 40 50 60


Eq

uit

y R

isk P

rem

ium

% %Turkey:

-20

-10

0

10

20

-20

-10

0

10

20

-15 -10 -5 0 5 10 15 20

-15 -10 -5 0 5 10 15 20


Eq

uit

y R

isk P

rem

ium

% %Taiwan:


2,400

2,000

1,600

1,200

800

400

2,400

2,000

1,600

1,200

800

400

U.S.:


4

6

8

10 7

8

9

10

04 06 08 10 12 14 16 18 20



1,600

1,200

800

400

1,600

1,200

800

400

South Africa:


6

8

10

12

146

8

10

12

04 06 08 10 12 14 16 18 20



3

4

5

6

7

8

9

10

11

12

3

4

5

6

7

8

9

10

11

12

-10 -5 0 5 10 15 20 25

-10 -5 0 5 10 15 20 25


Eq

uit

y R

isk P

rem

ium

% %U.S.:

5

6

7

8

9

10

11

12

13

14

15

5

6

7

8

9

10

11

12

13

14

15

-20 -10 0 10 20 30 40

-20 -10 0 10 20 30 40


Eq

uit

y R

isk P

rem

ium

% %South Africa:


Putamen Capital ERP Quant StrategyUsing ERP as the sole driver of equity allocation strategy, we build a quantmodel that provides country recommendation based on the expectation ofnarrowing risk premium and invest that recommendation in an equal-weighted portfolio. For example, if there are twenty countries recommendedat the end of the day, then the model will assign 5% allocation for eachcountry to be invested the following day. Although the recommendation isgiven on a daily basis, the country recommendation does not shift as often.Since June 2003 to end of April 2020, the average turnover for each countryis 3.1%, or roughly 136 trades in 4413 trading days. Whenever there is anaddition or elimination of a country recommendation, however, the modelhas to be rebalanced.

In the simulated return, barring any transaction cost, $100 invested in June2003 would have turned into $7734 at the end of April 2020, 31 timesgreater relative to the $244 return from the MSCI ACWI benchmark. Thistranslates to 29.3% annualized return during the 17-year period, comparedto 5.4% for the benchmark. Moreover, drawdown is reduced to 25% vs 60%for the benchmark.

The model’s rolling downside tracking error, measured as theunderperformance of the model on a 2-year rolling basis, also neverbreached 12%. In plain terms, this mean that investors could expect that atany time they invest in the fund, historically they would not underperformthe benchmark by more than 12%.


10,000

5,000

3,000

2,000

1,000

500

300

200

100

50

10,000

5,000

3,000

2,000

1,000

500

300

200

100

50

ERP Strategy

Benchmark*

Simulated Return in US$ Terms:

*MSCI ACWI

45.0

30.0

20.0

15.0

10.0

5.0

3.5

2.5

1.5

1.0

45.0

30.0

20.0

15.0

10.0

5.0

3.5

2.5

1.5

1.0

Outperformance of ERP Strategy

-60

-50

-40

-30

-20

-10

0

-60

-50

-40

-30

-20

-10

0

03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

% %2-Year Rolling Drawdown

Putamen Capital ERP Quant Strategy


10,000

5,000

3,500

2,000

1,000

500

350

200

100

50

10,000

5,000

3,500

2,000

1,000

500

350

200

100

50

ERP Strategy

Benchmark*


*MSCI ACWI

20

40

60

80

100

20

40

60

80

100

03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

% %Percentage of Country/Region Under Model Recommendation



40

30

20

10

7

5

3

2

1

40

30

20

10

7

5

3

2

1

ERP Strategy Performance Relative to Benchmark*

*In U.S. dollar terms; MSCI ACWI

-10

-8

-6

-4

-2

0

-10

-8

-6

-4

-2

0

03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

% %Outperformance 2-Year Rolling Drawdown



Putamen Capital Long/Short (Pure Alpha) ERP Quant Strategy

We also constructed a pure alpha or long/short strategy derived purely fromthe ERP indicator. For the short-leg of the portfolio, we use MSCI All CountryWorld index, whereas the long-leg is our ERP Strategy Portfolio.

In the simulated return, barring any transaction cost, $100 invested in June2003 would have turned into $2941 at the end of April 2020, 12 timesgreater relative to the $244 return from the MSCI ACWI benchmark. Thistranslates to 22.1% annualized return during the 17-year period, comparedto 5.4% for the benchmark. The main attractiveness of this strategy is themuch lower standard deviation and drawdown performance, averaging only11.9% (annualized) and 11.55%, respectively, since June 2003 to April 2020.



5,000

3,500

2,500

1,500

1,000

500

350

250

150

100

50

5,000

3,500

2,500

1,500

1,000

500

350

250

150

100

50

Long/Short ERP Strategy

Benchmark*


*MSCI ACWI

50.0

35.0

25.0

15.0

10.0

5.0

3.5

2.5

1.5

1.0

0.5

50.0

35.0

25.0

15.0

10.0

5.0

3.5

2.5

1.5

1.0

0.5

Outperformance of Long/Short ERP Strategy

-60

-40

-20

0

-60

-40

-20

0

03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

% %2-Year Rolling Drawdown

Putamen Capital Long/Short (Pure Alpha) ERP Quant Strategy

ConclusionMarket-Implied Cost of Equity (MICE) and its Equity Risk Premium (ERP)counterpart prove to be highly valuable for both fundamental research andquantitative model’s input. We classify ERP functions into two-fold: first, asan overview of global and country-level risk/return trade-off and second, asan input to portfolio asset allocation strategy.

We believe that the quantification of ERP will further enhance ourknowledge and get a better grasp of the market. There are several furtherresearch and development that could be expanded from ERP indicator, suchas:

- Portfolio optimization using ERP

and

- ERP-based predictive model on equity return

If you are interested in learning more, please contact us [email protected]


mailto:[email protected]

Copyright © 2020, Putamen Capital. All rights reserved.The information, recommendations, analysis and research materials presented inthis document are provided for information purposes only and should not beconsidered or used as an offer or solicitation to sell or buy financial securities orother financial instruments or products, nor to constitute any advice orrecommendation with respect to such securities, financial instruments orproducts. The text, images and other materials contained or displayed on anyPutamen Capital products, services, reports, emails or website are proprietary toPutamen Capital and should not be circulated without the expressed authorizationof Putamen Capital. Any use of graphs, text or other material from this report bythe recipient must acknowledge Putamen Capital as the source and requiresadvance authorization. Putamen Capital relies on a variety of data providers foreconomic and financial market information. The data used, or referred to, in thisreport are judged to be reliable, but Putamen Capital cannot be held responsiblefor the accuracy of data used herein.


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