Last updated: 19:53 / Tuesday, 23 July 2013
AXA IM Research

The “True” Value of the Equity Risk Premium

The “True” Value of the Equity Risk Premium

The equity risk premium, or ERP, can be defined as the return paid to equity investors in excess of the long-term risk-free rate. It is a key metric for investors looking to set portfolio return expectations and take strategic asset allocation decisions.

It also happens to be one of the most widely discussed issues in portfolio management, filling academic literature with lively debate on whether the ERP is positive, negative, or non- existent.

To complicate matters further, there are multiple ways to calculate the equity risk premium, and each methodology provides a different answer to the fundamental question: what level of excess returns should investors expect from their equity holdings in the future?

In this piece, AXA Investment Managers examines three ways to determine the equity risk premium (ERP), namely the ex- post ERP, the required ERP and the expected ERP, assessing their strengths and flaws.

That these approaches, which rely on different sets of measures, do not produce the same result should not come as a surprise. Yet, in a steady state environment it would be reasonable to expect these values to converge within a narrow range, if not on a single figure.

The average expected ERP over the past decade is roughly 3.5% for US equities as well as for other developed market equities, and 4% for emerging market equities.

The asset manager proposes a synthetic approach, reconciling the three measures by focusing on the long-term equilibrium.

An ERP of 3.5% is consistent with the decomposition of what a steady-state equity return should be.

You can read full piece on the document attached.