Written By: Leif Cussen
Leif Cussen, manager of the Old Mutual Style Premia Absolute Return Fund, discusses how returns that had previously been classified as alpha can now be captured in a cost-effective manner to build portfolios with low correlations to markets
Not long ago, effective diversifying strategies among alternatives could only be accessed by those able to pay hedge funds “two and twenty”: an annual management charge of 2%, alongside a performance fee of 20%. But over time, some of the drivers of their returns have been demystified, allowing more fee-constrained investors to capture some of these attractive, diversifying properties.
Academic research has revealed that persistent and pervasive investment factors across asset classes, as well as within them, constituted some of what had previously been classified as alpha. The advent of generic, systematic – or computer-driven – strategies has enabled investors to harness these factors at a reduced cost.
While such factors tend to have fairly low risk-adjusted returns, by combining them across multiple asset classes, more interesting return streams can be constructed. Moreover, it is possible to do so while creating a volatility-targeted portfolio, with a low correlation to major asset classes.
In this piece, we discuss how these factors are selected and exactly how such portfolios can be created.
We call these factors “style premia”, as they refer to different investment styles. Terminology varies and this approach is also sometimes described as “risk premia” or “dynamic beta” investing. So-called “smart beta” strategies also seek to exploit these factors – but from a long-only stance, whereby they seek to outperform benchmarks or indices, rather than generate absolute returns. Intuitively most investors could probably name a number of different factors that generate returns across different asset classes, but in order to create a robust, systematic strategy, it is crucial for style premia to be selected following rigorous research.
At its core, this should involve the investigation of themes that have demonstrated sustainable performance over time, irrespective of the direction movement of the markets, and provide answers to the following questions:
- Does the theme have a strong grounding in academic research?
- Is there is an underlying reason why the theme delivers a return (typically structural, behavioural or compensation for risk)?
- Has the theme demonstrated a tendency to persist across time?
- Is the theme pervasive across multiple regions and/or asset classes (where applicable)?
Moreover, the selection of premia should follow a rules-based approach, with an emphasis on transparency, to allow their performance to be clearly attributed and understood.
A multi-asset approach
Our research has led us to focus on four style premia that function across a range of asset classes: value, momentum, quality and carry.
Equity investors are likely to be familiar with the concept of value: buying stocks that trade for less than their intrinsic values, in the expectation that relatively cheap shares tend to outperform. This is an investment style favoured by famous investors such as Warren Buffett. Yet investors in fixed income and currencies can also utilise such a strategy, by targeting differentials in valuations across bond markets and between currencies.
Momentum is another well-known style, whereby investors buy assets that have advanced, in the expectation recent performance will continue. It is different to value – which involves investors focusing on matters like a company’s operational performance – with regard to equities, as momentum dictates an emphasis on pure price dynamics. It is also applicable in equity, fixed income and currency markets.
Meanwhile, quality involves investing on the view that high-quality and lower-risk assets tend to deliver higher returns on a risk-adjusted basis, and carry focuses on the potentially higher returns offered by relatively higher-yielding assets.
Over time, the risk-adjusted returns of style premia will vary, providing opportunities to construct appealing portfolios from different combinations of them.
Generic, multi-asset style premia such as value, momentum, quality and carry typically deliver relatively low risk-adjusted returns on a standalone basis. But when brought together into one portfolio, investors can take advantage of diversification to deliver much more attractive Sharpe ratios.
It follows that when blending these strategies together, by taking a multi-asset approach, a large investment universe opens up – even if one choses only the most liquid of instruments. Available for inclusion are global equities; government bond and interest-rate futures, across a range of tenors; and FX forwards, both G10 and emerging markets. Implemented as market-neutral style premia, these instruments can exhibit low correlations with traditional asset classes. As such, style premia can act as an efficient diversifier from both traditional and alternative investment exposures, in our view. The style premia themselves, meanwhile, also tend to be uncorrelated across asset classes: equities-based style premia typically display very low correlations with both fixed income and FX-based premia.
We believe that timing returns to style premia factors is exceptionally difficult; as such, we favour utilising a risk-based optimisation approach to allocate between the different factors. This process can take account of volatility and correlation forecasts to target aggregate levels of volatility for the portfolio.
At the same time, historical drawdown and leverage constraints can also be applied, while managing the contribution to the overall level of risk in the portfolio from each premia and asset class.
Just as this type of systematic investing has grown in popularity, so too has the perceived risk of crowding, whereby investors huddle around the same positions, creating problems when the market environment shifts and there is a “rush to the exit”. The purposefully generic nature of the style-premia approach could even compound the risks posed by crowding, namely lower returns and higher chances of significant drawdowns.
As a result of this, it is important for investors who deploy style premia to consider how their portfolios might fare in the event the market suffers risk-off episodes. Strategies aimed at mitigating the downside would be particularly useful under such scenarios.
While style premia present an exciting and low-cost opportunity to capture what had once been the within the purview of hedge funds alone, they clearly pose risks, too. That is why we favour considering the investment philosophy, quality of implementation and level of experience of any manager who runs these sorts of systematic strategies – as well as their plan of action in the event that investors rush to the exit.
Please remember that past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back any of the amount originally invested. Exchange rates may cause the value of overseas investments to rise or fall.