Written By: Michele Mazzoleni
Michele Mazzoleni of Research Affiliates describes the history and characteristics of alternative risk premia, noting that careful consideration of potential pitfalls is necessary if they are to be implemented successfully
Alternative sources of returns to traditional asset classes constitute a compelling proposition for improving investment portfolio performance. These alternative solutions, frequently categorised under the umbrella of alternative risk premia (ARP), exploit uncorrelated sources of premia across major asset classes and aim to deliver absolute returns and diversification, especially during major equity drawdowns. How do ARP strategies actually work? What are some of their potential challenges, and how can these issues be addressed?
How do alternative risk premia strategies work?
ARP strategies should not be viewed as a mystery, because they typically build on the familiar concept of factor investing. Specifically, investment factors systematically exploit patterns in capital markets to generate return premia from long-short positions. For instance, consider an investment universe composed solely of a group of developed equity market indices. Collectively, these equity markets deliver a global equity premium, or equity beta, to investors. This global equity premium is the key ingredient in most portfolios. Unfortunately, equity beta can be volatile and suffer severe losses, as we experienced during the 2008 global financial crisis.
ARP strategies can protect a traditional portfolio during these major drawdowns. In its simplest form, an alternative strategy would rank the developed market indices based on some predictive characteristic, for example, book-to-price or trailing 12-month returns. Subsequently, by investing in futures markets, it would buy the equity markets with the highest rankings and sell the ones with the lowest rankings. Effectively, this long-short portfolio would hedge the global equity beta, while on average extracting a return premium. Importantly, this premium should, and will aim to deliver exactly when global equity markets experience significant drawdowns.
The term factor investing underscores an investment process that is quantitative in nature and potentially more transparent and accessible than what hedge funds offered in the past. Indeed, factor investing was often labelled as proprietary research or unique skill, suggesting the manager had a secret sauce. These strategies were only available through black-box, high-fee, and difficult-to-access fund structures. Yet, over the last decade, the returns generated by these alternative solutions have been in part explained and broken down into various return drivers, such as carry, value, and trend following. These advancements mean that today’s investors can access many of these uncorrelated sources of returns through more understandable, lower-fee, and easier-to-access ARP strategies.
Robust investment factors are typically rooted in intuitive economic foundations and have been proven to work across major asset classes and time periods. The carry factor, which systematically seeks assets with relatively high yields, originates from the hedging needs of a particular group of investors – for example, those investing in commodities – or can be related to the macroeconomic profile of a country, such as in foreign currencies.
The value factor is well characterised by the discomfort required to hold unloved cheap securities. Such a burden should require compensation in the form of excess returns. The spirit of trend following is revealed by its name – which indicates buying winners and selling losers – and is at least partially associated with investors’ overreaction to news. Remarkably, evidence of trend chasing goes back centuries, from the Dutch tulip craze in the 1630s to the stock market of Imperial Russia.
Challenges when designing ARP solutions
The simplest designs of investment factors, although having many desirable characteristics, can also have a number of unintended and undesirable properties. Indeed, many factors tend to underperform around the turning points in equity market cycles. In particular, stock market corrections and sudden volatility spikes coincide with disappointing ARP returns, because alternative portfolios may be caught “out of step” with the changing risk appetites across capital markets.
Market turning points are especially challenging for momentum strategies, whose very nature is to profit from extended market trends. In addition, dollar-neutral portfolios are rarely beta neutral, implying that the academic definitions of factors, such as carry and value, could actually be exposed to unwanted market beta. Lastly, traditional asset class and signal definitions could be misleading. For instance, commodities are a collection of rather different subgroups, and seasonal patterns can obfuscate their signals.
Because of their more complex properties, off-the-shelf ARP solutions do not exist. These strategies are more than a simple smart beta extension in the alternatives space. The nature of these markets and factors requires each manager to embrace a philosophy regarding how to best harvest the risk premia, and these philosophies can vary greatly. For instance, signal construction and selection, leverage management, implementation costs, stated goals, and more generally the transparency of the overall investment process are all helpful pieces of information in revealing the investment convictions of each manager.
Opportunities with ARP strategies
Investment factors can be evolved beyond their simplest definitions in order to mitigate their shortcomings. For instance, carry portfolios can be reshuffled in a way that allows an investor to earn a yield premium while removing expected market exposures. In a similar spirit, an investment universe can be categorised into subgroups to capture the most promising value opportunities and to reduce unwarranted market bets. These opportunities if following the academic design of a factor portfolio – buy 1/3, neutral 1/3, and sell 1/3 – might be suboptimal from an alpha perspective.
Trend strategies can be designed aiming to dynamically adapt to market environments, while maintaining an intuitive economic interpretation. Often, trend following is viewed as an irreversible choice between fast, medium, and slow momentum speeds. That does not need to be the case. Following the turning points of a market cycle – the so-called correction and rebound phases – an investor can selectively decide whether to adopt fast or slow momentum signals. Importantly, this approach can address the concern that market trends are not as sustained as they were in past decades and, therefore, trend strategies are poised to underperform.
In conclusion, alternative risk premia strategies have been the focus of academics and practitioners for decades, are built on intuitive economic foundations and can offer significant diversification benefits to traditional portfolios. Their successful implementation, however, requires careful consideration of the unintended consequences that may be hidden in academic designs. Going forward, continuous research and innovation around well-known factors will be key in ensuring that a strategy’s performance will match its backtest.
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