Making Sense of Alternative Risk Premia
The popularity of single-factor equity programs has seen a proliferation of Alternative Risk Premia (ARP) strategies from fund managers and (investment) banks. This has been spurred by greater availability of data, poor performance of traditional managed funds, and a greater acceptance of factor investing, to name just a few influences. Many factors are now being combined into multifactor/multi-asset (MFMA) ARP strategies. This paper examines how ARP strategies have performed, concluding that while they offer some diversification benefits, they should not be seen as risk hedges (underwhelming performance in 2018 is evidence of this). While ARP strategies may supplement good asset allocation in times of market stress, they are not a replacement for it.
What are ARP?
The terms systematic premia, factor investing, alternative beta, smart beta, and alternative risk premia are all used relatively interchangeably though there are some nuances. ARP is a form of security selection which exists between a traditional index-based approach and completely discretionary investing.
Alternative Risk Premia (ARP) are a form of active investing which uses factors that are expected to predict future investment returns. ARP primarily evolved from traditional single factor equities (like equity value) into many more complex premia across all asset classes. This paper reviews the performance of ARP which are combined into a systematic, multi-factor/multi-asset strategy (MFMA). Our perspective is as a Multi-Asset investor considering the potential contribution of these strategies on a Multi-Asset portfolio.
The popularity of single-factor equity programs has seen a proliferation of ARP products from fund managers and (investment) banks. This process accelerated in recent years for five primary reasons: ARP benefits from the greater availability of data; the poor performance of many traditional stock picking and hedge fund managers in 2008/09, led to a general trend to passive investing; there is greater institutional acceptance of factor investing; lower costs alongside low cash rates; and, as bond yields have declined, investors have sought alternative sources of portfolio diversification (and return).
However, ARP are far more complex than typical factor-based strategies and are, unlike a market index, anything but passive products. Greater care appears necessary to differentiate those more likely to meet expectations, especially after their poor performance in 2018. We have conducted a detailed review of MFMA strategies primarily to assess whether they may play a useful role in improving the long-term risk/return profile of a balanced or multi-asset portfolio.
Evidence around the key single-factor equity ARP is generally accepted and makes intuitive sense, though there can be long-periods of relative underperformance (e.g. value v growth). In theory at least, combining individually good investments into a portfolio should lead to better portfolio outcomes. Taken at face value, MFMA achieved an attractive Sharpe ratio of 0.7. However, we find in the case of MFMA, this includes significant equity and bond beta and performance is heavily dependent on manager selection (though this isn’t unique to MFMA). Figure 1 depicts our portfolio risk analysis of ARP.
Unlike generally accepted definitions for what constitutes market betas, there is less consistency in measurement of ARP factors. This has led to a wide-range of performance amongst providers which diminishes confidence that predicted returns can be realised. On average, MFMA strategies demonstrate low correlation to major asset classes as they are usually designed to be market neutral. However, in practice, this has been difficult to achieve in stressed periods. Hence MFMA provide modest diversification (normally measured as low correlation) over time but make poor hedges.
Our view is the modest alpha in these strategies is offset by the significant complexity. Strategies that are more likely to succeed have strong underlying economic rationale, transparent construction and have a history of performance across market regimes. Targeted use of ARP could enhance a multi-asset portfolio for the purposes of evaluating opportunities and managing risk across a cycle but is not a panacea for expensive, correlated markets. Simpler, defensive strategies such as low-beta and quality or commodity-carry show more promise.
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