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A quick guide to alternative risk premia

Alternative risk premia were once the domain of hedge fund strategies, but have now become more mainstream. What are they and where do they fit into a portfolio?

29/08/2018

Multi-Asset Investments

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What are alternative risk premia (ARP)?

What was once the domain of hedge fund strategies has become more mainstream. Investors now recognise that “alternative risk premia” (ARP) – strategies built around well-known concepts such as carry, momentum and value investing – can help diversify the sources of return and risk in their portfolios at a much lower cost and with greater transparency then ever before.

ARP are essentially return sources that are distinct from traditional market returns. What makes them alternative is they tend to be lowly-correlated to the overall market and are typically structured as a long-short investment strategy.

How investors use ARP

A driving force behind the use of alternative investment strategies has been a desire to improve the diversification of portfolios. We can broadly consider two categories of diversifying allocations.

The first of these is to diversify by adding exposure that is negatively correlated to the main risk(s) in a portfolio. This is normally added as a defensive or “crisis risk” allocation to protect the portfolio during “bad times” and is intended to have a high payoff over a short time horizon when needed.

The second form of diversification is an uncorrelated exposure which is designed to be effective over a longer time horizon. This form of allocation seeks to provide a more consistent source of positive returns, but may not provide large returns during “bad times”. ARP fall into the second of these diversification categories, a space traditionally thought to be occupied by hedge funds.

One question for investors to think about is a stand-alone versus holistic approach to investing in ARP. Managing an ARP strategy successfully requires a deep understanding of the risk factors that drive performance. Simply adding ARPs without thought around their interaction and impact on overall portfolio risk may not be the best solution.

Evolution of ARP at Schroders

Since launching our first ARP strategy at Schroders in 2010, we have added selectively to our universe, building each strategy internally and refining them over time. Key milestones included the creation of our Cross-Asset Trend strategy in 2010, and the subsequent addition of a range of ARP in our portfolios from 2012 onwards. To run an ARP strategy successfully, we believe requires a strong research and governance framework.

ARP’s place in the portfolio

ARP managers focus on both the need to generate returns and the need to provide a consistent level of diversification to traditional assets. While these may seem to be common aspirations across all managers, we observe that some have set, in our view, very aggressive return targets for themselves which in turn may severely limit their ability to provide diversification, especially during times when it matters most. As well as understanding and managing risk within portfolios, it is also important to think about how ARP will perform on a broader scale

Multi-asset investing is fundamentally about understanding drivers of risk and return and using that insight to design and manage portfolios towards specific investor outcomes. In many ways, ARP are the natural evolution in this process, by providing access to alternative sources of return traditionally associated with hedge funds and reducing concentrations of traditional beta risk in a liquid, transparent and cost-effective way.