As traditional hedge fund managers cede ground – and lose assets – to traditional asset managers and even ETFs, institutional investors can still tap some of the risk premia that hedge funds were targeting. The advantage in using an alternative risk premia manager, says Ashley Lester, head of research, multi asset at Schroders, is that ARP managers are both cheaper and more transparent than hedge fund managers and typically seek a broader range of risk premia.
The search for alternative risk premia began almost as soon as the concept of the “market” as the main risk premium was laid out in the early 1960s, through the Capital Asset Pricing Model. In equities, this search has yielded commonly accepted factors including value, size, momentum and quality. While these remain the best known, Lester points out others have since emerged, both in equities and in other asset classes.
In today’s low return world, alternative risk premia seem to promise market neutral sources of return while also diversifying the sources of return, since they are not highly correlated with traditional assets. But investors may not be using them to their full potential, Lester says.
ARP portfolios are typically designed to show consistent volatility over time. This is convenient for both asset owners and ARP managers, but is very different from the behaviour of a traditional 60/40 portfolio, the volatility of which can easily triple during times of market stress.
Squaring the sums
The problem with this arrangement, Lester argues, is that it can leave portfolios effectively undiversified at times when diversification is most needed. He gives the example of a portfolio with a 50% allocation to ARP with a 10% target volatility and a traditional asset portfolio with 10% volatility on average. On average, this portfolio appears well diversified, since half its risk comes from the ARP portfolio and half its risk comes from the traditional portfolio.
But at times of market stress, the volatility of the traditional portfolio might be three times as large as the volatility of the ARP portfolio. Because of the mathematics of portfolio variance – often known as the mathematics of squared sums – this reduces the ARP contribution to portfolio risk to a minimal level. Instead of accounting for half of the portfolio risk, as it did before the crisis, “it’s providing a tenth of your portfolio volatility – virtually nothing at all,” Lester points out. “In fact, you might as well just leave the whole thing in cash in terms of portfolio volatility. That’s because the extra risk in your overall portfolio coming from your ARP allocation is just 5%. So you are not effectively diversifying during times of stress when you most need to do so.”
He proposes two solutions. One is for plans to reduce risk in traditional assets during times of stress – but not everyone is comfortable or able to sell into a falling market. Besides, doing so violates the basic value instincts of many managers.
The alternative is to raise the risk level of the ARP. Doing so, Lester finds, makes a 10% improvement to the portfolio’s overall Sharpe Ratio.
“By increasing the risk in the ARP portfolio, you can achieve better diversification through time while having only a marginal effect on your portfolio volatility. This is because ARP at that time is contributing so little to your portfolio volatility anyway,” he says. “You achieve extra return while taking on little extra portfolio-level risk.”
While Lester cautions that investors should take any simulation of ARP results “with a very, very heavy grain of salt,” he concludes that “the basic financial logic of diversification can often lead to surprising and informative conclusions for portfolio management.”