Alternatives investors have always been focused on the possibility of achieving a measure of downside protection, accessing differentiated exposures and identifying truly uncorrelated, complementary sources of return. In addition to conventional ways to modify multi-asset portfolios through incorporation of liquid alternatives, such as hedge funds and commodity trading advisors (“CTAs”), there has been an increase in the number of investors seeking newer ways to improve their portfolios.
In much the same way that long-only investors have considered “passive” investing as a way to adjust their exposures efficiently and to reduce cost, alternatives investors have begun to explore systematic and index-based solutions—such as “alternative risk premia”—as a way to achieve those same objectives. In this paper, we seek to introduce the concept of alternative risk premia, explain how investors can access them, and present the potential benefits and drawbacks associated with them.
The concept underlying alternative risk premia is the potential reward to an investor for taking on some form of risk. As the name suggests, this risk is “alternative” to traditional market risk or traditional beta in the sense that it is non-correlating and tends to be structured in the form of a long/ short investment.
Alternative risk premia tend to exhibit heterogeneous statistical properties, making them potentially diversifying building blocks to a broader multi-asset portfolio.
Display 1 highlights commonly used alternative risk premia, which often result from market behaviors or structural
conditions. For example, herding behavior and instances in which investors “chase winners and sell losers” create momentum. Mean reversion of asset prices to fair- value anchors often leads to opportunities classified as value. Investor mispricing of asset yields may lead to carry opportunities. In commodities markets, for example, carry is defined as the price differential between futures contracts of different maturities. This figure may be positive or negative because of supply and demand dynamics and other factors. The large derivatives market often provides opportunities to design novel alternative risk premia, both behavioral and structural, related to asset volatility. For example, during market crises, investors seek safer assets, and low volatility stocks tend to outperform.
While the term “alternative risk premia” is fairly new, investors have had exposure to these sorts of returns through hedge fund strategies like quantitative equity, macro and managed futures for many years. The key differences today are the ways investors access and implement them.
While having an understanding of alternative risk premia is important, what is attractive and compelling to investors is to think about their utility. In our view, these premia can be thought of as an extension of factor-based investing and can serve as building blocks for portfolio construction.
Original factor-based investing started with the Capital Asset Pricing Model (“CAPM”), which sought to explain investment performance using a risk- free rate and a single market risk factor or premium.1 Over the years, it became increasingly apparent, through the groundbreaking research of Eugene Fama, Kenneth French and Mark Carhart, among others, that a single market risk premium was not the only driver of asset returns and that investors could exploit additional factors within or across asset classes.2 More recent research suggests that investors can harvest “alternative” risk premia that persist because of human behavior and the structure of certain investment markets. Alternative risk premia are of interest to investors because, unlike stocks and bonds, they are generally unrelated to broader macro fundamentals. Therefore, they can provide diversification benefits when included in portfolios alongside traditional investments.3
Points of Distinction
Persistently low interest rates are making The terms “alternative risk premia” and “smart beta” are often lumped together. However, in our view, there are important distinctions between the two: smart beta is generally derived from long-only investment strategies, whereas alternative risk premia are generally derived from long/short strategies with a number of them attempting to be market-neutral.
It is also important to note that alternative risk premia should not be confused with “alpha,” which refl cts an idiosyncratic component of return believed to be derived from a manager’s security selection and market-timing skill. Display 2 illustrates this distinction, as we see it, and provides a useful framework for considering the return sources that may comprise an absolute return portfolio solution.
Who Invests in Alternative Risk Premia?
Some of the earliest adopters of alternative risk premia strategies included sophisticated institutions, such as the Nordic and Scandinavian pension funds. Over time, the level of interest in these types of strategies—particularly among institutional investors—has grown. Today, investors are broadly diversified by geography and type: insurance companies, large institutions, endowments, risk premia-specific asset managers and hedge fund allocators.
We expect growth to continue, and recent survey data seems to bear this out. A February 2017 survey from bFinance suggests that alternative risk premia has been the area of greatest investor interest on a rolling 12-month basis.4 In March 2017, Deutsche Bank reported survey results showing that the percentage of respondents who allocate to alternative beta/risk premia strategies had increased to 26%, up from 20% in 2015 and 15% in 2014. At a more granular level, nearly half of all pension fund respondents reported allocating to alternative beta/risk premia solutions today, which is nearly double the proportion observed in the prior year’s survey.5 And interestingly, a recent survey from Morgan Stanley Prime Brokerage (Display 3) reports that 79% of investors with >$5 billion in hedge fund investments are currently allocating to, or considering an investment in, risk premia.6
As investor interest in alternative risk premia has grown, so has recognition about the many ways these strategies can be used in portfolios. Once mainly considered vehicles for constructing specific hedges, they are now regarded as a valuable asset allocation tool.
Implementing Alternative Risk Premia
Investors tend to implement alternative risk premia in three different ways:7
- Purchasing them individually or in packages from banks in the form of bank swaps linked to bank-designed alternative risk premia indices.
- Investing in a manager who designs its own risk premia and runs them within a typical hedge fund or mutual fund construct.
- Working with an asset manager who serves as a “fiduciary”, providing structuring, risk management and selection techniques on a customized basis.
Investors must weigh the relative merits of each implementation method.
When investors access alternative risk premia through a bank swap, they generally receive the return of an alternative risk premia index. For example, if the index return is positive then the investor receives the index return less a set index fee. The bank swap is typically short maturity (e.g., one year) and it can roll, so the investor often has the option to increase or decrease the time horizon or the notional value of the swap. With an excess return index, the corresponding excess return swap requires no upfront cash funding from the investor. Depending on the International Swaps and Derivatives Association (“ISDA”) agreement, the investor may post collateral to the swap counterparty, the bank, between coupon payments as the swap’s mark-to-market value varies. The main benefits of this implementation include liquidity, transparency and not having to fully fund the position. The drawbacks relate to the need to focus heavily on provider selection, premia selection, portfolio oversight (which cannot be done by the bank as its role is counterparty, not portfolio manager), potential cost dispersion, and the operational inconvenience of implementation. Setting up an ISDA and monitoring risk takes time and resources. Display 4 illustrates a typical bank swap transaction.
If an investor chooses to invest in a dedicated alternative risk premia fund, all investment selection and risk management decisions are outsourced to a fund manager.
In this case, the investor commits 100% of the cash upfront and is subject to the same fund terms as other investors. The main advantage here is ease of implementation; the drawbacks include the requirement to befullyfunded,fundfeesandthelackof ability to customize or have transparency.
Outsourcing to a fiduciary or asset manager seems to be a popular model among institutional investors. The fiduciary is often able to use its buying power to implement the bank swaps, potentially eliminating the requirement for an investor to fully fund, to obtain optimal pricing and to create a customized format. However, the fiduciary is required to provide the operational and oversight benefits of a fund manager.
What Are the Potential Benefits of Investing in Alternative Risk Premia?
The most obvious benefit is the potential return an investor could receive in exchange for taking on a specific exposure; from a portfolio perspective, there would be the potentially attractive risk/return properties. Many alternative risk premia exhibit low correlations to traditional portfolio investments. If incorporated into a portfolio appropriately, these strategies could complement traditional exposures in much the same way investments in hedge funds and CTAs purport to do.
When provided in the form of bank swaps, alternative risk premia are generally created using conventional instruments that have daily pricing. Prices are usually published daily in the form of indices whose tickers are available for review online through services, such as Bloomberg. Depending on the terms of the swap, the premia can usually be exited quickly, thus providing potentially greater liquidity than more conventional fund structures. However, it should be noted that dedicated alternative risk premia funds can offer attractive liquidity terms as well.
If using bank swaps, the banks are required to document the universe of investments and metrics around how the index is constructed and trades (e.g., frequency, time of day, amount, universe of securities). Th se are available in published “rule books” and provide a good degree of transparency for those willing to conduct thorough due diligence.
Alternative risk premia can be cost efficient and potentially capital efficient:
- Bank swap products and some of the newer risk premia funds typically do not have performance fees and may be cheaper than other sources of alternative exposure, such as hedge funds and CTAs. Of course, an investor would need to conduct full due diligence on each premium and compare that to options in order to fully evaluate cost. As discussed later, costing is not consistent across providers. We believe thorough due diligence and knowledge of peer pricing can lead to significant benefits and a difference in results.
- For many institutional investors, the daily pricing and liquidity of these investments could be beneficial from the perspective of regulatory reporting requirements. For example, alternative risk premia may not be classified in the same category as other alternatives. They may be categorized on balance sheets as more liquid investments, which could offer the significant benefit of freeing up capital for investors with capital constraints.
- When implemented in the form of bank swaps, they require less capital commitment for leverage purposes. Swap investors do not commit all capital upfront, as is required for investments in funds.
Finally, as alternative risk premia are systematic and rules-based, once designed they are not subject to human intervention—either prudent judgment or imprudent emotional overreaction. Thus, these strategies could help prevent style drift and the potentially negative consequences of exposure to a manager’s unintended market timing.
How Can Investors Use Alternative Risk Premia?
- DIRECT HEDGE FUND/CTA REPLACEMENT:
With the potential for comparatively lower cost, greater liquidity and greater transparency than traditional hedge fund and CTA structures, alternative risk premia could be an attractive option for an investor seeking to replace a portion of his hedge fund allocation. However, we believe this option does not fully address an investor’s needs in the absolute return space. There is the risk that this approach would remove all alpha opportunities, something we see as a key component of a successful absolute return portfolio solution.
- HEDGE FUND PORTFOLIO COMPLETION:
By addressing gaps and concentrations in existing factors, inclusion of alternative risk premia in a hedge fund portfolio could make that portfolio more balanced, better diversified, more cost effective and better able to adapt to market regime changes.
- HEDGE FUND PORTFOLIO EFFICIENCY:
Dedicated alternatives portfolios are often subject to cash drag because they need to hold high levels of cash to manage redemptions from, and commitments to, less liquid investments. An allocation to risk premia, if designed appropriately, could provide the opportunity for “cash-plus” returns, an improvement over idle cash.
- COMPLEMENT TO A MULTI-ASSETPORTFOLIO:
Introducing alternative risk premia to a broader portfolio of traditional market betas may provide greater diversification and drawdown protection during periods in which traditional asset classes exhibit high correlations.
- ALPHA/BETA/FACTOR SEPARATION:
Having efficient and liquid exposure to alternative systematic premia or beta at low cost could allow the manager selection process to focus more specifically on identifying true alpha, which in turn could facilitate replacement of non-alpha generating strategies.
- PERFORMANCE MEASUREMENT:
Sophisticated investors can use alternative risk premia as “benchmarks” or factors for evaluating the composition of individual hedge funds or portfolios, potentially gaining greater insight into their investment exposures. For example, if a manager is not generating alpha but is actually making most of its returns from alternative risk premia and market beta, then it may find it difficult to justify performance fees. Further, being able to monitor one’s exposure in a more refined manner could help prevent unintended overexposure to a certain factor or premium.
As is the case with all investments, alternative risk premia come with inherent risks. In our view, these risks include, but are not limited to, the following:
1. RETURNS ARE NOT NORMALLY DISTRIBUTED AND CORRELATIONS MAY CHANGE OVER TIME
While this behavior may be viewed as an attractive quality of alternative risk premia, it does make it more difficult to apply conventional asset allocation methods. Basic optimization techniques may not adequately identify risk or correlations, which would make it more challenging to identify the risk of tail events during periods of highly correlated returns.
Display 5 shows the distribution of two examples of alternative risk premia and highlights their “non-normal” distribution patterns. Alongside these, the diagram presents traditional investments, which tend to exhibit a “normal,” bell-curved distribution pattern. The difference in distribution of alternative risk premia returns is important because it means they can potentially provide differing and complementary returns to those of the traditional markets, thus providing hedging and diversification benefits.
Display 6 presents a correlation matrix of alternative risk premia, which shows that these strategies shift over time and that this variance is significant. Of particular note is the highly correlated behavior of the premia during market downturns. This might suggest there is a risk that these strategies won’t work as expected and could move in tandem when you least want them to. It is therefore crucial to be able to evaluate and understand them in order to attempt to address these risks. A further point of consideration with regard to time is that alternative risk premia returns can be persistent, episodic or structural. For example, our research has shown that value premia tend to be persistent; commodity carry and equity index skew are more episodic; and equity dividend premia are structural, characterized by the risk of decay over time.
2. HISTORICAL PERFORMANCE IS SUBJECT TO BACKTEST BIAS.
Investors must bear in mind that alternative risk premia trading strategies are vulnerable to overfitting of backtest data and lack of robustness during “live” periods. In a report by the Journal of Portfolio Management, the author reported a median 73% deterioration in Sharpe ratios between backtested and live performance periods for a set of trading strategies run by global investment banks.8 Further, the report established a link between performance deterioration and strategy complexity, with a realized reduction in live versus backtested Sharpe ratios of the most complex strategies exceeding those of the simplest ones by over 30%, suggesting the complex ones may be overfitted. Our proprietary analysis of over 1,000 alternative risk premia strategies has also identified a number of instances and patterns of potential for deterioration between backtested and live data.
On a more positive note, time is providing an increasingly robust set of live data from which to evaluate these strategies. In fact, in August 2017, bFinance highlighted that their collection of live track records eliminated backtest bias, concluding that in their sample of alternative risk premia strategies, the live track records do appear to be delivering “what it says on the tin, fulfilling the characteristics that investors are seeking from ARP strategies” with attractive risk-adjusted return characteristics.9
3. NO SET RULES GOVERNING HOW ALTERNATIVE RISK PREMIA ARE DESIGNED.
Bank providers and risk premia providers may operate differently in the design process. This leads to a situation in which risk premia with similar names have been designed differently and may have dramatically varying return profiles. The same bFinance report referenced above highlights that dispersion appears to be greatly affected by managers’ implementation methodologies, as well as the wide variety of premia and asset class choices.9
To illustrate this point, Display 7 shows the variance among risk premia categorized as “U.S. Equity Value” by different bank providers evaluated by Morgan Stanley Investment Management over the last three years. While the names of these premia are similar, the methods providers use to harvest the same risk premia are very different. As a consequence, we see wide dispersion in their results.
The variables that can meaningfully impact the returns of alternative risk premia include index construction— using different sets of investments (e.g., top 20 investments versus top 50), hedging approach (i.e., single stocks versus indices), re-balancing frequency (e.g., daily versus weekly), timeframe for look- back (e.g., momentum measured over different time periods) – and construction of execution costs.
As mentioned previously, the cost efficiency of these can be highly advantageous. However, Display 8 shows how widely execution costs can vary by provider in the case of the bank swap products. You can see that the cost is made up of two core components: explicit and implicit costs. How the premia is designed and how the fees are applied can result in very different overall costs. In this case, while the explicit “sticker” price for Vendor 2 is the cheapest overall, that is not the case when all costs are evaluated.
4. WITH INCREASING POPULARITY COMES THE RISK OF CROWDING.
In theoretical terms, if the risk premium is “pure” then it should always be there. However, there are capacity considerations for alternative risk premia strategies. As articulated by AQR’s Cliff Asness, “The
price of risk (how much you’re rewarded in extra expected return) can vary through time, and perhaps fall as the risk premium is more popularized.”10 There have been cases in which this has occurred, and it is something of which investors must be mindful.
As we hope the above points make clear, it is essential for an investor to have a thorough and methodical due diligence process in place to evaluate alternative risk premia.
We see alternative risk premia as an interesting, evolving and dynamic space with a wide variety of applications. As articulated in our recent paper, “Perspective on the Future of Hedge Fund Investing,” we are actively seeking ways to enhance our clients’ portfolios.11 We believe that broadening the opportunity set to include strategies like alternative risk premia can be an efficient way to do that.
By Morgan Stanley Investment Management
Patrick Reid, CFA, Managing Director Portfolio Advisor
Mark Van Der Zwan, CFA, Chief Investment Officer and Head of AIP Hedge Fund Team