Published by Chris Pritchard on
Estimated reading time: 4 minutes
Alternative Risk Premia (ARP) refers to generating returns by taking risks that are quite different to traditional market risks, such as equity risk and credit risk.
It involves investing systematically in ‘styles’ across different markets and asset classes. Examples of this are:
One key difference is market neutrality. Diversified growth funds will typically buy asset classes such as equities and bonds, exposing themselves directly to general market movements. True ARP strategies are market-neutral in the sense that their return is not expected to be linked to, or dependent on, the prevailing market movements. Therefore, most strategies of this type will use some form of derivatives in order to remove the market impact. In theory, they expect to generate returns in all market environments.
Another difference is the dynamic nature of diversified growth and absolute return funds. Portfolio turnover can be relatively high in ARP funds, but the key ‘styles’ and the way they are implemented is rarely changed. Conversely, diversified growth and absolute return funds will move dynamically between different asset classes, strategies and themes depending on the investment manager’s views at any given time.
Our research does suggest that these strategies do genuinely provide uncorrelated returns to more traditional markets. The techniques used by ARP fund managers are similar to those that have been employed by successful active managers over a very long period, and there is strong academic evidence supporting these approaches. We think these types of strategies are here to stay, and will be an important component of diversified portfolios for years to come.
However, the journey is not always smooth. This can be seen recently with a number of ARP funds struggling in 2018, with returns of -10% or more not uncommon. Whilst 2018 was also a year of poor returns for global equity markets, the two are not as linked as they may seem.
Global equity market falls occurred in October and December whereas ARP funds suffered drawdowns in the first half of the year, and the drivers of the performance were quite different. For example, one common ARP strategy comes from a belief that “value” stocks will outperform. Whilst investing in this way, buying the ‘cheap’ stocks and short-selling the ‘expensive’ ones, is supported by strong academic evidence, during the early part of 2018 it resulted in significant losses as value stocks underperformed the wider market. In other words, cheap stocks tended to get cheaper. What was also disappointing was that the other strategies employed by ARP funds did not return enough to pick up the slack, and so the diversified approach across different strategies, markets and asset classes still left a number of funds reporting losses. However, these types of strategies have experienced similar losses before and recovered. As long as there is still academic evidence to suggest ARP will generate positive returns that are uncorrelated to traditional risk premia, then the strategy should still deliver in the long run.
Short answer – yes, but not for all pension schemes.
Longer answer – pension scheme trustees who are considering an investment into ARP should consider our three key tests.
If you would like to hear more on alternative risk premia, please get in touch with your local investment consultant who will be more than happy to help.