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The search for diversifying assets never goes away. The latest new diversifier on the scene is Alternative Risk Premia strategies. But what are they? And why should investors consider them?”
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:
- Momentum style - Looks to invest in markets or assets that have performed well recently, or selling those that have performed poorly. This idea could be put forward on the view that investors tend to chase winners and sell losers.
- Value style - Which involves choosing markets or assets that appear cheap relative to the wider market on one or more fundamental metrics. Investors who believe that the market overreacts to good news and bad news could employ this strategy.
How do these strategies differ from diversified growth funds and absolute return funds?
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.
Is this just another market fad?
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.
What happened in 2018?
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.
Is this an appropriate investment for pension schemes?
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.
- A long investment time horizon. What happened in 2018 shows us that these types of strategies can have significant drawdowns, and it can take a number of years to recover these losses. The same considerations that are taken when investing in equities should be taken when investing in ARP. Just like an equity investment, Trustees must be able to accept the potential volatility that these strategies can experience.
- A board of trustees that is both financially sophisticated and prepared to dedicate the time to receive training on the key “styles” that ARP funds invest in, and the sophisticated processes that are used to try to harness potential returns. Assessing the performance of these strategies is not as easy as more traditional markets. Performance will be driven by the success or failure of the underlying strategies rather than by more general market movements, and so it is important that trustees understand what they are investing in, and the risks they are taking.
- A growth portfolio that already has allocations to more traditional risk premia, such as equity and credit risk premia. We do not believe that ARP would make up the majority of any growth portfolio, and is more suited to acting as a diversifier alongside other traditional risk assets.
How we can help
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.