2014 12 Mercer Risk Premia Investing From The Traditional To Alternatives PDF
2014 12 Mercer Risk Premia Investing From The Traditional To Alternatives PDF
2014 12 Mercer Risk Premia Investing From The Traditional To Alternatives PDF
In this paper we provide an overview of the risk premia concept and focus on a
set of liquid “alternative” (or non-traditional) risk premia in particular. We cover
the following topics:
• Identifying traditional risk premia (how risk premia can be defined and the
common exposures for investors).
• The possible roles of alternative risk premia (why investors might want to
gain exposure).
Overall, we believe that investors can benefit from a bias to alternative risk
premia in their equity portfolios — capturing additional drivers of return above
and beyond simple equity market beta. In essence, their role in this context is
as a tilt to the underling equity market exposure.
3
While the theory To warrant exposure on a standalone basis, alternative risk premia products
will need to compete with other liquid growth assets, such as exotic credit
is relatively and hedge funds. While the theory behind alternative risk premia is relatively
compelling, at this stage the practical evidence of managers being able to
compelling, capture these risk premia on a standalone basis, systematically, and in their
simple form (net of fees, transaction costs, leverage constraints, etc.) is weaker.
alternative risk Given this, we believe that manager (and/or strategy) selection should be as
rigorous as for any other alternative asset class; in particular, we note that there
premia products is a degree of overlap between this space and global macro hedge funds,
reinforcing the importance of manager due diligence.
need to compete
with other growth
assets, such as IDENTIFYING TRADITIONAL RISK PREMIA
exotic credit and Before we start documenting possible alternative risk premia, it is worth
highlighting what we regard as traditional risk premia. Risk premia in general
hedge funds. can be defined as “sources of return that represent identifiable, replicable,
and exploitable compensation for taking investment risk”.
The risk premium that dominates most investor portfolios is the equity risk
premium. Widely understood today, the notion of equity market beta (the
return from owning the market portfolio in equities) only really emerged in
the 1970s with the first index funds in the US.2 Other recognised betas (or
market risk premia) traditionally accessed by institutional investors now
include credit (the compensation for lending money to corporates) and
term premia (or duration).
2. When Vanguard’s first market cap weighted equity fund was launched in 1976 it was assumed
to be a “pure alpha” way of investing in equities.
4
behavioural, and exotic market opportunities have been identified,
highlighted, and increasingly accessed explicitly by institutional investors.3
The term
We have grouped them into two main categories4: alternative risk
• Alternative risk premia — Provide systematic explanations for returns premia includes
historically thought of as alpha, typically extracted through long/short
positions in traditional asset classes. This is the primary focus of the style premia, such
remainder of this paper.
as value and carry,
• Exotic betas — Provide more granularity to the historic notions of broad
traditional risk premia and/or reflect niche equity and credit exposures in through to hedge
nonmainstream markets. We include in our definition long-only investments
in debt and equity in nonmainstream markets (such as emerging market fund premia.
debt or frontier equity), hybrid instruments (such as convertible bonds) and
relatively new instruments (such as catastrophe bonds). For some investors
these exposures will already be established investments — as time goes by
we might expect some of today’s exotic betas to become “traditional”.
Traditional
beta Traditional
(e.g. equity) beta
3. Investor interest in “risk factors” is a related approach, albeit often used more “qualitatively”
than “quantitatively”. See Hawker, “Diversification: A Look at Risk Factors”, Mercer, May 2010.
4. One could also distinguish other sources of return commonly exploited in alternative asset
classes — such as the illiquidity premium in some hedge fund and private market strategies,
esoteric risk factors such as legal process risk as a source of value, and political/regulatory
risks in infrastructure investing. Arguably these aren’t replicable systematically, so we ignore
them for the purpose of this paper.
5
Alternative risk IDENTIFYING ALTERNATIVE RISK PREMIA
premia have been Conceptually, alternative risk premia are not new. They are highlighted in
academic work dating back to, for example, Cassel in 1918, Graham and
exploited by Dodd in 1934, and Banz in 1980.5 In practice, they have been exploited by
investors for decades (and likely centuries) — albeit, in many cases, implicitly
investors for rather than explicitly. Based on academic and investment literature, we can
decades — albeit, identify six categories of alternative risk premia that it might be possible to
capture systematically:
in many cases, • Carry strategies — Borrowing at a rate that is lower than the lending rate; for
implicitly rather example, borrowing in currencies with lower interest rates while investing in
currencies with higher interest rates. Frankel (2007) and Galati, Heath, and
than explicitly. McGuire (2007) provide overviews of the significant academic analysis with
respect to currency carry.
• Value strategies — Securities that are cheap relative to their peers will
outperform on a relative basis (conversely, those that are expensive relative
to their peers will underperform on a relative basis). This is a common bias in
long/short equity strategies, but the approach is also applicable in a macro
setting (long cheap stock markets, short expensive, etc.). Academic evidence
comes from, for example, Fama and French (1998), looking at value stocks
versus the broad market.
5. Cassel identified the notion of “purchasing power parity” (a value premia) as a driver of
currency markets; Graham and Dodd, in their seminal text “Security Analysis”, set out the case
for value investing in equities; and Banz studied the size bias in stock markets (where small
cap equities have higher risk adjusted returns than large cap stocks).
6. Anchoring refers to the use of current prices (or other reference points) to anchor their view
of the fair value of an asset, while cognitive dissonance reflects the tendency to ignore new
information that conflicts with their previously held beliefs; both delay the translation of new
information into new pricing of assets. Fair weather investing is the tendency to buy things
that have had recent good performance, while fear and greed can result in, when things are
going well, investors becoming irrationally greedy, and when they are going badly,
becoming overly fearful. Both can help explain prices overshooting fair value and the
extension of trends.
6
• Size/liquidity strategies — Identified by Banz in 1981 as a source of higher
risk-adjusted returns in the equity markets, the small cap size
bias is deemed to be compensation for investing in less liquid, less
marketable, and informationally less efficient securities. The pure premium
can be captured by, for example, being long small cap stocks and short large
caps.7 See academic analysis by Fama and French (1993).
7. Investing in a long-only portfolio of small cap stocks will provide exposure to the premium,
albeit coupled with a material amount of equity beta. A long/short approach can enable
investors to gain a more material exposure to the premium, such that it can act as a
“diversifier” to equity assets and not simply a portfolio tilt.
7
Taking the six premia we just discussed, we can identify some common ways of
exploiting them by asset class. The map of the risk premia is shown in Figure 2.
The methods of accessing the risk premia that are set out in Figure 2 are
common examples but not unique or exhaustive definitions. In much the same
way that the S&P GSCI and Bloomberg commodity indices both seek to
provide “commodity beta” (but with vastly different results — see Appendix A),
the various alternative risk premia can be (and are) accessed in different ways
by different providers.
8. Backwardation refers to a situation in which the price for future delivery of a commodity in a
futures contract is less than the current spot price for the commodity. Contango is the
opposite situation.
9. On-the-run treasuries are the most recently issued US treasury bonds of a given maturity;
off-the-run treasuries are prior issues that remain outstanding in the market.
8
At the very least, the impact of this will be to cause noise (random return
differences) between different approaches for capturing the same premium. In
Alternative risk
other cases, it might be a reflection of a positive/negative alpha in the strategy
design and implementation (as referenced previously). It may be hard to
premia can help to
distinguish the two, which emphasises the need to be humble in your diversify the equity
expectations, thoughtful in manager selection, and focus on a diversified
and robust portfolio construction. risk in a growth
portfolio.
THE POSSIBLE ROLE OF ALTERNATIVE
RISK PREMIA
Alternative risk premia do not provide a silver bullet for asset allocators, but
they do provide additional and differentiated sources of returns that could be
additive to a traditional growth portfolio.
A typical growth portfolio is dominated by equity risk (and maybe credit risk);
alternative risk premia can provide a set of liquid investment strategies whose
long-term returns are not reliant on the growth of the equity market. This is
important because, for example, in 20% of 10-year periods since 1925, the US
equity market has delivered a realised equity risk premium less than zero (and
40% of times less than 3% per annum, a typical long-term objective for many
investors). As such, it is desirable to identify and to harvest other robust
sources of growth (other return drivers).
9
Analysis from product providers is a useful supplement, even when there is a
danger that they are subject to a natural confirmation bias in their work. Taking
the data with an element of caution, in Figure 3 we note estimates of
performance for some key alternative risk premia.
rry
um
rry
um
rry
um
e
lu
lu
lu
lu
tu
Ca
Ca
Ca
Ca
Va
Va
Va
Va
transaction costs.
t
em
en
en
en
om
om
om
om
M
M
Noting that equity markets have historically delivered a Sharpe ratio of about
0.2–0.3, the data in Figure 3 suggest that a reasonably efficient attempt to
capture naïve alternative risk premia might be worthy of consideration as a
source of returns within a growth portfolio. The apparent robustness of the
back-tested return streams is further supported by the theoretical (economic
and behavioural) justifications that can be made for their existence; a track
record that is intuitive (suggesting that future ebbs and flows of performance
should be understandable and can be ridden through in the same way
investors accept the noise of equity market volatility); and related studies that
suggest long-term returns would have been available from these premia
through history.10
10. Not available for all risk premia, but, for example, for momentum see Baltas and Kosowski
(“Momentum Strategies in Futures Markets and Trend-Following Funds”, 2012) looking at
trend following since the mid-1970s and Hurst, Ooi, and Pedersen (“A Century of Evidence on
Trend Following Investing”, AQR Capital Management, 2012), which suggests a net-of-fees
Sharpe ratio of 1.0 for multi-asset trend following since 1902.
10
ENHANCING RETURNS THROUGH DIVERSIFICATION
While Figure 3 looks at the return potential of individual risk premia, we note
that the potential richness of returns can be enhanced by diversifying across
the various risk premia. Figure 4 provides the correlations across three style
premia between January 1990 and August 2013.
The low correlations between different style premia highlight the potential
diversification benefit from blending a number of them together in a portfolio.
11
The analysis reiterates the potential diversification benefits of momentum
strategies in periods of extreme equity weakness,11 but it also highlights more
generally the low correlations of alternative risk premia with the broader equity
markets. This provides support to the claim that the drivers of returns for
alternative risk premia are distinct from equity risk and should therefore be
able to help as a differentiated source of growth within an investment portfolio.
However, investors should note that some alternative risk premia (notably
currency carry) suffer from a negative skew, with periods of steady positive
returns followed by sudden and large drawdowns (encouraging the
description “picking up pennies in front of steam rollers”). While this
characteristic does not undermine the investment case for these strategies,
it does argue for a more thoughtful and diversified implementation.
PRACTICAL IMPLEMENTATION
So we have argued that alternative risk premia are not new, and yet the
concept has been driving new products and product innovation over the past
year or so. What has changed and where do new alternative risk premia
strategies sit within the strategy line-up we are used to? First, to put it into
context, it is worth thinking about the extent to which existing and familiar
strategies use alternative risk premia to add value.
12
2. Systematic global macro (and managed futures) managers15
The exposures of two systematic global managers are shown in Figure 6.16
Typically a systematic macro manager believes in taking many small bets
across multiple markets and asset classes, often specialised predominantly
on one of the core style premia (value, carry, or, in the case of managed
futures managers, trend). Individual discretionary macro managers tend to
be more idiosyncratic, although in aggregate you might expect them to
converge on broader risk premia type approaches.
Momentum/ Momentum/
Trend Trend
Value Value
Size/ Size/
Liquidity Liquidity
Quality/ Quality/
Defensive Defensive
Event/ Event/
Idiosyncratic Idiosyncratic
Blue squares represent risk premia captured in the strategy; grey squares represent parts of the
matrix that are not commonly recognised as exploitable risk premia. Categorisation and
interpretation by Mercer.
13
The more 1. However, these managers will often be relatively idiosyncratic, tactically
varying their focus on different premia (implicitly or explicitly) as markets
interesting move, as well as generating value from idiosyncratic security selection. A
final differentiator is likely to be the acceptance of some illiquidity in a multi-
strategies invest strategy hedge fund (and the returns available along with the illiquidity
premium) as well as exploiting complexity and other esoteric risk factors
across multiple such as legal process risk as a source of value (see “Hedge Fund — House
View”, Mercer 2012).
risk premia in a
balanced way. NEWER ALTERNATIVE RISK PREMIA PRODUCTS
Over the past few years several new products have been launched under the
banner of alternative risk premia (some of these are marketed as “smart beta”
strategies). These strategies are designed to be diversifiers in an investor’s
growth portfolio, supplementing or replacing other possible growth assets.
Some are narrowly focused strategies seeking to provide simple and cost-
effective exposure to one or two premia. Potentially more interesting, however,
are those that instead target the benefits of diversification — investing across
multiple risk premia in a balanced way.17 Many of these strategies also seek
equity market neutrality (and nondirectionality to other traditional betas),
making them useful from a portfolio construction perspective. The maps in
Figure 7 illustrate the mix of premia captured by two example managers.
Momentum/ Momentum/
Trend Trend
Value Value
Size/ Size/
Liquidity Liquidity
Quality/ Quality/
Defensive Defensive
Event/ Event/
Idiosyncratic Idiosyncratic
Blue squares represent risk premia captured in the strategy; grey squares represent parts of the
matrix that are not commonly recognised as exploitable risk premia. Categorisation and
interpretation by Mercer.
17. Trend following may be the exception here. Arguably the trend premium is less efficient than
others listed in this paper (that is, less likely to produce a rich source of returns), but it comes
with interesting diversification properties, especially in extreme market downturns, which
might justify its use on a standalone basis.
14
The challenge remains, however, in the translation of theory into practice.
While the theory behind alternative risk premia is relatively compelling, at this
The challenge
stage the practical evidence of managers being able capture these risk premia
in their simple form (net of fees, transaction costs, leverage constraints, etc.) is
remains in the
weaker. Many funds are new and much of the analysis relies on back-tested translation of
performance — and for all the products with a degree of track record, it is not
clear how many others have already been wound up because performance has theory into practice.
not matched expectations. As highlighted in the section “Identifying
Alternative Risk Premia” (page 6), we also believe that strategy design and
implementation can be value-adding elements of risk premia investing. The
commonalities that these types of strategy share with systematic global macro
strategies also highlight the importance of manager selection.
18. A number of multi-asset managers (diversified growth funds), for example, make significant
use of alternative risk premia because they are expected to provide liquid and low cost
diversification.
15
We believe that the CONCLUSION
concept of building We believe that the key takeaways from looking at alternative risk premia are
as follows:
a growth portfolio
with a balanced • These concepts can provide a valuable way of understanding, assessing, and
monitoring investment managers in the liquid alternatives space as well as in
and diversified mix traditional style-biased equity universes.
of return drivers is a • There is a strong theoretical rationale for their contribution to investment
returns historically; the logic extends to their ability to drive positive returns
sensible approach into the future. We believe that this justifies at least tilting equity portfolios
towards them to help enhance expected returns, for example.
to adopt. • Because these premia represent distinct sources of return versus traditional
market betas, they have the potential to help diversify the return drivers in an
investor’s growth portfolio and share the burden for generating long-term
growth. For this they would need to have their own capital allocation within
the growth portfolio — and not simply be a tilt to, for example, the investor’s
traditional equity allocation.
• The new products launched in this space share many similarities with
systematic global macro strategies, albeit often providing exposure to a
broader range of risk premia and limiting market directionality. As such, it
would seem reasonable to consider these strategies (each on their own
merits) as an alternative to a more traditional global macro manager.
• To the extent that the practical evidence of capturing alternative risk premia
proves as compelling as the academic literature would suggest, it may be
that strategies explicitly focused on the capture of these premia will
ultimately demand a greater share of an investor’s portfolio. The liquid
and transparent nature of these strategies will have clear attractions for
some investors; however, they will need to be able to compete for capital
with more established alternative investments, in particular other hedge
fund strategies.
Overall, we believe that the concept of building a growth portfolio with a
balanced and diversified mix of return drivers is a sensible approach to adopt.
Many alternative risk premia already help enhance returns in active equity
mandates, and some investors will have exposure within their hedge fund
allocations. The theory suggests that they could be used more widely as
diversifying sources of return, although the new products, offering pure and
systematic exposures to these premia, are relatively untested. For the moment,
it remains early days for this evolving product set.
16
APPENDIX A — COMPARISON OF TWO
COMMODITY INDICES
The two most popular commodity indices are the S&P GSCI Commodity Index
and the Bloomberg Commodity Index.19 Both seek to provide commodity
beta, through a systematic trading strategy (thus being part-way between an
exotic beta and an alternative risk premium). Their construction frameworks
are summarised below, with a chart of performance following. As can be seen,
the correlation between them has been high (>0.9). However, there have also
been some large divergences in performance. Ultimately, both are valid ways of
gaining exposure to commodity beta, with the performance differences over
recent years illustrating the potential noise that could also be expected from
individual alternative beta strategies.
450
400 BCOM
350 S&PGSCI
300
250
200
150
100
50
17
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