Risk Premia Strategies
The Art of Selectively Harvesting Attractive Risk Premia
- Risk premia investing is about simplifying and improving the way our clients make asset allocation decisions with the ultimate aim of delivering a more dependable and less volatile investment return.
- Allocating assets to risk premia strategies within a variety of asset classes, rather than simply investing in asset classes, can help our clients diversify portfolio risk, and reduce drawdown and volatility. In other words, allocating investment to strategies rather than to assets is more likely to deliver a positive outcome versus the more traditional forms of asset allocation. In a world of low returns, that may be very valuable proposition.
QMS Advisors offers a description and classification of a selection of risk premia strategies across assets covering equities, bonds, credit, currency and derivative markets (which we group under the heading of volatility) and we find that most strategies can be classified either as income, momentum or relative value. This classification system is derived from historical risk/return characteristics.
- Income strategies typically accrue payments over the long-term but may give the possibility of occasional (but very large losses during periods of market turmoil, i.e. drawdown). Many value and carry strategies also fall into this category.
- Momentum strategies, on the other hand, perform best during periods of economic crisis or market turmoil. Momentum strategies include quality equity, call over-writing and FX momentum.
- Relative value strategies, however, tend to be more distinct sources of return but may suffer from liquidity constraints.
Risk premia investing entices significant and numerous risks. Severe drawdown is evident in many individual strategies and so investment decisions will still need to be made. Style timing also potentially becomes more important when allocating assets to risk premia and we provide some ideas on how that might be achieved.
Diversification is therefore key and we can show you how, using a variety of portfolio construction techniques, we can help you combine portfolios of risk premia to deliver decent returns with much lower volatility and drawdown.
Risk premia investing has been the subject of much academic research for many years, but in the current environment of low returns and heightened risk of loss, the interest in this approach has been steadily growing.Moving from a theoretical framework to implementing a risk premia strategy involves considerable challenges. In many instances, particularly within the equity market, returns are often expressed on a long/short basis, adding a significant amount of cost and complexity. Theoretical portfolios are often rebalanced to such a degree that annual turnover rates not only eat into returns, but also involve a considerable amount of portfolio management, putting them out of the reach of many investors. Capacity constraints are also a concern of many market practitioners and the main index providers. Yet, many risk premia strategies are available in index format, largely facilitating the implementation of such solutions (i.e. short VIX contango strategies, low volatility strategies, equity quality & income strategies, dividend swaps, etc.).
Many may consider this no more than financial alchemy and there is inevitably an element of truth in this. The point here is to demonstrate how risk premia investing cannot only deliver an interesting return profile but also to show how these ideas have moved quickly from paper to practice.We have found that simply assigning 10-20% of a traditional asset allocation to a portfolio of risk premia would have improved returns, with a 10% allocation adding 100 bps per annum and a 20% allocation adding around 200 bps. Volatility in each case was also lower. Of course, hindsight bias may be in play here and a key part of the risk premia debate is the persistence of these trends going forward. However, this criticism could be applied to many other forms of investment strategy.
WHAT IS RISK PREMIA INVESTING:
- Improving risk-adjusted returns in a low-yield world
Risk premia harvesting, smart beta, factor-based asset allocation and style timing are in essence what quantitative teams do, that is to identify, analyze, build and develop strategies that in multiple ways improve risk-adjusted returns. This is now increasingly known as risk-premia investing.
The idea of harvesting risk-premia across different asset classes beyond the traditional assets of equities, bonds, credit etc. is not new. Risk models have been decomposing returns into factor exposures and "quants" have been compiling factor-based stock portfolios for decades. So why is there such an interest in the subject today? The enthusiasm for the approach is, in part, driven by a paucity of available investment returns on more traditional assets. With interest rates and credit spreads historically low, as well as equity markets near peak levels, achieving reasonable post-cost returns from a traditional asset-allocation mix is clearly a challenge.
Perhaps more importantly, this enthusiasm might be the consequence of the failure of existing practice to not only deliver stable returns but to do so with acceptable levels of capital protection. Indeed, elevated levels of correlations across multiple asset classes during the last financial crisis called the very concept of diversification into question.
So a lack of attractive returns, the growing difficulty of predicting those returns and associated risks, as well as the limits to diversification within the standard asset allocation framework are what we believe are the driving forces behind today’s interest in risk premia-based asset allocation.
- About Smart Beta equity indices
The move to develop risk premia-based investment strategies is happening at a time of considerable activity in the alternative index world. Index providers, be it traditional suppliers such as MSCI, FTSE and S&P or investment banks are all rushing to provide new and innovative indices as an alternative to existing market-cap weighted indices. This is in part to address the relatively new audience of potential risk premia investors, but also it is in simple recognition that market-cap weighted indices are just not very good.
Alternative weighting schemes are not particularly new. Most recognize that market cap weighted benchmarks have struggled versus other formulated indices since the late 1990s and the likes of RAFI fundamentally weighted indices have been around for several years now. Beating the market-cap benchmark has in theory always been easy; but importantly not all new alternative index weighting schemes are actually risk premia (although most are marketed as such). Rather, they are simply improvements on current benchmark construction.
- In theory, everyone beats the benchmark
Recent academic research has shown that most alternative weighted indices outperformed their market-weighted benchmark, and so did most randomly created portfolios. It has also been demonstrated that only three alternative indices (equal-risk contribution, inverse volatility and risk efficient) beat the average random portfolio, with the average random portfolio's performance being logically very similar to the equal-weighted index. Smart beta may then have an easy target in offering alternatives to the market cap-weighted benchmark. Whilst many of these techniques will fail after costs, market cap indices are, in our view, worthy targets.
- Smart beta – better than beta but not quite alpha
Whilst many readily interchange the concepts of smart beta and risk premia, it is important to be aware that on a long-only equity basis the dominant factor driving smart beta returns will still be the underlying equity benchmark. It is really only when run on a long/short or long versus the benchmark basis that correlations drop and the diversification benefits of risk premia investing become apparent. Aversion to leverage and restrictions on shorting are then major impediments to equity risk-premia asset allocation. In addition, increased costs, market impact and liquidity will also become major performance headwinds. This is not to say that we would not prefer to organize the equity market into sensible long-only blocks based on risk premia to beat the benchmark, rather we are pointing out that to move from theory to practice involves jumping through several large practical hoops.
- Definition of risk premia
Discussions on risk premia investing often involve a mix of theory and application. The theory is simple enough: investing in risk premia as an alternative (or as an add-on) to the traditional mix of bonds/equity/credit/property etc. should deliver a significantly better - and more predictable outcome - than traditional combinations of asset classes alone. In reality, risk premia investing is mainly an extension of existing research on systematic hedge fund replication strategies and quant factor investing.
- Persistence and Economical rationale
There is no formal definition of what constitutes a risk premium beyond the concept that investors should reap a reward for bearing some amount of risk. We’ve discovered there are just as many ways of classifying risk premia as there are suggestions for risk premia themselves.
So to simplify, we have decided that a risk premium has:
- Demonstrated an attractive positive historical return profile;
- A fundamental value that allows a judgement on future expected returns; and
- Diversification benefits when combined into a multi-asset portfolio
- Basic classification of risk premia strategies:
- Income – strategies aiming to receive a certain steady flow of money, typically in the form of interest rates or dividend payments. Such strategies are often exposed to large losses during confidence crises, when the expected income no longer offsets the risk of holding the instruments;
- Momentum – strategies designed to bring significant gains in market downturns, whilst maintaining a decent performance in other circumstances. CTA-type momentum strategies tend, by design, to perform well when markets rise or fall significantly. An equity overwriting strategy performs best when stock prices fall, and still benefits from the option premia in other circumstances. Quality equity also belongs to this grouping; and
- Relative value – outright systematic alpha strategies based on market anomalies and inefficiencies, for example convertible arbitrage and dividend swaps. Such discrepancies are expected to correct over a time frame which may vary from a few days for technical strategies to a few months or even years for more fundamental strategies.
The basic concept recognizes that assets are driven by a set of common risk factors for which the investor typically gets paid and, by controlling and timing exposures to these risk factors, the investor can deliver a superior and more robust outcome than through more traditional forms of asset allocation.
An important point here is that the investor gets paid, i.e. the understanding is that the returns generated through exposure to risk premia are in some way more useful and dependable than exposures to more traditional asset classes. We are simply saying that buying cheap and selling expensive stocks is a more dependable way to make money in the long term than say simply over-weighting equities versus bonds (the value risk premium is a more reliable source of return than the traditional equity risk premium, which has proved mostly useless as a predictor of future returns from equities versus bonds).
A recurrent problem that investors have faced historically are the simultaneous regime shifts experienced by most assets; as assets become highly correlated among each other to hitherto dormant or hidden risk factors (balance sheet risk, illiquidity risk, etc.), particularly during times of crisis. In addition, correlations across major asset classes are inconsistent through time (i.e. shift in the sign of the correlation between bond and equity markets in the last couple of decades). Actually, assets have multiple overlapping underlying factors driving them (i.e. economic growth, real interest rates and inflation expectations, etc.). These factors are interconnected and vary in importance over time. During the 1990s, disinflation was the key driver (bonds and equities were then positively correlated). Since 1999, economic growth has been the major driving factor (bonds and equities were then negatively correlated). These relationships are obvious to explain ex-post but complex to anticipate. Currently, anticipating the sign of the correlation between bond and equity markets post QE tapering remains a conundrum for most investors.
The attraction of adding alternative risk premia assets to a more traditional multi-asset portfolio is that not only are historical correlations across risk premia lower than for traditional asset classes, but these correlations are more consistent and robust to regime shifts. Of course, uncorrelated or less correlated returns are always sought by investors, so we can see the potential appeal but, as we highlight, long-term correlations (and beliefs) do change.
- Risk premia strategies can be used as an efficient diversification tool for traditional managers. A traditional long-only fund manager could, for example, invest 40% of their holdings in potentially ‚safe haven fixed income assets, 40% in equities and 20% in Credit. Over the long run, the average correlation between this traditional asset mix is 0.55, with correlation moving higher over crisis periods. The risk premia strategies we cover in this document display correlation that are below 0.20, on average and remain relatively diversified over crisis periods. Moreover, their correlation with traditional assets are usually not statistically significant (below 0.25). So if our traditional long only asset manager was to invest just 10% of their portfolio’s risk budget into these strategies, this would greatly impact their performance, moving from a Sharpe ratio of 0.6 to a ratio of 0.76.
- Consistence, durability and robustness of expected returns
A critical part of understanding historical returns - and therefore understanding risk premia - is being able to determine how likely those returns are repeatable going forward. Future returns for volatility, carry and value-based strategies will all be a function of the starting price. Strategies based purely on market inefficiencies are then far harder to judge given it is often the case that a market anomaly, once recognized, quickly disappears.
- The ex-dividend effect is a case in point. We think we know why the strategy works (tax arbitrage, mainly) but despite this, we still struggle to understand why it stopped performing in 2009. Other strategies have periods of under-performance but, in degrees of confidence, you’d expect value-based strategies to work again in the future whilst for a market anomaly such as the ex-dividend effect you simply have no idea. We’d then caution against using specific difficult to explain market anomalies as risk premia strategies.
- Another case in point would be momentum strategies in FX markets. Momentum strategies exploit the persistence of directional moves over an appropriately selected time frame, a phenomenon well documented in academic literature and the so-called CTA hedge-fund industry has grown up based, in large part, on that market phenomenon. Yet, momentum trading has been challenging in recent years. A potential rise in rates could trigger an increase in FX volatility via the FX interest rate spread link, which could in turn provide more opportunities for momentum trading going forward. This is evidenced by the better performance of FX momentum strategies so far during 2013.
- What sets risk premia investing apart?
Building alpha models is nothing new and most market anomalies such as value, momentum etc. are well recognized, well documented and largely deployed by existing quantitative investors. Moreover, traditional equity quant portfolios have historically far outperformed a combined risk premia approach. How to explain the apparent enthusiasm for risk premia indices in place of standard equity approaches in this context?
- Firstly, risk premia opens up the quantitative black box; most quant funds do not fully divulge their stock selection strategies and, many investors have become sceptical of active quantitative models
- All investors have different investment objectives. Active quant fund managers (as with most fund managers) are heavily constrained by short-term performance metrics and mandated benchmark restrictions. So returns are often not achievable under normal benchmark constraints. Many risk premia are obtained through taking a longer term view which often exploits the short term consideration of other active market participants;
- Risk premia gives broader access to quant techniques without the need for extensive quantitative infrastructure; and
- It allows greater flexibility to style time and to shift exposures depending on the investment profile and prevailing macro conditions.
Beyond technicalities and implementation issues, thinking in terms of risk premia is a way of breaking down the walls between asset classes and understanding that some investment styles share similar characteristics. While it seems obvious that systematically monetizing the volatility risk premium in equities or in foreign exchange is very similar, it may not be as obvious that quality equity and FX momentum strategies also share common performance characteristics.
- Optimally combining risk premia strategies
Understanding how to combine these strategies is a crucial part of the exercise. In particular, we show that performance and behavior of risk premia strategies are linked to common factors and, as such, we can identify a crisis factor, an equity factor and a market premium factor.
The crisis factor stands out as the main risk factor when it comes to allocating across risk premia. Crises are key drivers of the performance of strategies such as quality equity, overwriting and a variety of momentum strategies. They are also the main source of risk for income strategies. Tactical indicators and some strategic thinking may help keep a lid on drawdown for income strategies or emphasize performance of momentum strategies. Tactical timing is a set of filtering and risk management techniques which allow automatic controlling of the downside of a strategy.
Strategic timing is useful and stems from the realization that risk premia are exposed to global macro factors, albeit less dramatically than traditional asset classes. It is closely linked to the understanding of macro drivers of each strategy. We therefore propose to measure the sensitivity of our strategies to risk factors. Investors can then overweight strategies that might perform well in their favored global macroeconomic environment scenario.
TYPOLOGY OF RISK PREMIA STRATEGIES:
QMS Advisors covers a wide spectrum of risk premia strategies within, among and across the equity, credit, derivatives and foreign exchange markets