6 June 2019
In their turn-of-the-year review, GAM Systematic’s Lars Jaeger and Paolo Scripelliti asserted their belief that 2018 will probably go down in history as the year Alternative Risk Premia (ARP) strategies made the transition from niche to mainstream. However, as is often the case with cutting-edge investment concepts, misunderstandings and misgivings can dissuade less-informed investors from making the most of the available opportunities to diversify their investment portfolios. In this article, we seek to lay three of the biggest myths and misconceptions to rest.
While it is true that the concept of ARP is irrevocably tied to that of hedge funds in that it seeks to harness the same risk premia that have historically gone a long way towards explaining the returns that were associated with so-called ‘hedge fund alpha’, this is where the objective comparison ends. For years, many hedge funds were associated with opaque investment approaches and investors were required to pay excessive fees in order to access this largely unquantifiable ‘magic sauce’ which promised to transform the overall performance and efficiency of their investment portfolios. Conversely, if correctly implemented, alternative risk premia strategies can offer valuable diversification into uncorrelated sources of return with complete transparency, daily liquidity and low costs.
‘Smart beta’ has quickly become a buzz term relating to something mystical that nobody really understands the true meaning of, but everyone allegedly wants because they believe all their peers are benefiting from it. However, ARP has nothing to do with this concept, since smart beta actually refers to the notion of reweighting broad equity indices based on different indicators (such as price / earnings ratios – a measure of the relative expensiveness of individual stocks) with the aim of generating a return that is fundamentally different to that derived from index tracking. The latter is inherently dependent on often random (‘un-smart’) and individually large share price movements of heavily weighted stocks due to their capitalisation. One of the early pioneers of smart beta fittingly referred to the notion of ‘fundamental indexing’. Consequently, the more popular euphemism of ‘smart beta’ is just another example of the financial industry’s amazing ability to come up with fancy names for rather intuitive concepts.
Perhaps an easier definition of ARP is to use the simpler concept of alternative beta. ARP strategies are effectively an extension to the approach of factor investing across multiple factors and asset classes – not just equities. The objective is to attract sources of returns historically referred to as alpha but which have been academically recognised as ‘hidden beta’ or risk premia. This kind of beta cannot be accessed by long-only investment approaches but instead harnesses those techniques that that have largely been employed by the hedge world – such as spread trading (long / short), the use of non-linear payment profiles (options) and dynamic exposures (leverage). ARP strategies can be defined as ‘liquid diversifiers’ due to the liquidity of the instruments in which they invest and a return profile that is designed to be lowly correlated to that of traditional assets.
Having once been considered the ugly duckling within the alternative investment universe with the invidious task of letting the beautiful hedge fund swans know that their realised performance might not quite live up to appearances, ARP has in fact grown into a beautiful white swan itself. Consequently, the concept is now establishing a very firm footprint among the global investor community, particularly since ARP strategies possess the potential to generate performance patterns which have, until recently, largely remained uncaptured, or were accessible only to the most sophisticated hedge fund managers, in a format that is also transparent, liquid and cost-efficient. But it is accurate to state that a large proportion of the ARP universe have yet to establish the length of proven track record that would entice a conservative investor (although it is worth noting that some members of the GAM Systematic team have been trading ARP for more than 14 years). Similarly, defining the size of the burgeoning ARP ‘industry’ accurately is a tough objective given our view that some ARP offerings could not accurately be described as ‘pure-play’ ARP. However, as of Q4, 2018 Cambridge Associates reported that they were monitoring a universe of 33 ARP strategies with collective assets under management in excess of USD 73 billion1 for the purposes of ongoing research – far too large, in our view, to be described as ‘niche’.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a specific security is not a recommendation to buy or sell that security. Past performance is not an indicator of future performance and current or future trends.
Important Information on Alternative Premia: Alternative Premia strategies are speculative and are not suitable for all investors, nor do they represent a complete investment program. GAM Alternative Premia products are only available to qualified investors who are comfortable with the substantial risks associated with investing in Alternative Premia. Many of the investment programs are speculative and entail substantial risks. An investment in Alternative Premia strategies includes the risks inherent in an investment in securities, the use of leverage, short sales, options, futures, derivative instruments, investments in non-US securities and “junk” bonds. Investors should recognize that they will bear index based fees and expenses at the fund level, and indirectly, fees and expenses. In addition, the overall performance of Alternative Premia products is dependent not only on the investment performance of individual indices, but also on the ability of a GAM investment manager to allocate assets amongst such indices on an ongoing basis. There can be no assurances that an investment strategy (hedging or otherwise) will be successful or that a manager will employ such strategies with respect to all or any portion of a portfolio. Alternative Premia strategies may be highly leveraged and the volatility of the price of their interests may be great. Investors could lose some or all of their investments. Investing in securities of foreign issuers involves special risks including currency rate fluctuations, political and economic instability, foreign taxes and different auditing and reporting standards. These risks are greater in emerging market countries. Leverage, including borrowing, may cause an underlying portfolio to be more volatile than if the portfolio had not been leveraged.