We believe the year 2018 will most likely be referred to as the year in which alternative risk premia (ARP) finally broke through into the mind-set of mainstream institutional investors. Once the ignored ugly duckling within the liquid alternative investment class, and considered a second class citizen to the more beautiful hedge fund swans, in our view, ARP has now grown into a beautiful swan in its own right.
At the same time, the old hedge fund notion of “alpha” is largely gone, reduced in equal part by years of mediocre returns (net of high fees) as well as their lack of diversification during challenging markets. The ascent of ARP has occurred as investors seem to have finally realised that a large portion of alpha returns can be captured by ARP investment strategies that neither hide behind a black box nor levy high fees.
So the hedge fund swans were ultimately joined by the ugly-duckling-turned-into-a-swan ARP investment approach. At this point, the challenging markets of 2018 took their toll and the performance of ARP strategies, as well as hedge funds and active management and even passive long investments, turned south. Critics are likely to conclude from this showing that ARP will experience the same downfall as hedge funds have endured in recent years.
We disagree. ARP is literally focused on extracting risk premia from markets and, unless we see a seismic shift to a new long-term state of negative returns for accepting risk, we believe the ARP concept should weather this storm. Just as the traditional global equity and bond markets have positive and negative years (albeit the latter occurring much less often), so do ARP; however, the intrinsic diversification inherent in ARP portfolio construction should mean that substantial drawdowns are less frequent.
The last time the ARP industry experienced losses within a single calendar year was 2008, at a time when the approach was still in its infancy and 99% of the current ARP providers did not have such an offering. Thus many providers (as well as many investors) simply had not yet experienced a negative year before 2018.
But it would be rather unusual if ARP as an investment paradigm never had a negative year. We believe that 2018 serves well to remind investors that ARP constitute a rather powerful way to add a systematic performance driver to any portfolio while nevertheless adhering to the principles of modern financial market theory. In our view, ARP products should certainly not be considered a silver bullet defying the laws of (capital markets) gravity with only positive returns. They are not a hedge to traditional asset classes but rather a diversifying risk allocation that is not primarily driven by the same drivers as traditional equity and bond holdings. And, over time, should deliver sound returns and diversification as has been the case in our view.
The appeal of ARP – as efficient alternative risk-taking strategies, largely uncorrelated to traditional assets – remains intact, even when soft patches of performance inevitably develop from time to time. Writing off ARP on the basis of a single negative year is like stating in 1943 “I think there is a world market for maybe five computers”, as the former CEO and President of IBM Thomas Watson famously quipped. In fact, some team members at GAM Systematic take pride in possessing a rather unique length of experience in ARP investing – having traded ARP live in 2008 (and whose ARP experience goes back to 2004) – which puts us, we believe, in a position to shed some light on, and deliver some perspective in relation to, recent ARP characteristics and performance over time.
The value proposition and return profile of ARP have led to a proliferation in the number of products and strategies offered by both investment managers and investment banks. Moreover, the variety of academic papers and publications available on the subject might have also contributed to a widespread belief that ARP is rather commoditised and could be very easily implemented. However, practitioners ARP models are actually not as generic as many investors and academics may believe. If the concept was truly commoditised, performance would be more homogenous – and it is not – and selecting a manager would only come down to fees.
2018 taught us the contrary, at least if thoughtful implementation is the intention. Choices made throughout the key areas of the ARP investment process, such as single premia model construction and then portfolio construction, are crucial in shaping the final performance outcome. A swift analysis of the spectrum of managers, the spread of returns and the ability of certain managers to consistently outperform the average ARP strategy amply demonstrates this heterogeneity. Over the last 12 months, we have witnessed market reversals, style rotations, the likely end of the new normal (zero real rates), and the return of volatility. A brief analysis of various ARP return paths over the course of 2018 also highlights that there are more stable and less stable ways to implement the ARP investment paradigm.
Overall, few asset classes were immune to the higher volatility, reversals and implications of the events of 2018. At the end of the year global stock markets returned -9.4%, as measured by the MSCI All Country World Equity index, while global fixed income fared better, but were also negative, returning -1.2%, as measured by the Barclays Global Aggregate index. Like equities and fixed income, commodities also lost ground, with the BCOM index posting a total return of -11.2% over the year, and hedge funds, as measured by the HFRX Global Hedge Fund index, posted a 6.7% decline. The alternative risk premia industry outperformed that hedge fund index with a -4.7% full calendar year performance, as measured by the SG ARP Index.
In our view, the ARP premise remains as strong as ever. ARP aims to deliver returns that do not rely primarily on global growth rates and on interest rates – the main drivers of equity and bond market performance. In fact 2018 could even support the important empirically supported premise: occasional losses are part of any risk premium based investment strategy be it active, passive or systematic.There is no dependency on some mysteriously defined alpha but solely on regular market dynamics of return offered for bearing a risk. There will be years of stronger performance and years of weaker performance in ARP and any other investment strategy.
The challenging trading conditions and subsequent dispersion of ARP returns witnessed in 2018 have underlined the need for a specialised and experience-based approach. Our view is firmly that this demonstrates how a robust investment approach, extensive research and thoughtful portfolio construction can shape future investment outcomes for the better.
*Where are you marching?