11 February 2020
Key differentiators across Alternative Risk Premia (ARP) offerings continue to come from choices in diversification across a broad set of liquid strategies, experience in the development, implementation and continuous retesting of models, and the choices in risk framework for portfolio construction. GAM Systematic’s Lars Jaeger suggests these are likely to continue to prove key differentiators in the years ahead.
Alternative Risk Premia moved into a mainstream investment paradigm around 2014 when dozens of products popped up in a short period of time, and this trend continues today. These products often come from rather unexpected places: traditional asset managers, investment banks, (former or still active) hedge funds and fund of funds. However, alongside the impressive growth of the ARP industry, a second development has started to unravel in front of investors’ eyes, which is generating some confusion.
In an industry where, due to its systematic nature and generic definition of its return sources, one could expect a rather uniform, if not commoditised offering, empirical evidence and recent results have showed quite the contrary. ARP managers as a whole actually display significant performance dispersion (see chart 1). In the challenging markets of 2018 in which ARP performance broadly turned south and the average manager experienced losses of some 6%, differences across various providers were significant. Some managers were down 15%; others came close to being flat. In the much more benevolent environment of 2019 where the average manager secured gains of around 3-4%, dispersion was no less significant. Double digit losses, although rarer, did occur, while other offerings locked in double digit gains.
The excitement that came with all the new offerings, each with its own claim for unique expertise, stirred up a lot of dust obscuring a clear view. That dust has now started to settle, and the performance pattern of the last 24 months yielded some interesting results. An environment that witnessed changing market conditions, trends breaking and styles rotating saw some ARP managers consistently outperforming their peers. So, what are the grounds in assessing what makes a good ARP manager or at least a better performing manager? It is, in our view, choices made throughout the key areas of the ARP research and investment process: strategy and style selection, individual strategy implementation choices, and portfolio construction. All three areas are crucial in shaping portfolio risk profile and performance outcomes. The quality check of a manager thus stretches along three dimensions:
- Diversification choices
- Model implementation
- Portfolio construction methodology
Chart 1: Performance dispersion of ARP managers
Past performance is not an indicator of future performance and current or future trends.
The beauty of ARP lies in the diversification potential it offers. Its universe stretches over styles and asset classes covering such distinct strategies as equity value and commodity carry, FX trend and merger arbitrage, bond carry and FX value. Each of these strategies offers its own distinct return drivers. And while they each barely come with Sharpe ratios higher than 0.3 it is their combination that brings an overall ARP portfolio’s risk-return ratio closer to the desired range of 1 while not being highly correlated to traditional markets if the premia are structured thoughtfully.
It is surprising to observe how many products in today’s ARP industry take rather less advantage of the diversification potential ARP offers. This can be observed when looking at 2018 and 2019 performance patterns. An especially poor performance in 2018 combined with middling performance in 2019 is in some cases a reflection of a momentum (or trend following) bias in the portfolio, as this reflects how the momentum style did in the last two years. One can see that same pattern even on an intra-yearly basis in 2019. The month of August was an especially strong month for momentum, while that very style suffered severely in September and especially October (mostly due to reversals in bond yields). The reader is invited to apply such information when evaluating performance across the ARP space. Another bias – or lack of breadth within portfolios – is reflected in portfolios that suffered throughout 2018 and 2019. These were likely overly allocated to equity risk premia, especially to the equity value premia, which displayed very poor performance over both years. Individual months of surprisingly strong performance for these portfolios – even while their full year performance was weak – provide a further hint that this equity bias is likely a driver; September 2019 proved to be an exceptionally strong month for equity value. Again, the reader may draw her or his own conclusions about breadth and implementation and allocation choices when evaluating individual managers’ performance.
Where do such allocation biases come from? Their origins often seem to lie in the background of the respective portfolio manager and their resulting comfort zones. Alternative risk premia managers can be broadly separated into two categories: those with roots in traditional asset management companies, and those with a (mostly quantitative) hedge fund background, now seeing the opportunity to reposition part of their product offering in ARP. While the former – traditional managers – often have a strong equity factor lens and especially a value lens, the latter come with a trend following or momentum lens as that has driven much of their historical returns. So, the biases are, respectively, coming to ARP with an equity lens and coming with a trend following lens. Sticking to your comfort zone, however, can yield undesirable portfolio biases because as a minimum portfolio breadth will not be maximised and at worst your comfort zones could be the overweighted epicentres of underperformance.
The long-standing academic credibility of ARP strategies is as important as their reliance on data and computer science to define their specific harvesting algorithms. In combination, these traits – academic literature implemented with the rigour of data science – have created what we at GAM regard as an erroneous impression that ARP building blocks and portfolios are homogeneous and commoditised. This incorrect conclusion of homogeneity has been further reinforced by the use of similar categorisations by style (momentum, value, carry) – in other words, a shared risk premia phrasebook.
It is now evident to all managers and investors, given the dispersion in performance outcomes, that the process of successfully harvesting single risk premia requires experience, considered choices and constant attention to detail. For instance, it may appear easy to employ generic momentum models to extract risk premia from FX or commodity markets. But it is indeed complex to decide which specific contracts to consider, how to integrate them into an actual strategy and how to specifically trade them at low cost.
We believe there are five essential elements or blocks that any ARP manager will (consciously or unconsciously) have to consider in building each ARP strategy: 1. definition of the eligible investment universe; 2. choice of modelling data to be considered; 3. choice of signals for position taking; 4. portfolio construction; and 5. risk management. Some choices generate relatively minor differences, while others may have a substantial impact on overall exposure, risk profile and performance, thus creating dispersion among investment managers harvesting the risk premium before we consider the aforementioned portfolio construction choices and biases. Often expectations of outperformance potential are placed on the step of signal generation. However, this is only one out of five key steps. A sole focus on this one step can lead to overly complex models (subject to over-fitting) that do not cope well in the noisy realm of capital markets reality. We stress that each step is important and will contribute to the investment outcome. Lacking consideration of one or several of them can be the origin of suboptimal performance of the individual risk premia.
Another point is that markets evolve, investor behaviour changes and risks change, so if models are not thoughtfully reassessed over time the likelihood of being left behind in the race to find rewards for absorbing risk can increase. At the same time it is essential not to be fooled into creating and believing overly optimistic, over-fitted, back-tested results.
In terms of portfolio construction, sizing and timing of exposures, many traditional asset classes have clear ties to the prevailing macroeconomic environment, so an assessment of the latter might lead to interesting timing opportunities. But can the same be said for ARP? Is there an optimal point in time in which to invest in ARP? The short answer is: No. The long answer is equally: No. Timing risk premia is challenging and the empirical data reflects this. The construction and implementation techniques in ARP portfolios entail a rather complex (and non-stationary) mix of the underlying asset classes, and as such timing remains difficult and of uncertain value, in our researched view. The sole certain effects of such an exercise remain concentration (or increase of potential tail risk) and increased turnover (which lead to increased trading costs).
In traditional equity and fixed income markets, 2019 was an ideal year to be fully invested, despite pockets of volatility and potential worrisome catalysts; traditional beta shone. It is generally agreed that we are closer to the end of the economic cycle now. The increases in volatility, “risk off” moves, and potentially a turning point in the global economy moving closer, are concerning for traditional beta, but do not change our fundamental outlook for ARP. On a forward-looking basis, moderating global growth, rates uncertainty, dispersion, and healthier volatility levels generally may lead to steady state expected returns in the ARP space.
Source: GAM unless otherwise stated. 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. Past performance is no indicator for the current or future development. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.
Alternative Premia strategies and other systematic investment 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 an 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.