Alternative Risk Premia (ARP): What Are They?
We’re in an environment where cash rates and bond rates don’t yield much, if anything, in the developed world. Stocks are also expensive as market participants don’t really have much in the way of alternatives in terms of where to store their wealth. The traditional 60/40 asset allocation mix is not likely to perform well. So, in recent years, investors have broadened their search for returns by looking for non-traditional, or ‘alternative’ risk premia (ARP).
Many alternative risk premia (ARP) strategies have been implemented by institutional investors like hedge funds.
These entities look to develop asset allocations to mitigate mark-to-market volatility and can potentially profit from the market going in either direction through long-short portfolio strategies.
In this article, we’ll cover a few of the latest developed in the ARP space in a Q&A type format.
What are alternative risk premia strategies (ARP) and why are they becoming popular?
Alternative risk premia are similar in concept to “smart beta” strategies, which most traders and investors are familiar with.
Smart beta is designed to outperform a market cap weighted stock index by having higher returns at the same risk, the same returns at less risk, or some permutation where the risk-adjusted returns are superior to the traditional all-stocks portfolio.
Smart beta is generally accomplished by re-weighting stocks in an index based on common investment themes.
For example, an index might overweight the less volatile utilities and consumer staples stocks relative to cyclicals or consumer discretionary stocks. This is a standard left-tail risk mitigation strategy on its own outside of ARP.
Based on research done among both academics and institutional investors, the idea behind building smart beta portfolios follows the fact that certain traits or “factors” associated with certain assets lead to better risk-adjusted returns, especially when blended together well.
This might include factors like:
– low volatility (comparable returns at lower risk)
– value (lower P/E, or higher earnings or cash flow relative to price)
– size (bigger companies are more diversified with more stable cash flows)
ARP strategies have similar roots.
They involve isolating common investment themes by alternative asset managers.
They, however, typically differ from the more passive smart beta strategies by looking at the forward returns of various asset classes then layering factoring investing on top of it.
Portfolios are generally long-short as opposed to the more typical long-only strategies in smart beta allocations.
This generally means ARP strategies have a beta of around zero (i.e., agnostic on asset class direction) by having a long-short slant to the portfolio. In turn, this also creates a new type of asset class.
And it’s also why alternative asset managers vie to create quality products around them. Their investors don’t want to pay for beta, which is free.
Over the last decade, ARP strategies have attracted over $200 billion in assets.
What are the benefits of alternative risk premia strategies to investors?
The biggest risk in most people’s portfolios is equity risk.
Even among many institutions, like pensions, they will typically allocate their money in equities or equity-like asset classes (e.g., private equity, real estate) up to a level of volatility they can stand, then sprinkle in other asset classes – mostly bonds – for the remainder.
Even if the portfolio is something like 60-65 percent stocks and 35-40 percent fixed income securities, the equities portion is more volatile and thus constitutes about 90 percent of the portfolio’s overall risk despite it seeming more or less balanced in basic capital allocation terms.
So, investors like pension funds and others following equity-centric approaches are looking for a few different things:
i) Wanting to diversify away this equity risk, which tends to be concentrated.
ii) They want to reduce portfolio volatility. Or if they do take on higher volatility, they want to be sure they’re getting returns commensurate for taking on that risk.
iii) Find additional sources of returns. And naturally when you find sources of returns that are ideally as uncorrelated as possible to other types of returns, then your reward relative to your risk goes up in terms of the ratio. We explained the mathematical nature of this in a separate article.
ARP portfolio strategies look to deliver returns that are independent of the equity and fixed income markets to provide this source of diversification.
An ARP strategy that’s designed to go after the low volatility premium – i.e., that low volatility stocks provide superior risk-adjusted returns to high volatility stocks – would:
a) go long low volatility stocks
b) hedge out the equity risk by shorting high volatility stocks
Hedging out the equity risk would effectively get rid of the beta in the portfolio.
However, the investment manager may not necessarily hedge them based on equal dollar amounts but rather based on their risk.
For example, let’s say the “low volatility” stocks group has an annualized volatility of 15 percent while the “high volatility” group has an annualized volatility of 30 percent.
In terms of the raw dollar amount, the manager could own twice as much of the low volatility stocks relative to the high volatility group and effectively hedge out the equity beta to turn it into a portfolio exclusively of the “low volatility” factor.
And let’s say the low volatility group has an expected return of four percent per year. (The four percent expected returns might seem small, but in comparison to cash and its zero returns, the Sharpe ratio of four percent equity returns off 15 percent volatility is 0.27 (4 divided by 15)).
And let’s say the high volatility group has an expected return of six percent per year.
So, our expected returns would be, following the idea we’d buy twice as much of the low vol stocks as the high vol stocks given the expected volatility differential
Expected returns = 0.04*2 – 0.06*1 = 2 percent
Two percent doesn’t seem like much, but that ARP strategy is essentially trying to be market neutral. Plus investment managers typically use leverage, with 4x to 6x leverage being common among hedge funds.
By pursuing this type of strategy, the investment manager is trying to isolate the “low volatility” factors so that investors are only exposed to that type of premium.
And of course, the actual returns figure is likely to be a bit different than two percent. There will be times when the high volatility shorts outperform the low volatility longs (and vice versa).
ARP strategies are intended to be transparent and liquid – at least more liquid that what you often see in many alternative asset management portfolios (e.g., private equity, venture capital).
This further enhances their attractiveness as part of a diversified portfolio.
How can alternative risk premia products be evaluated?
Bloomberg and Goldman Sachs Asset Management recently came out with the Bloomberg GSAM Risk Premia Indices.
The indices not only keep track of a representative sample of ARP strategies but are also investable.
The idea behind the benchmark is that investors lacked a way to evaluate how ARP products are doing relative to other styles to help ascertain their risk and return.
Alternative risk premia indices currently exist in the marketplace, but they tend to aggregate the returns of various ARP managers. This creates more of an overview of various peers, not a true benchmark that has the transparency that investors want in one.
The idea of indexing ARP is new.
Equities went from being indexed to going more into smart beta. Comparing smart beta to an index was easy because various equity indices already existed (e.g., S&P 500, NASDAQ, Dow Jones, Russell 2000, etc.).
ARP went into execution before a standard benchmark or index was developed unlike traditional equities.
Accordingly, investors have been unsure as to how to benchmark ARP investment managers when it comes to their performance and how to analyze their strategies for return and risk potential.
Would it be appropriate to index them to standard equities strategies, or is the risk and return different to a point where ARP deserves its own index?
For example, fixed income managers are often indexed to the following:
- Barclays Capital US Aggregate Bond Index
- Barclays Capital US Corporate High Yield Bond Index, or
- Barclays Capital US Treasury Bond Index…
…depending on what they do. A strategy based on developed market government bonds is very different than distressed credit.
Indexing fixed income strategies to the S&P 500, the standard performance comparison index for equities managers, would not be appropriate.
Moreover, with ARP, there is a wide dispersion in how these strategies are implemented.
Naturally, this means there’s a wide dispersion in returns.
Some ARP investment managers apply it with respect to different asset classes. Some may apply it singly to equities, fixed income, or others.
Others may mix different asset classes, such as risk parity without the individual beta in each asset class. There are numerous different ways the strategy can be applied while still fitting into the ARP category.
Bloomberg partnered with Goldman Sachs as a way to design a range of indices that could help address the challenges associated with benchmarking ARP strategies.
This is done by deriving a consensus of how to define manager performance and how it can be measured.
If ARP indices are transparent and replicable, they can help to understand performance of alternative risk premia strategies over time as well as offer low-cost beta to the asset class.