Alternatives for Institutional Portfolios

Alternative Risk Premia (ARP) portfolios have started to supplant hedge fund investments in institutional portfolios. Perceived lower cost, better liquidity, and improved transparency have diverted assets or created new demand within the alternative space. As part of the move toward factor investing, we will discuss what ARPs are and their pros and cons for investors.

What Is a Risk Premium?

A risk premium is the minimum compensation an investor expects for taking on the risk of an investment. An example is the value premium in equity markets, first formalized in academic literature by the seminal Fama-French article in 1992. A value fund aims to capture that premium using the idea that cheap stocks, based on valuation metrics including P/B, P/E and P/CF, outperform the market over the long run because they bear an excess risk. That fund’s return, however, will typically have a market beta to broad market indices close to 1.0. In other words, 100% of its return can be explained by global equity markets instead of the value premium.

Fig 1. Global value fund universe 3yr rolling beta to world market index 02-17. Source: Morningstar

Hedging Out Unwanted Risks

An Alternative Risk Premium (ARP) aims at isolating a given premium and hedging unwanted or irrelevant market risks.

The ARP version of the value premium will be market neutral—that is, it will have the market beta hedged out by selling short a commensurate amount of market index exposure. In the previous case, since the beta was 1, the manager would sell short 100% of the value of the portfolio into a reference market index (beta = 1). In doing so, the performance of a portfolio consisting of long value stocks and short the market will technically be driven by the value factor, since that would be the only driver of difference between those two portfolios.

There are subtleties to that statement covered in an equity portfolio hedging discussion, but the principle remains.

Another example is the term structure premium, which profits from a positively sloping yield curve. The term structure of interest rates leads to higher yield for risk, liquidity, and uncertainty reasons for long maturities (e.g. 10-year at 3%) vs. shorter maturities (e.g. 5-year at 2%) (here’s an example of the current US term structure).

The difference between the two yields is the term premium. In an ARP form, capturing that term premium without market sensitivity (i.e. duration) requires selling short the lower-yielding 5-year bond and buying an amount of the 10-year bond that would neutralize its duration. This duration-neutral trade will capture the yield difference between the two bonds. If the difference is large enough, the buyer benefits from a carry trade without any interest rate sensitivity.

Fig. 2. Evolution of alpha and beta. Source: Lumx Asset Management

The Ever-Receding Alpha Component of Hedge Fund Returns

In the modern portfolio theory and asset pricing models, a market premium is the explained return of a strategy or asset, the beta, while the remainder of the regression, includes alpha. Since alpha is typically the main unexplained factor, its computation depends on the definitions of beta. In stage 1 (Fig. 1) there were no indices, so no beta.

The first beta to be defined involved equity indices (such as the Composite Index, ancestor of the S&P 500, created in 1923, and the first Dow Jones index in 1884), which became broadly available globally in the ‘70s as the CAPM asset pricing model diffused from academia to financial markets, setting up stage 2. Subsequently, an ever-greater number of market indices developed for other asset classes including bonds (BBUSAggregate, 1973) and commodities (GSCI, 1991) meant that beta expanded along with passive investment solutions.

In the 1990s, following the Fama-French article on market factors (1992), value indices appeared (MSCI World Value, 1997) and introduced the ability to identify equity risk premia in asset pricing models, reducing further the alpha in their regression in stage 3.

The Rise of Equity Risk Premia

Concurrently, equity market neutral hedge funds implemented hedged versions of equity risk premia, setting the stage for the first delivery in mid-2000 of Equity ARPs, Value, Low Beta, Quality, Momentum, and their contested cousin, Size.

An ARP, delivered as an index, replicates the performance of a systematic strategy designed to capture the premium. In our value example, we’re buying the cheapest 20% of stocks of the S&P 500  based on P/B monthly and selling short the index for the same amount every Friday at the close. The buyer thus has a guaranteed exposure to that premium, as the counterparty, typically an investment bank, promises to pay the performance of the index daily.

From Equity to Multi-Asset Risk Premia

In the last five years, the universe of investable ARPs has further expanded to encompass thousands of options distributed by a dozen investment banks and some asset managers. By allowing investment in those indices, the industry has further reduced the variety of alpha available in stage 4, which has highlighted the structural, alternative beta nature of hedge fund returns, even though their fees are only justified by the large alpha they supposedly generate.

Hedge Fund and ARP Cohabitation

A typical diversified fund of hedge fund has a beta of 0.67 (and identical correlation) to a diversified alternative risk premia index. The remainder is explained by returns attributable to trading skills, i.e. managing the portfolio of premia efficiently or reducing their implementation costs, and liquidity premia including event strategies, corporate, or structured credit selections, which are not replicable in the liquid form required for daily ARP delivery.

The more liquid strategies are often, ex-post, replicable with a selected portfolio of ARPs. Out of sample, the results are less potent because managers adapt to their market environment and the observation can take months to appear in the performance path. Hence, an investment in an ARP portfolio should not aim to replicate a hedge fund portfolio. An ARP portfolio will have the diversification benefits expected from an alternative investment, albeit in a more liquid (daily vs. monthly or more), less costly (from half price to 15%), and fully transparent form given the right setup—all arguments raised against hedge fund investing by institutions.

Hence, an alternative portfolio can aggregate 65% of ARPs, and 35% in hedge fund methodologies that diversify the ARP makeup, including trading strategies and liquidity premia, or strategies trafficking in inefficient markets such as credit or emerging countries. An alternative portfolio with such a structure will have better expected risk return, lower fees, and improved liquidity over a traditional hedge fund portfolio. Due to the shorter live track record of ARPs, however, caution is required before diving in fully; starting with a test program is smart.

Keeping Open Eyes When Investing in Bank ARPs

Investing in ARPs seems simple and effective. However, the resulting portfolio, while by nature hedged, can have significant leverage to reach an attractive return. With a Sharpe ratio of 1, a 6% return target will lead to a portfolio that can have 4x to 8x notional exposure. Hence, good risk management and an intimate understanding of the portfolios’ behavior are both essential.

Also, past performance gives little indication as to the behavior of an algorithm describing an index. In our database, comprising 1,000-plus indices, less than 20% were live before 2012. Moreover, 20% initiated in the last 18 months, the track records before that being back tests. Many suffer from the bane of backtesting, optimization, so that the performance is attractive in key stress moments to prospective investors.

Hence, basing the portfolio construction and risk management of the portfolio solely on such an input will only lead to larger losses than expected.

Conclusion

The recent development of ARPs provides an opportunity for sophisticated investors to invest in a liquid alternative portfolio without the negative stigma attached to hedge fund investing. Their breadth and accessibility provide investment managers with a large toolbox to construct alternative portfolios, or to serve as a strong liquid base complementing hedge fund strategies.

ARPs are nonetheless complex to master, and bear risks that may not be well captured with basic performance-based risk management tools. Hence, such management needs to be the preserve of investment professionals with the ability to monitor the investments properly.

About the Author

Eric Bissonnier started his investment career in 1992 in cross-asset and multi-currency portfolios. In 1998, he joined a hedge fund specialist and invested in hundreds of hedge funds for institutional clients of the firm. In the last five years, he expanded alternative investments into alternative risk premia, blending systematic and discretionary processes. Mr. Bissonnier holds a master’s in Economics from the University of Geneva and is a frequent speaker on asset allocation, hedge funds, risk management, and risk premia.