The trouble with alternative risk premia strategies

Alternative risk premia strategies are gaining popularity, but there are some drawbacks

The trouble with alternative risk premia strategies
With traditional investments failing to meet investors’ expectations, more funds are exploring factors such as momentum, value, and volatility entering the market. Related to factor investing, alternative risk premia [ARP] strategies are gaining favour in the investment industry — though they have some limitations.

“[P]ortfolios combining multiple alternative risk premia are among the few investment options that offer not only high return potential but also meaningful portfolio diversification,” said PIMCO strategist Ashish Tiwari in a recent note. “Generally lower fees and better liquidity terms than traditional hedge funds further add to their appeal.”

According to Tiwari, these strategies also may be easier for investors to understand and monitor than traditional, qualitative investment strategies. However, the sheer volume of potential ARP strategies may be overwhelming for them.

“More than 300 alternative risk factors have been identified in academic literature,” said Brad Guynn, another strategist from PIMCO. “When contemplating an ARP allocation, we believe investors should be highly selective.”

According to Guynn, ARP allocations should be done selectively. Strategies that lack a reasonable economic explanation behind their existence or the returns they have produced should be regarded with scepticism. Conservative assumptions for transaction costs should also be made when determining the potential returns from a strategy. Finally, for true diversification, Guynn suggests focusing on strategies that are truly divorced from traditional market exposures.

Of course, diversification through ARP strategies is not always achieved or desirable. For example, trend-following strategies, which take long and short positions on securities based on price trends across different asset classes, achieve long-term returns because of occasional big wins that make up for many smaller losses.

“In order to both diversify portfolios and increase the probability of capturing these large moves, many managers try to maximize the number of markets where the strategy is run,” Guynn said. “However, this ‘kitchen sink’ approach may result in allocating to highly correlated markets. Furthermore, shifting toward less-liquid instruments may also increase transaction costs without significantly diversifying the underlying exposures.”

Transaction costs aren’t just an issue for short-horizon strategies that rely on frequent trades. Some less-liquid strategy implementations may also entail high costs for entering and exiting positions. The cost of shorting single-name equities can also surge during times of market stress, further eroding returns for some equity strategies.

Solutions that integrate different ARP strategies may offer benefits compared to those that just take one factor into account. As an example, Tiwari cited the use of value and carry, two sources of long-term returns, when owning cheap commodity assets and waiting for them to return to fair value. “[I]ntegrating value and carry allows for dynamic allocation between them in proportion to their relative attractiveness,” he said.

According a survey of 200 institutional investors done for BlackRock, more than US$300 billion in assets were invested in ARP strategies as of 2016.
  

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