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Alternative risk premia: a 10-year study
Lars Jaeger
Two developments are capturing the imagination of a broad investor base: smart beta and new ways to allocate between asset classes and return drivers. Recent research from GAM shows how the two can be combined with quantifiable benefits.
The research note ‘Alternative Risk Premia – A New Generation of Alternative Investments in Liquid, Cost-efficient and Transparent Form’, follows recent work by the global bond manager on alternative beta strategies and hedge fund replication, which are similarly hot topics among big investors internationally.
Lars Jaeger, GAM’s head of quantitative research in its alternative investment solutions unit, says that the two concepts are allowing a broader investor base to access performance patterns previously accessible to only the most sophisticated hedge fund managers.
“They provide a better balance between fees charged and performance achieved,” he says, “enabling money managers to navigate more safely through the hazardous waters of today’s investment environment of record-low bond yields and extended equity valuations.”
Basically, the concepts are twists on the two fundamental paths generally travelled in the search for consistent returns – alpha and diversification. Systematic returns from the use of factors within markets – exploiting the alternative risk premia – offer a similar promise as alpha but from a very different source. While they are not free from possible systematic risk, those risks are not from broad equity or bond markets, therefore offering diversification.
In his latest research, Jaeger has used a ‘live’ track record going back 10 years, including his time at another manager, Partners Group. It does not involve theoretic backtesting.
The risk premia in the portfolio cover value, momentum and carry (which includes volatility). The results are compared to a conventional long-only risk-balanced equity and bond portfolio. Allocations across various components was, in both cases, based on an equal risk-weighting scheme using volatility as the measure of risk.
The traditional risk-balanced portfolio generates a return of 5.3 per cent a year between October 2004 and October 2014. The same portfolio including alternative risk premia generates 8.3 per cent a year.
“The explanation behind the performance enhancement is simple: diversification into the new return sources provided by liquid alternatives,” Jaeger says.
But it is not quite as simple as it sounds. History can teach us a few things, Jaeger says. Flight-to-quality scenarios, such as in 2008, are challenging for many alternative risk premia, while trend-following strategies perform best. But when markets exit those conditions, such as in 2009, and available risk premia are still at elevated levels, those trend followers would give back some of their gains.
Jaeger says: “While hedge funds have traditionally been sold as both performers and diversifiers, their structural problems, in particular their fee load, have at times stood in the way of living up to their true potential. The concept of alternative risk premia, on the other hand, has the potential to finally live up to both traditional promises.”
