ARP strategies have a low correlation with traditional asset classes
- Alternative risk premia (ARP) can provide a source of return to pension fund investors
- ARP funds extend the approach of factor investing across multiple factors and asset classes
- Investors should be aware that ARP strategies may experience double-digit drawdowns at some point
- The most common spot for ARP is within hedge fund portfolios
Elevated equity market valuations and potentially rising bond yields suggest the future return environment for traditional risk assets could be difficult. Faced with this challenge, pension fund investors are seeking alternative sources of return. Alternative risk premia (ARP) strategies – which harvest well-established risk premia and market anomalies across asset classes – may fit the bill.
ARP strategies have exhibited low correlations to traditional asset classes and demonstrated reasonable resilience in times of equity market stress, particularly relative to other diversifying assets. Although live track records are short and any conclusions drawn from back-tested data should be viewed sceptically, investors may find that these liquid and cost-effective strategies deliver diversifying characteristics comparable to traditional safe-haven assets.
Based on limited euro-denominated fund data, ARP strategies have improved the risk/return trade-off in a balanced portfolio setting better than other liquid diversifying strategies, and they have exhibited strong, and relatively stable, diversifying characteristics relative to equity markets. Fees and liquidity are also appealing.
ARP funds extend the approach of factor investing across multiple factors and asset classes. This extension means these funds are less exposed to any one individual risk factor. Individual factor performance can be cyclical and difficult, if not impossible, to time. However, correlations across factors have historically been low, meaning factor combinations within a single portfolio may produce a smoother return profile and diversifying characteristics versus other components in pension fund portfolios.
Most ARP funds apply multiple factor approaches across equities, commodities, fixed income, and currencies. Typically, these funds target four main factors – value, momentum, carry and quality (figure 1) but they may incorporate other risk premia or market anomalies into their strategies.
ARP strategies are often categorised as liquid diversifiers owing to their relatively accommodative liquidity terms (often weekly or monthly) and generally low correlation to traditional assets. Other liquid diversifiers that European pension funds invest in are trend followers, safe-haven currencies (dollars, yen and Swiss francs), absolute return diversified growth funds (absolute return DGF), and gold.
Over a five-year time period (April 2014-March 2019) which was characterised by low volatility and strong equity markets, adding a 20% allocation to ARP strategies into a balanced 60/40 portfolio slightly improved risk-adjusted returns, reduced market beta exposure and produced the highest overall Sharpe ratio compared with the addition of other diversifying assets (figure 2). The inclusion of safe-haven currencies or gold produced better returns, albeit at higher volatility levels.
However, a balanced 60/40 portfolio without liquid diversifiers performed better on both an absolute and risk-adjusted basis than a portfolio including diversifiers. This outperformance is unsurprising considering the bull market conditions of the period in question. If faced with more challenging market conditions, a diversified portfolio, incorporating liquid diversifiers, would be expected to generate better downside protection.
ARP funds may be most complimentary to an equity-heavy portfolio. They have a modest correlation (0.4) to the MSCI World index which suggests these funds could play a complementary role in an equity-dominant portfolio. For portfolios with high allocations to corporate bonds, macro and trend following strategies, the benefits of adding an allocation to ARP funds is less clear, as correlations to these asset classes are significantly higher.
When considering an allocation to ARP strategies as a portfolio diversifier, the beta persistence of the underlying fund should also be considered. For a fund to be a good diversifier, a consistently low or negative beta to other asset classes would be necessary, especially in times of market stress.
A fund with a wide beta range may be sub-optimal in providing diversified returns at the most important times. ARP funds have demonstrated decent diversifying characteristics to an equity-dominant portfolio with an average beta to the MSCI World index of 0.12. However, there has been a slow but steady increase of ARP funds’ market betas in recent years, which may serve to reduce diversifying characteristics of ARP funds going forward.
Diversified hedge fund strategies and macro strategies have relatively stable betas to developed equity markets while diversified fund-of-fund strategies have demonstrated the highest average beta. In contrast, pure trend-following strategies have a wider beta range and have tended to run with lower absolute market beta of 0.08 indicating the strongest diversifying characteristics over time.
The ARP fund universe encompasses a wide range of return and volatility profiles, meaning manager selection is important. The level of targeted volatility and leverage, as well as the degree to which factor weightings can change, affects ARP fund performance. As a result, ARP funds are not highly correlated with each other. In fact, the average pairwise correlation of the funds in the ARP universe considered is less than 0.4, meaning fund performance can vary significantly across funds.
There are several considerations investors should be aware of when assessing ARP funds. Much of the data released by ARP funds is unaudited and composed of back tests or short time periods. Investors are recommended to approach the space with caution and treat back-tested results with a high degree of scepticism.
Fee structures also vary across ARP funds, although they are generally reasonable compared with traditional hedge fund partnerships. Management fees typically range between 0.5% and 1.0% and many funds charge no performance fee.
Given these lower fees, the inclusion of ARP strategies in hedge fund allocations can help to reduce overall fee levels. However, investors should also consider fees in the context of the level of volatility targeted and consider how that target compares with realised volatility. The cost per unit of volatility can vary by fund, as ARP funds may target different volatility levels despite charging similar fees. Investors should consider volatility adjusting the manager’s targeted returns to ascertain whether headline fees are, in fact, as reasonable as they appear.
Investors should be aware that ARP strategies may experience double-digit drawdowns at some point. Shocks to the strategy have yet to occur over the limited time frame that most products have been in operation. A realistic drawdown for a 10% volatility strategy would be between 15% and 20% at some point during a market cycle.
ARP strategies use leverage and investors should not be surprised to see long-plus-short (gross) exposures in the 500-900% range, or even higher, while net exposures are generally low. Considering the significant use of leverage, investors should be aware that ARP strategies are not low-risk strategies, and any large-scale market de-leveraging may adversely affect these strategies.
Several of the earliest-launched ARP funds have had such success in raising capital that they are now closed to new investors. As more assets enter this space and as more managers cap their capacity, investors may find it challenging to access the highest-quality funds.
For those investors who decide that the diversifying and liquidity characteristics of ARP funds are appealing, an additional question might be where such funds should sit in a portfolio. The most common spot is within hedge fund portfolios, owing to their low correlation, broad asset class reach, and volatility-targeting approach.
Investors also assign ARP strategies to a diversifying strategy bucket or alongside traditional safe-haven assets. Although their return profiles may encourage some investors to pair them with bonds, they are not fixed-income alternatives and could perform much differently to bonds in a crisis. The decision is ultimately up to each investor, but for many, placing an ARP fund in the hedge funds allocation alongside other absolute return strategies may be most appropriate.
Trudi Boardman is a hedge fund specialist consultant at Cambridge Associates