Risk diversification ‘on’
Increasing sophistication and understanding of risk premia is leading to new approaches to combine them in a portfolio, writes Joseph Mariathasan
At a glance
• Diversifying across risk factors rather than asset classes is said to determine return outcomes.
• Hedge funds claim to do this, but include market beta.
• Market beta, smart beta and exotic beta along with alpha provide sources of return.
• Market beta and smart beta can be obtained cheaply.
• Diversifying across a range of risk factors is possible but needs to be done systematically.
One of the most important lessons learned from the global financial crisis of 2008 was that “diversification across assets does not necessarily imply diversification across risk factors and it is risk factor diversification that determines return outcomes, especially during systemic risk events,” says Andrew Weisman, CIO of Janus Capital Management’s liquid alternatives funds.
As he goes on to point out, the vast majority of investment portfolios performed very poorly during the financial crisis primarily owing to a concentrated exposure to the equity risk premium. The solution would be to diversify across risk premia and the ability to do that has been the core investment proposition of the hedge fund industry. Hedge funds have historically attempted to justify their higher fees by claiming to offer attractive returns uncorrelated to the broader sources of risk that dominate investors’ portfolios.
There is certainly an element of truth in that, but few hedge funds are able to achieve it. As Matthew McBrady, the CIO for BlackRock’s multi-strategy hedge fund platform points out, many hedge fund strategies exhibit meaningful beta exposure to most market indices: “This suggests that investors are potentially paying hedge fund fees, at least in part, for returns that resemble easily accessible market returns.”
Towers Watson has met thousands of hedge funds over the past 15 years but has invested in fewer than 50, according to Damian Loveday, head of the diversified strategies team.
“Investors are now asking ‘what am I paying for with a manager? How much of that exposure can I get through cheaper risk premia products’,” says Bruce Keith, CEO of InfraHedge. What is worth paying for they would argue, is true alpha, but what institutional investors are being offered is usually overloaded with exposures to risks that can be accessed in much cheaper ways.
Investment returns in any strategy can best be described as comprising distinct components: the most straightforward is market beta; another is what can be broadly described as alternative beta, which McBrady splits into smart beta and exotic beta; finally is true alpha. As institutional investors and the capital markets have become more sophisticated, the pricing of market beta products has plummeted although there are certainly still many long-only active managers able to charge active fees for essentially index-plus strategies.
Similarly, McBrady finds that many hedge funds, particularly long/short equity, still derive a significant portion of their returns from exposure to risk factors. Once the exclusive province of active managers and hedge funds, these approaches exploit anomalies or risk premia that have historically generated positive returns (value, quality, size or momentum). These strategies occupy a middle ground in the continuum between active and passive investing and can now largely be accessed via low-fee and high-capacity products such as ETFs.
True alpha lies at the other end of the spectrum. It represents the returns managers generate that are not attributable to market risks or systematic anomalies. Security selection alpha, for example, represents the returns managers generate that cannot be explained by underlying market exposure, style factors, or recent stock price performance.
McBrady sees long/short equity funds as offering one of the best sources of security selection alpha available to institutional investors. Even so, he cautions that the market is dominated by funds that persist in having a 30–40% net-long position, so their security selection alpha often comes stapled together with quite a lot of equity beta. Furthermore, he adds: “While virtually all managers claim they add value through timing their underlying market exposure, analysis shows that this is rarely the case.”
McBrady’s exotic beta lies between true alpha and smart beta. It is a form of risk premia strategy, which, combined with smart beta-type risk premia, lies behind both many hedge fund and much cheaper active quant strategies. Like smart beta, exotic beta strategies exploit systematic risk premia and explain a meaningful portion of hedge fund returns. While typically expressed in terms of rather opaque and complicated sounding hedge fund strategy names, McBrady argues that, at core, all exotic beta strategies amount to simple compensation earned by investors for being willing to take on exposure to non-market (or ‘exotic’) risks or for providing liquidity to other classes of investors.
In contrast to smart beta, these strategies are often more complex to analyse and difficult to access, providing significant barriers to entry. Examples of exotic beta strategies include providing catastrophe reinsurance and merger arbitrage, where investors earn for providing insurance for ‘deal-break’ risk.
The other major category is liquidity provision. While liquidity premia are often associated with assets such as private equity, private real estate, and privately originated loans, liquidity provision is also the core driver of higher frequency statistical arbitrage returns. In some cases, strategies also exploit both sources of value. Distressed investing offers a great example. Distressed investors take on exposure to the complex risks that firms and their investors face as they navigate complicated bankruptcy procedures. They also essentially provide liquidity to the previous owners of a company’s debt who are often prohibited by investment guidelines from holding distressed securities.
What more sophisticated investors are increasingly doing, according to Keith of InfraHedge, is to invest in risk premia products such as smart beta ETFs and then ask their hedge fund managers to produce much more concentrated portfolios: “The hedge fund manager may have 20 high conviction bets in an equity long/short portfolio, but he may then be adding 30 more for diversification. The investor does not need that if he just wants access to the hedge fund alpha.”
Seeking true alpha in hedge funds may be very difficult, while accessing alternative beta via hedge funds is straightforward but arguably overpriced. The smart beta ETFs that are now flooding the market offer what appears to be cheap exposure to specific risk premia mentioned above – value, momentum, small-caps and low volatility stocks. While this perspective does have some logical appeal, Weisman of Janus raises issues that also need to be considered: “What is a low cost provider?” he asks. “When dealing with single risk factor swap or ETF providers it can be very difficult to precisely determine the actual fees being paid by the investor. While there may be a low quoted number for the product there can be substantial undisclosed revenues that are being earned by the provider such as securities lending revenue and brokerage transaction expenses. In many cases the additional revenues can amount to 200bps or more in undisclosed revenue that is being earned by a provider.”
Another issue with smart beta products, as Thomas Kieselstein, CIO of Quoniam Asset Management argues, is that exposure to just one or two of these risk premia, or a handful at most, offers a limited opportunity to generate extra returns. Moreover, some risk premia such as low volatility, which has come into prominence only over the last five years or so, may prove to be short lived as the markets arbitrage them away.
Quoniam has attempted to get round this recently with the launch of a diversified approach to risk premia investing that aims to achieve returns of 6% per annum with 6% volatility and long-only fee levels. Its approach isolates 13 independent risk premia. For example, taking advantage of the small-cap effect with a portfolio of small-cap equities also gives a high exposure to equity markets as a whole. By having a small-cap portfolio and hedging out the equity market beta, the exposure can be limited to the size effect and the risk capital released can be used to leverage the exposure.
Other risk premia can be isolated in the same way. Examples include the carry premium obtained by investing in high-yield bonds and hedging out interest rate exposure and commodity momentum plays whereby the portfolio goes long positive momentum and short negative momentum. Quoniam’s group of risk premia encompasses predominantly what McBrady would class as smart beta, as well as ideas such as low volatility stocks or value in both traditional and alternative asset classes and also risk premia associated with long/short strategies in dimensions such as value, yield curve plays, size and momentum.
What it sees as common to all is that they should be independent of equity markets and have a low correlation with each other. The risk premia are combined on an equal weighting which can be thought of as a sophisticated form of risk parity based not on the volatility of simple asset classes, but on the volatility of the risk premia. “Portfolios can include all the risk premia, or just those that are independent of equity markets to act as a complement to an existing portfolio,” explains Kieselstein.
For institutional investors, accessing market beta and smart beta risk premia is straightforward. Accessing exotic beta and alpha is difficult, expensive and often highly capricious. But this may be changing: “We have been working over the last year with a manager who could deliver M&A risk premia in a new repeatable way,” says Towers Watson’s Loveday. Structuring robust portfolios using a risk premia approach is certainly worth considering as it does appear to be possible to have both relatively attractive fees with a performance that satisfies objectives. But as Weisman argues, in the final analysis, when dealing with well-documented risk factors, the devil will be in the detail.
The selected risk factors should be relatively statistically independent or they should not be included. The implementation of each risk factor should be well engineered and incorporate appropriate money management protocols; most notably the inclusion of a process by which the volatility of the daily P&L is rigorously monitored and targeted to prevent severe losses capital. Finally, when implementing a strategy for combining and managing risk factors, transparency and transactional flexibility are essential complements.