Last week my attention was drawn to an article in the FT arguing that ARP strategies will be tested in the next downturn. Although the article didn’t say anything particularly controversial, it is a good opportunity to highlight our ARP philosophy and address a few of the concerns raised by the author.
The concept of a risk premium is far from new in the context of investing. In its simplest form, it refers to the expected compensation for assuming some form of risk over and above the return from holding a risk-free asset. Perhaps the best known is the equity risk premium, which as the name suggests reflects the expected excess return over the risk-free rate from a broad allocation to the equity market.
Many years ago, investors would have had to pay a reasonably high fee to a traditional asset manager for this premium, but over time that fee has been significantly reduced as index investing has made it far more accessible. That trend makes perfect sense: there is little manager skill involved in tracking the broad equity market and therefore a low fee is appropriate.
Alternative risk premia (often referred to as factors) can be thought of in much the same way. Each premium or factor represents some form of structural or behavioural feature of markets that is both persistent and positively rewarded on average over time. Roll back a few years and investors would have had to pay significant management and performance fees to a hedge fund to access a particular ARP strategy, with the risk premium in question often passed off as ‘manager alpha’. But over time, as these strategies – and the market features they look to capture – have become better understood, many of them have become easier and cheaper for investors to access.
Equity factors – value and size, for example – were the first to be replicated; now investors can access strategies spanning most asset classes. A typical portfolio of ARPs will likely allocate to equity factor strategies alongside a wide range of others, such as fixed-income carry, commodity volatility or currency momentum.
We allocate to both traditional market risk premia (which takes the form of a well diversified mix of asset classes) and ARP strategies (commodity curve carry, for instance), combined with a portfolio of tactical positions and holistic risk management.
Why are these criteria important?
1) Complicated strategies risk falling into the trap of over-fitting. Our research suggests that on average across the universe of ARPs available from investment banks, the realised risk-adjusted return after the strategy is launched is at least 75% lower than that suggested by its backtest!
2) Some ARPs are more liquid than others. Illiquid strategies are susceptible to crowding that can potentially erode performance, while liquid strategies also have a cost advantage over less liquid ones.
3) The more transparent a strategy, the more we are able to understand the drivers of performance. By developing and managing strategies in-house where possible, we are able to manage expectations and are more likely to stick with a strategy through periods of short-term underperformance, which is crucial in order to earn the risk premium over the long run.
4) Because we manage our ARP strategies within the context of a broader portfolio, we only allocate to strategies that complement the overall portfolio. This means that we avoid adding strategies that might on paper help to diversify an ARP-only fund, but that can have a strong positive correlation with our clients’ overall asset mix, especially in times of market stress. It is for this reason that we avoid allocating to short equity volatility strategies, for example, which suffered in February 2018 at the same time as equities sold off. This approach also meant that we had limited exposure to the equity style rotation in September of this year.
The FT article last week highlighted three main concerns: 1) for a given risk premium, there is rarely a universal definition or approach taken by individual managers, and this can lead to significant variation in performance; 2) a lack of simple rules of thumb linking factors and their returns can lead to tenuous definitions and an over-reliance on judgment calls; and 3) there is no guarantee that a factor’s historical returns will persist as new money arriving into ARP strategies can lead to overvaluation. Therefore, the author argues, ARP strategies’ resilience will be tested more in the next downturn than in the artificially inflated markets of today.
While certainly valid, I’m not sure these points relate exclusively to ARP strategies; much the same could be said of many investible assets and investment approaches. Managing a portfolio of ARPs is not easy, but we believe that adhering to the four principles set out above is the best way to mitigate these concerns and provide something genuinely additive for our clients.