A new report from Aon discusses the contemporary market for alternative risk premia: where it is, how it got here; where it may be headed.
The authors, Matthew Towsey and Chris Walvoord, begin with some very basic considerations of what ‘risk premia’ are. They are, on the one hand, the payments one receives for taking on a risk that others do not wish to hold (providing insurance), or they are on the other the winnings one pockets on strategies that take advantage of market anomalies.
Looking at this from the insurance provider point of view, a good example of a risk premium is the income from a short volatility strategy, selling straddles on an index. The seller, as Towsey and Walvoord put the point, “receives an option premium for bearing the risk of a large increase in volatility, which generally accompanies a large fall in the market.” This can be successful long term (as can the sale of fire insurance), but is prone to big pay-outs when the insured event occurs, that is, when a fire burns someone’s house down, or when the volatlity of the market suddenly increases.
Looking at risk premia from the anomaly point of view, these authors suggest that the most obvious example is a trend following or “momentum” strategy. This “shouldn’t” work, if you believe that markets are driven by rational expectations, nor is it really a reward for bearing a certain kind of risk (aside from the risk of a sudden reversal of trend).
Trend following has a tendency to perform well in high volatility periods, so it might be employed as a hedge to a short vol strategy.
An alternative risk premia strategy can fall into either of those camps, anamoly pursuing or insurance providing. What makes it alternative is in essence the ability of managers to go long and/or short and their readiness to invest across asset classes. In general, say Towsey and Walvoord, ARP strategies will involve both types of premia, because there is synergy between them.
Sharpe Ratios
Unfortunately, the track record of most ARP products is brief, simply because as an investment style this is a recent development. As our Aon authors tell us, this means that back-testing has to be employed for analysis or illustration, “with all the caveats that entails.”
The authors look at the Sharpe ratios of various strategies. They start with five asset classes: commodities, currencies, fixed income, equities (index based) and stocks (single name strategies). For each of the first three asset classes named, they look to the Sharpe ratio for a carry, a momentum, and a value play. For the equities and stock classes, there is no “carry” strategy, but there still exists the choice between momentum and value. So this breakdown yields a list of 13 strategies.
The “winning” ARP here is the stock momentum strategy, which has a Sharpe ratio above 0.9. The “losing” ARP is commodity value, which has a Sharpe ratio of just 0.1.
What is more important though is that the 13 “substrategies” are not highly correlated with one another. Pairwise, the average correlation is 0.14. Thus, “creating a portfolio of these strategies should produce much higher risk-adjusted returns than individually allocating to any single strategy.” And indeed, that is what these authors find when they crunch the numbers.
An ARP strategy, then, looks to be “a compelling addition to a traditional 60/40 portfolio, even with a moderate level of correlation.”
Some Caveats
But there is further good news. The correlation of a traditional portfolio to the hypothetical and back tested ARP portfolio AON has created is very low. Looking for the whole period from 1990 to March of 2016, the ARP portfolio has a correlation of only 0.2 with equities, 0.0 with bonds, where equities are represented by the MSCI World Index, bonds by the Barclays Global Aggregate Bond Index.
But there are cautions to be mentioned, and ARP is not for everyone. Trading costs are “not trivial,” for example. The costs in a particular case will depend on the strategy and the trading platform.
Finally (although the authors’ list of caveats is longer, this will be the final point for purposes of our precis) there is a danger of crowding going forward. One can expect more assets to flow into ARP over time, and it is an open question “whether the strategies will continue to work as effectively in such a scenario.”