Scholarly sources: alternative risk premia

Academic research isn’t only for textbooks; it can also serve as a useful foundation for investment analyses. While bottom-up fundamental research can differentiate stocks, academia has already identified systematic sources of returns across equities, from value to size to momentum.

For example, in one academic theory, economists Werner De Bondt and Richard Thaler extended the view that stock prices overreact to information. They suggested that contrarian strategies, which is the buying of past “losers” and selling past “winners,” can achieve abnormal returns. They were able to show that over holding periods of three to five years, stocks that performed poorly over the prior three to five years achieve higher returns than ones that performed well over the same time period.

Though the interpretation of these results are still in debate among academics and finance experts, these kinds of thoroughly researched theories form the basis of some investment strategies, particularly alternative risk premia (ARP).

The idea of risk premia is to capture a risk premium on assets. Investors invest because they’re looking to achieve some sort of return based on the risk they’re taking. Technically speaking, the systematic reward for taking on an investment risk is called the risk premium. Simply speaking, it’s the gap between how risky the asset is and how much an investor could potentially gain at the risk-free rate.

Risk premia shouldn’t be confused with factor investing, which has gained popularity lately as one of the pillars of passive strategies. For instance, bond investors are typically exposed to inflation risk. Inflation is the factor. Most traditional risk premia are exposed to key macro and market risk factors at different levels. In contrast, ARP are often exposed to a broader set of risk factors in addition to macro risks, including investment styles, behavioral biases and investor constraints.

As investors look for new sources of return and diversification, ARP has emerged as a viable asset class. While traditional risk premia can be attractive to some investors, others realized that there were other ways they could use risk premia to capture market inefficiencies. This was aided by academic research, which had already highlighted sources of systematic returns, especially within the stock markets.

ARP differ from traditional risk premia, and tend to be the more complex of the two. ARP is most commonly used by strategies already used by hedge funds, which is why it falls under the alternatives umbrella. As a result, ARP often has a relatively low correlation with traditional risk premia. This can enhance diversification for investors who want to explore risk premia.

What’s more, ARP has no actual beta to the market. In other words, it’s uncorrelated to stocks and bonds over the long term. ARP isn’t designed to make significant sums of money in all environments but is designed to be a diversification tool to help investors weather different and shifting markets.

ARP isn’t like other non-traditional investment strategies such as smart beta. Although smart beta can include exposure to risk premia, it tends to encompass long-only portfolios, applying alternative weighting schemes versus conventional market-cap weights. ARP isn’t long only, and it’s also less directional.

Speaking of differences, ARP aren’t hedge fund strategies either. While the techniques used by hedge funds are similar, ARP tends to offer better liquidity but little to no alpha.

That doesn’t mean investors can’t capture potential returns using risk premia strategies. Let’s use emerging markets and currencies as an example. While emerging-market currencies are perceived as risky and often have a higher rate of inflation than developed-market currencies, investors can be compensated for that risk over time. Academic research has shown that high-yielding emerging-market currencies typically depreciate less than what is priced in, and often appreciate relative to low-yielding currencies.

By going long emerging-market currencies and shorting U.S. or other developed-market currencies, over time, ARP would be able to capture the spread. Here it’s not about basing decisions on market behavior but on what the research has shown to be relatively true, and by investing in a way that allows investors to maximize what they could achieve in that portion between the two assets. It’s all about the spread.

Important Information

Alpha is a measure of performance that takes the volatility of a mutual fund and compares its risk-adjusted performance to a benchmark index.

Beta is a measure of the volatility of a portfolio in comparison to a benchmark index.

Smart beta involves a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization-based indices.

Diversification does not ensure a profit or protect against a loss in a declining market.

Risk premia strategies, when compared to traditional indexes, can be more costly, risky, and have extended periods of underperformance. In addition, portfolio turnover and rebalancing costs can be higher than traditional indexes. These strategies can also employ complex trading strategies that expose an investor to a higher risk of loss including long and short, leverage, and hedging. The underlying securities held in a risk premia portfolio can also be more risky including, but not limited to commodities, high yield bonds, options and currencies. They present the risk of disproportionately increased losses and/or reduced gains when the financial asset or measure to which the strategy is linked changes in unexpected ways.

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