Factor-Based Alpha Investment Strategies Are Risk Management Tools

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Factor-driven alpha investment strategies, designed to manage risks within a portfolio while also delivering market-beating returns, come in a number of different forms. The most common factor-based alpha strategies include carry, momentum, value, risk and volatility funds.

These approaches act as the building blocks for quantitative strategies including smart beta and risk premia, which are being harvested worldwide for their alpha-generating but fee-reducing advantages when building a diverse portfolio of funds.

A carry trading strategy involves borrowing in a currency which yields a low interest rate, and investing under another currency – either by targeting higher interest rates or an investment in assets in the second currency. While carry trades are used to generate positive alpha returns, investors stand to lose materially given exchange rate risks and possible events including plummeting values of the invested assets. As such, carry trading strategies are usually only suitable for large institutions.

Other alpha strategies, meanwhile, can play a role in risk management and even offer more stable returns on investment when markets fall.

Value strategies, for example, can benefit under poor market conditions thanks to investors’ search for quality assets during periods of market underperformance. A long-short value strategy involves buying stocks which are trading below their fair or potential value, and selling ones which are overpriced (on a price-to-earnings basis, for instance).

Momentum strategies generate returns from including ‘hot’ stocks in favour with the investment market, and selling ‘cold’ ones which have fallen out of favour.

Alpha strategies can also complement each other, and in doing so, contribute to risk management within a fund. Long-short value strategies, for example, tend to be relatively uncorrelated to long-short momentum portfolios – in other words, they often generate alpha at different times.

Other strategies, including minimum volatility (which targets stable stocks and avoids volatile stocks or sectors) and equal-risk-contribution indices (where constituents contribute equally to overall portfolio risk) can maintain solid performances when investment market bubbles burst, thanks to the diversification features of these types of funds.

This is particularly relevant for equal-risk-contribution strategies, which consider both volatility and a stock’s correlation to other included holdings when weighting them – in a way calculating the quantity of risk which each stock brings to the index.

Naturally, a volatile stock adds more risk to a fund or portfolio than others, as does a stock which is highly correlated to other constituents in the portfolio.

For example, technology companies contributed much higher weightings than should have been the case during the tech boom of the 1990s. When the tech bubble burst in 2000, this sector alone materially weighed on major market indices since their weightings in these indices had been pushed artificially high during the boom years. In other words, standard indices which weight constituents by size bring greater risks during times when one or more sectors resemble bubbles.

In this case, an equal-risk-contribution fund helps spread risks more evenly across sectors, since stocks which are highly correlated with one another contribute lower weightings towards the index. Booming sectors are slightly less represented than in traditional funds so as to improve risk-adjusted performance metrics.

Another obvious example was the financial markets crash of 2008, during which time an asset management strategy which included an equal-risk-contribution component would likely have outperformed standard indices.

Alpha strategies, therefore, can play an important role in the management of investment risks across a portfolio – in addition to driving returns. One theoretical drawback, however, is that
alpha strategies nullify themselves over the long run since their growing popularity props up the prices of so-called value stocks, for example. But various studies have shown that alpha funds have outperformed market indices over long time horizons.

An alpha fund can incorporate more than one of these strategies in order to add fund diversification and smooth volatility and returns.