Savvy investors around the world are taking advantage of the benefits of risk premia strategies, whether on a standalone basis or through a multi-strategy or multi-factor approach.
Risk premia seek to reproduce the kinds of returns usually generated by hedge funds, but through a more transparent and low-cost approach. Like hedge funds, risk premia target absolute returns through long-short positions across various asset classes, strategy types and financial instruments including derivatives.
As an addition to typical growth portfolios, which are usually exposed to equity markets more than any other asset class, risk premia can diversify portfolios by bringing returns which are uncorrelated to equity risk.
Risk premia is a type of alpha strategy, meaning these funds target excess returns. As substitutes or additions to other alpha strategies used by hedge funds and mutual funds, risk premia and smart beta strategies have quickly grown in the US as well as Europe and Australasia. While some believe that smart beta strategies will become victims of their own success in the long run, several studies have shown they are able to deliver benchmark-beating returns over long time horizons.
Risk premia strategies offer alternative return drivers and sources of positive alpha in a portfolio irrespective of the performance of equity markets. In today’s uncertain economic environment, where some market commentators are predicting another stock market crash similar to the global financial crisis of 2008, diversification away from high equity market exposure is one of the drawcards of risk premia strategies.
A slightly smaller bias towards equity risk means a portfolio will be less correlated to equity markets. There is growing consensus that there are more optimal ways to generate healthy risk-adjusted returns than the ‘standard’ portfolio mix of about 60% equity exposure and 40% bond allocations.
In fact, many investors are now allocating capital by exposure to underlying return factors, rather than the traditional method of diversifying across asset classes.
While many portfolio managers use hedge funds as a source of diversification and additional return drivers, a number of investors are now turning to risk premia since this approach can offer similar absolute returns but with more available fund information and lower fees.
The trend could see a gradually shrinking role for traditional active fund management within a portfolio, to increased allocations for risk-based assets as investors recognise the value which risk premia can add.
Some long-term studies, including one by index-provider MSCI which looked at the performance of risk premia over a 23 year period, suggest that increased allocations to risk premia strategies tend to moderate volatility and improve risk-adjusted returns.
Investors can further diversify portfolios by including two or more different risk premia strategies. Different risk premia strategies, by nature, usually have low correlations to one another since the risks they target are not the same. For example, a momentum strategy which buys assets with positive momentum and sells out-of-favour ones, would likely have a low correlation to a value strategy, which favours relatively undervalued assets and sells overvalued ones.
Some investors prefer to keep these two strategies under separate portfolios to avoid diluting their total return benefits, while others prefer to blend these factor approaches into a single portfolio in order to smooth returns and assist in risk management.
Traditional equity fund managers are incorporating risk premia into their portfolios to offer additional sources of returns and diversification, while many hedge funds are also using their expertise to take advantage of risk premia within their portfolios.
Investors can evaluate risk premia strategies on whether or not the targeted risk is expected to remain in play going forward, and on whether the rules behind the strategy are rational and transparent.
Though risk premia usually aim for stable, risk-adjusted returns, they can in certain negative market situations become volatile investments which incur hefty losses. To safeguard against this risk, these products can have volatility control mechanisms built into them, in the form of a volatility target or cap.
Volatility targets ensure fluctuations in returns are kept within a predefined range by adding or subtracting risk-free return components to a portfolio in response to changes in volatility. Like other types of investments, risk premia can also include stop-loss orders which limit the downside risk of a particular strategy in the event of heavy losses. Though these add fees, they help in the risk management of portfolios.
One restraint to the adoption of risk premia, however, is that they are largely inaccessible to individual retail investors since their complex makeup restricts them to over-the-counter markets.
Since risk premia require long-short positions and the use of derivatives, they are usually not able to be packaged as exchange traded funds (ETFs), thus excluding retail and other investors from this niche market. For the time being, at least, risk premia are only practically available to large institutions which are able to trade in swaps, or to private wealth firms through the use of certificates.
While the term risk premia refers to a set of investment strategies, a ‘risk premium’ is the excess return, above the risk-free rate of return, that an investment is expected to deliver.
