Many investors choose to blend a number of different risk premia into single portfolios in order to diversify funds and smooth returns. Among the most important factors to take into account when combining risk premia are:
a) Low strategy correlation
Choose strategies with low correlations to one another when combining risk premia. Important to note, however, is that this offers a backward-looking view on correlation. In the event of tail-risk scenarios, it can be difficult to predict whether or not strategies will react the same way (in other words, whether or not they are correlated under these conditions).
b) Diversification by asset class and investment style
Further diversification can be sought by including different asset classes and strategy implementation styles into a portfolio. For example, a long-short equity basket is unlikely to have a close correlation to a commodities curve arbitrage strategy. This is a fairly uncomplicated way to reach qualitative diversification.
c) Max. drawdown and worst-case scenarios
Most strategies have at least one Achilles’ heel, or adverse market condition, which can result in notable losses. Bearing this in mind, it makes sense to combine strategies which are vulnerable under different market scenarios or conditions. This provides a damage-control mechanism and balances risks.
For some investors, particularly those prone to risk, the best way to achieve steady risk-adjusted returns would be to combine all of the above approaches.
