While risk premia products target stable and steady returns on a risk-adjusted basis, they can occasionally be more volatile than anticipated, and even suffer significant losses in a very negative market scenario.
Considering a portfolio of six-to-eight risk premia products, a material underperformance by one of these could weigh significantly on the entire portfolio. For this reason, risk premia products are often packaged with a volatility target or cap. Volatility targets aim to manage expected volatility close to a desired level, which can be done by increasing or decreasing a portfolio’s exposure to a risk-free money-market component in response to fluctuating volatility.
Another solution, however, is to trade with a built-in stop-loss feature, where the bank selling the strategy will take a gap risk below a certain level. This ensures that, in any market condition, the underperformance of a strategy will be floored at a predefined level. When doable (depending on the nature of the underlying assets), this protection typically costs between 30 to 80 basis points a year, should the threshold be set at a reasonable level. While this adds fees to a strategy, these features help investors manage the risk and return profiles of their portfolios and can prove cost-efficient in the event of a severe underperformance by one or more parts of a portfolio.
