Risk premia strategies target absolute returns through long-short positions across various factors and asset classes. As such, these rules-based strategies in many ways resemble and rival hedge funds, though risk premia products tend to be much cheaper and more transparent than hedge funds.
Risk premia funds aim to profit from underlying risk factors, which have become the basis for capital allocation decisions to many investors.
An example of a risk premia strategy could be buying an alternatively-weighted index (for instance, one which assigns weightings by earnings rather than by size – as the benchmark does), and selling the benchmark index (often, but not always, the S&P 500 Index). Returns come from any outperformance, or premium, of the alternatively-weighted fund relative to the benchmark. This strategy can generate a positive alpha value (or return which beats the market) even if the market is in on a downward trend.
There are a number of analytical tools available which allow investors to gauge these returns on a risk-adjusted basis.
Risk premia can be accessed via different means, from over-the-counter (OTC) trades to exchange-traded funds (ETFs). They also target different asset classes, including equities, commodities, bonds, rates and foreign exchange. Like hedge fund, they can use leverage and derivatives to notch up returns.
And strategies vary greatly too. One strategy is to favour small-cap stocks, which tend to perform better over the long run than large caps. The premium attached to small, less liquid stocks which have less available information can be captured through being long small cap stocks and short large caps.
Value strategies which favour stocks that are cheap on a relative basis can also be implemented on a macro basis by going long cheap stock markets and short expensive ones.
A momentum strategy, meanwhile, favours stocks which are on an upward growth trajectory. Applied to a basket of equities, for example, this strategy can involve going long the top quintile of momentum stocks while short selling the bottom quintile (or those stocks with the least momentum).
The short position can be held open for an indefinite period, though closing the trade sooner rather than later saves on fees.
The appeal of risk premia investments, which fall under the umbrella of alpha strategies, is that they are able to generate returns independently from market conditions. Like smart beta (a long-only strategy which assigns alternative weightings to traditional indices), risk premia is a factor investing strategy driven by quantitative analysis.
But like hedge funds – though to a lesser degree – risk premia are still effectively inaccessible to many investors. The market for risk premia is currently limited to large institutional or wealth clients, just as it is for hedge funds.
This is because some features of risk premia products, including that they hold a long-short basket which often includes derivatives, are not always suitable for ETF markets, effectively closing individual retail investors out of this niche market. For this reason, risk premia are usually confined to OTC trading, but the market for these products is quickly evolving and may open up to more investors as it does so.
Compared with hedge funds, risk premia have an advantage in that they tend to cost less and are more transparent.
Naturally, risk premia strategies have to compete for capital with hedge funds and other alternative investment vehicles. Many large institutional investors have begun to see the value of risk premia and are shifting their absolute return portfolios away from hedge fund exposure towards risk premia.
Risk premia strategies help to diversify an investor’s sources of returns at a portfolio level. In order to be most effective, they should have their own capital allocations within a growth portfolio.
Risk premia strategies aim to capture the risk premium associated with inefficiencies in the market, where ‘risk premium’ refers to the excess return that can be expected from an investment above the return which could be generated from a risk-free asset.