Long-short risk premia strategies can make use of various tools to capture high returns, including short selling, leverage and derivatives. Risk premia are types of
The use of short selling allows risk premia, and hedge funds, to extract absolute returns irrespective of market conditions. This differs from long-only smart beta indices, which aim to yield relative returns over a benchmark index or portfolio.
Risk premia strategies target underlying risk factors responsible for market-beating returns, such as momentum and value factors. Each factor commands a risk premium, or form of compensation, since they are deemed risky by the market.
A strategy could involve buying an alternatively-weighted smart beta index while short selling the benchmark index, thereby extracting any superior performance of the smart beta portfolio over the benchmark. A market benchmark carries a market risk premium and is a proxy for beta factor exposure.
Below are some of the tools often used by both risk premia strategies and hedge funds:
Risk premia funds and hedge funds often use leverage to magnify the returns they would otherwise generate from an asset. This is done by using financial instruments (for example, options contracts) or buying on margin, which essentially refers to borrowing capital in order to acquire assets. In the case of buying on margin, the investment purchased needs to yield higher returns than the interest payable in order to generate an overall profit. This can greatly amplify returns but also has the potential to lead to heavy losses.
This involves borrowing an asset and selling it, with the expectation that its price will decline in value (at least relative to a corresponding long position). At a later stage, the investor must close the transaction and buy the asset back, returning it to the lender. If the asset has declined in price, the investor makes a positive return since he or she bought it for less than the initial selling price.
A long trade with a corresponding short position allows investors to make an absolute return based on the outperformance of one asset over another.
A derivative is a contract based on an underlying asset such as an equity, index, bond or commodity. Derivatives are either traded over-the-counter (OTC) or on exchanges (where they are standardised and regulated more closely).
The types of derivatives commonly used by risk premia strategies and hedge funds include futures contracts, forward contracts, swaps and options.
A futures contract is an agreement to trade an asset at a predetermined price at an agreed upon time in the future. The seller of the asset might believe that prices will decline in the future, so he or she may want to lock in a price close to current valuations. The buyer in a futures agreement, meanwhile, might expect prices to rise in the future and so would see the deal as a bargain.
Futures exchanges allow investors to easily trade index, equity, currency and commodities futures, with the latest prices readily available.
Instead of buying and owning the underlying asset, for example 100 index shares, an investor or risk premia fund might rather enter into a futures contract to enhance returns. This could involve short selling a stock’s corresponding futures contract while buying the underlying equity, if the futures contract is trading at a higher price than the stock. An absolute return can be derived from the difference between the two, by taking advantage of mispricing in the market.
One method of identifying mispricing is to calculate the cost of capital with pricing models like the capital asset pricing model
(CAPM). The CAPM model says that expected returns are a sum of the returns from a risk-free investment plus an asset’s risk premium.
Forward contracts are similar to futures contracts but do not trade on exchanges and can have more flexible terms, including settlement dates. As they are traded over-the-counter, they are less accessible to retail investors.
A swap is a contract between two parties to exchange the cash flows of their respective financial instruments for the duration of the agreement. Interest rate swaps and currency swaps are among the most common of these agreements.
Total return swaps, which are popular among hedge funds and other long-short funds, allow an investor to reap the benefits and returns of an asset without having to own it. This requires minimal cash outlay and is used to boost returns.
In a total return swap contract, one investor receives the income generated from an equity or bond asset without owning it. As compensation, the investor pays the asset owner a fixed or variable rate.
Options contracts offer hedge funds and risk premia funds leveraged positions in underlying assets, allowing them to amplify returns. An option gives the buyer the right, but not the obligation, to trade an asset at an agreed upon price by a predetermined date. The buyer has to pay a fee for this right. Since options usually trade at only a fraction of the underlying asset’s price, they can magnify returns.
As risk premia strategies assume long-short positions and make use of derivatives and leverage, they are usually not able to be packaged as exchange-traded funds (ETFs), making them inaccessible to many retail investors. However, rules-based premia products are cheaper and more transparent alternatives to hedge funds, and are becoming more widely available as the factor market gains traction. Additionally, investors are starting to allocate capital by factors
rather than by asset class.
Different quantitative strategies use different mechanisms to extract the benefits that factors offer.