The Mechanics Behind Risk Premia Strategies

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Risk premia strategies can take various forms, including long-only stances – known as smart beta – as well as long-short approaches. These are collectively known as quantitative investment strategies, though they are implemented in different ways.

Risk premia factors are sources of return that can span several asset classes and which explain why some investments outperform others. The most common factor is the risk premium associated with equity market exposure, which greatly influences the returns of most long-only equity investments.

Risk premia, including the market factor, are attractive to some investors because they offer compensation – in the form of better risk-adjusted returns – for being exposed to certain risks.

Beyond the market factor, other common sources of risk premia include the value factor (undervalued stocks tend to outperform over the long term) and size (smaller equity assets tend to outperform over the long term – they carry a risk premium partly because they are less liquid), among many other premia.

The size and value factors are included in some expanded versions of the capital asset pricing model, since financial theory was previously unable to explain why they resulted in better returns.

Strategies that aim to take advantage of factors are known as quantitative strategies.

Long-only risk premia

Long-only risk premia strategies are much simpler to implement than long-short alternatives, though their benefits are watered down by market exposure.

A long-only risk premia strategy, often in the form of smart beta products, involves buying and holding a fund with the expectation that it will deliver better returns than the benchmark against which it is measured.

The benchmark index offers beta, or broad equity market exposure. In other words, long-only risk premia strategies aim to beat the returns offered by the market.

Smart beta indices use alternative index construction techniques to target one or more premia. For example, a low volatility smart beta index might use the same constituents as the benchmark S&P 500 Index (which is weighted by size), but assign different weightings to constituents in order to reduce volatility.

This strategy aims to yield better risk-adjusted returns relative to the benchmark index, with a few percentage points worth of extra return and less volatility. The S&P 500 Index acts as a proxy for the broader US equity market.

Some investors contest the name given to long-only smart beta products (sometimes called custom indices) since they often target market-beating returns (alpha).

Long-short risk premia

While long-only risk premia strategies target relative returns, long-short risk premia target absolute returns which are not measured against benchmarks.

Part of the attraction is that returns can be generated irrespective of market conditions. These strategies also essentially strip out a large portion of the market factor, which means greater exposure to the targeted risk premia factor.

This type of trade is most often associated with hedge funds. But since hedge funds are relatively exclusive, being available only to high net-worth investors, risk premia alternatives are becoming increasingly popular.

Long-short risk premia involves buying a factor-based portfolio while short selling another, thereby extracting any outperformance of the one fund over the other on an absolute basis. Many investors include six-to-eight different risk premia in a single portfolio, which assists in diversification and helps to smooth returns. This also points to diversification by factors rather than the traditional method of diversifying across asset classes.

Short selling involves borrowing a fund, selling it, and then buying it back at a later stage in order to return it to the lender.

Funds are often borrowed from brokers, who can source them from their own inventories, from other clients or from other brokers. Once they have been sourced, they are sold and the proceeds of the sale are credited to the investor’s account.

Important to note is that since investors do not own the borrowed funds, any dividends arising during the time they are borrowed must be transferred to lenders.

The strategy must be closed at some point, when the investors must buy back an equal number of shares and return them to his or her broker.

Short transactions are usually open-ended, meaning there are often no predetermined times when the deal must be closed. However, when a short sale involves margin accounts, interest charges are involved, meaning the longer a trade is kept open, the more it will cost.

A long-short value fund would buy undervalued stocks (with the expectation that they will increase in value), while short selling overvalued ones (with the expectation that they will decline in value). In order to generate positive absolute returns, the long position has to outperform the short position on a net basis.

As another example, consider the above low volatility smart beta portfolio, which is based on the benchmark S&P 500 Index but has a tilt towards stocks which tend to generate more stable returns.

A simple long-short trade would involve buying the low volatility alternative index while short selling the benchmark index – with the expectation that the smart beta version will outperform the standard size-weighted index. In other words, the investor expects the low volatility risk premium to outweigh the market risk premium.

The short sale would involve borrowing index shares, selling them, and buying back an equal amount of shares at a later stage to return them to the lender. The optimal time to close the short sale would be when the spread between the smart beta index and the benchmark is at its greatest positive level (while also taking fees into account).

Long-short strategies are particularly attractive when markets are in decline, though these strategies do carry risks and can lead to heavy losses (this is why risk premia strategies can include built-in risk-control mechanisms). In addition to holding short positions, risk premia funds often also make use of leverage, derivatives and other tools to capture high returns.

The low volatility risk premia strategy pins its hopes on an outperformance of the low volatility factor inherent in many assets (this factor is not only present in the equity market, but also other asset classes such as commodities).

However, in the event that more volatile stocks yield material upside gains in bull markets, this strategy risks heavy losses since the low volatility index is likely to underperform the size-based benchmark index.

Risk-control mechanisms for long-short risk premia

Risk-control measures are often built into risk premia products. This is important since a substantial underperformance of one risk premia product can significantly weigh on the returns of an entire portfolio.

One risk-control mechanism is the inclusion of volatility caps or targets.

Volatility targets aim to keep volatility close to a desired level, usually by adjusting the exposure of a portfolio to a risk-free money market investment as volatility levels rise and fall.

Alternatively, risk premia products can have built-in stop-loss features, which restrict losses to a certain level.

This method of capital protection usually costs investors between 30 and 80 basis points annually, though they help to maintain peace of mind and help to manage the risk profiles of strategies.

Smart beta and risk premia markets are relatively new, though they are becoming more and more sophisticated (there are already Shariah-compliant options).

Smart beta and risk premia can target a variety of asset classes, though they usually invest in equity assets, commodities and foreign exchange. More recently, fixed-income investments have begun to appear. Multi-asset class strategies target more than one asset class, thereby creating a portfolio of assets.

However, many investors are turning away from the multi-asset approach to diversification, and are choosing to rather diversify their portfolios by factors. leverage, derivatives and other tools.