Analyses
Alternative Risk Premia: Seeing the Whole Picture
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Insight Article
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mai 27, 2020
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mai 27, 2020
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Alternative Risk Premia: Seeing the Whole Picture |
Alternative risk premia (ARP) is a newly coined industry category. While a convenient catchall term, it belies the heterogeneity of these strategies which can be risk-seeking, risk-mitigating and anywhere in between. Recent press has thrown a spotlight on ARP strategies, but it fails to tell the whole story.
The COVID-19 pandemic has taken a devastating human toll around the globe, resulting in an unprecedented hit to supply and demand and roiling markets. At the same time, we’ve seen significant volatility in oil, initially because of disputes between the Middle East and Russia and later because demand weakness has forced certain oil positions into negative pricing. The confluence of these events has resulted in seismic shifts across asset classes with levels of volatility not seen since 2008. (Display 1) Attendant dispersion within asset classes has led to performance challenges across investment strategies, and as a group ARP strategies were not immune.
Source: Bloomberg as of May 7, 2020
Recent press1 has suggested ARP didn’t “do their job,” judging this highly diverse category of strategies indiscriminately. When assessing performance of ARP, it’s important to remember what they are and what they’re not. They are factor-based sources of return derived from long/short strategies that are accessible in a liquid, transparent, low-cost format. Their job is providing investors with cost-effective ways to fine-tune their portfolio exposures. They are not (necessarily) designed to be defensive. There is a misperception that all risk premia are uncorrelated or negatively correlated to equities. This is true for some ARP, but many are designed to be pro- cyclical, thriving in benign, low-volatility environments.
Two Things Drive Dispersion Among Providers
The results for any one ARP product are closely tied to its underlying mix of ARP strategies. The fact that some popular ARP products lost money during the recent market turmoil is largely indicative of how they allocated across strategies. For instance, it seems that some of the larger players in the space had products that were overweight pro-cyclical strategies, which traded down as the pandemic unfolded. Some of this exposure may have been unintended, with allocators underestimating the shared risk between their strategies and markets. But, by and large, these products are run by experienced allocators who intentionally positioned them to perform well in bull market conditions. Not surprisingly, products with more defensive biases recently performed very well and exactly as expected.
However, even with a strategy mix designed to perform well in a crisis, providers achieve different results depending on how they implement the strategies. When discussing ARP performance, it’s important to remember that we generally reference averages representing the results of a broad range of providers. Small differences in provider implementation strategy can lead to wide dispersion, especially during highly volatile periods. Looking at the recent performance of Multi-Asset Trend illustrates this point. (Display 2) Multi-Asset Trend strategies use lookback periods to signal whether an asset is “trending” up or down, and then they invest long upward-trending assets and short downward-trending assets. Shorter- term (higher frequency) lookbacks tend to outperform in rapid shocks, while longer-term lookbacks tend to outperform in benign periods. Multi- Asset Trend providers who emphasized long-term trend in their products likely underperformed those that emphasized higher frequency signals. While we generally consider Multi-Asset Trend to be a defensive strategy, we saw a great deal of dispersion among providers during the crisis some of which can be explained by their strategies relating to lookback implementation.
Source: AIP Hedge Fund Solutions Team. Data as of May 8, 2020.
Managing Expectations About Individual Premia
Relationships among premia and traditional markets can be described as tendencies because the correlations are not perfect. Nonetheless, these tendencies exist and for certain strategies are quite robust. When assessing performance, the right question to ask is: Did this particular risk premium behave in this crisis as it has tended to behave in prior crises?
To answer this question and set performance expectations, we split performance of the equity market (less U.S. Treasury rate) into quintiles, with Quintile 1 representing strongest equity performance and Quintile 5 representing weakest. We then observed the premium’s average historical returns during each quintile, mapping its stability over time in order to provide context for assessing more recent behavior. Display 3 provides an example using FX Carry in G10 Currencies premium. What we see here is that FX Carry performs well in bull markets (Q1) and very poorly in bear markets (Q5) over the five-year and 10-year periods (royal blue and aqua blue bars). The red points represent the average weekly results for the premium from February – April 2020. The red line is the slope of the relationship across the quintiles over the same three months, and the green and purple lines represent the slope of the relationship across the quintiles over the last five and 10 years, respectively. The closer the lines are, the more reliable their relationship to those types of conditions is. In this case, the short-term relationship is nearly identical to the long-term historical relationship. In other words, FX Carry did not “fail” any more than “equities” failed in the COVID-19 crisis. It merely behaved as it always has relative to equity markets.
Source: AIP Hedge Fund Solutions Team. Data as of May 7, 2020.
No Major Surprises
Using this same methodology, Display 4 summarizes the February – April 2020 performance of some of the most popular ARP strategies against their long-term behavior. (While commodity strategies comprise a large part of the ARP universe, we excluded them from this table because they have much weaker tendencies and unstable relationships to equity markets. They have been highly impacted during the COVID-19 crisis because of the volatility of oil prices.) That certain ARP have recently disappointed from an absolute return perspective should come as no surprise. For example, one would have expected Volatility Carry premia, which seek to harvest returns by going short volatility, to perform poorly during a spike in volatility.
Source: AIP Hedge Fund Solutions Team. Data as of May 7, 2020.
Low Beta is the one defensive strategy that recently underperformed its historical relationship to the markets (Display 5). Low Beta tends to be defensive and has performed well in recent years, including the 2011 and 2018 sell-offs. However, it struggled in March and April 2020 when some high-beta technology names continued to outperform because of market nuances related to the COVID-19 crisis.
Source: AIP Hedge Fund Solutions Team. Data as of May 7, 2020.
Conclusion
Recent market turmoil has refocused investor attention on the importance of asset allocation and portfolio construction. It is our view that ARP have a unique role to play, delivering very specific exposures in a liquid, transparent and cost-effective way. Of course, it is critical to bear in mind that no investment is without risk. Investors must understand the correlations— especially stress correlations (coskew)— among ARP, their market sensitivities and their risk profiles, not just their return potentials. Having weathered this storm, investors now have additional data points on the resiliency of ARP during “extreme” periods that can be used for future modelling and more robust asset allocation decision-making.
We are in unprecedented times and expect a protracted period of uncertainty, volatility and heightened market risk. In times like these, investors need access to targeted and liquid strategies that provide specific exposures across a range of asset classes. With their liquidity, tradability and heterogeneity, ARP may be more valuable than ever.
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Managing Director
AIP Hedge Fund Team
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Managing Director
AIP Hedge Fund Team
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