Analyses
How Alternative Risk Premia Can Hedge Equity Risk When Bonds Cannot: The ARP Hedge Edge
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Insight Article
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décembre 14, 2021
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décembre 14, 2021
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How Alternative Risk Premia Can Hedge Equity Risk When Bonds Cannot: The ARP Hedge Edge |
For many decades, the classic portfolio allocation of 60% stocks and 40% bonds has been a mainstay for investors seeking to hedge equity risk. But our analysis of recent equity and bond performance calls into question how effective this approach is likely to be in coming years, as their correlation has steadily moved upward into positive territory (Display 1).
Sources: Morgan Stanley AIP, Bloomberg LLC, MSCI, from 12/31/18 through 9/3/21. The S&P 500 Total Return Index is a commonly accepted benchmark of large-cap U.S. stocks. The Bloomberg U.S. Treasury Index is a total return measure of long-term U.S. Treasury issues. You cannot invest directly in an index. Data is provided for informational purposes only. Past performance is no guarantee of future results. Sourced October 21, 2021.
The forces driving the positive correlation stem from the low yields that have been prevalent in government and investment-grade corporate bonds. But the threat of inflation and the more hawkish stance recently adopted by the U.S. Federal Reserve boost the likelihood that rates will rise and put downward pressure on bond prices, especially for long-duration sectors.
Thus, many investors are looking for alternatives that can substitute for at least a portion of their government and investment-grade bond portfolio. Alternative risk premia (ARP) deserve consideration because they can fill the role of bonds in a diversified portfolio: delivering positive expected returns with low or negative correlation to equities, but without the need to take long-duration risk.
However, ARP are a heterogeneous category, with about a dozen long-standing, well-known strategies (and many more niche and newer ones), spanning all asset classes including equities, rates, commodities, and currencies. ARP do not comprise a true asset class, but share the common trait of not being long-only traditional investments. Many ARP are countercyclical to equities, but some are very much pro-cyclical.
This report reviews how ARP have performed during different market environments, or regimes, both in the context of an equal risk-weighted portfolio of the most common strategies, and individually, based on risk-adjusted return.
Defining the Bond Regimes
ARP factors behave differently from each other and across market regimes. So a fundamental consideration is to seek to avoid strategies likely to perform poorly at the same time as bonds, while at least preserving capital when equities sell off.
To define bond regimes, we use a well-known framework based on yield curve movement. We define the four regimes as combinations of bull/bear and steepener/ flattener bond markets (described in Display 2). Bull/bear markets are defined based on the direction of shift of overall yield curve either upward or downward, while steepener/flattener measures the change in yield curve slope. Below the description of bond regime in each quadrant, Display 2 also highlights the best- and worst-performing ARPs for the 10 years ended August 31, 2021.
Sources: Morgan Stanley AIP, Goldman Sachs, ICE BofA, Bloomberg, JP Morgan, Societe Generale, Macquarie, for the 10 years ended 8/31/21. Long-term yields are represented by the 10-year U.S. Treasury; short-term yields by the 2-year U.S. Treasury. Relative performance of the 10-year and 2-year Treasuries was evaluated for each of the 523 weeks during the 10-year performance period, and categorized as one of the four regimes described above. Overall performance of each regime was determined by summing the weekly returns. A fuller discussion of individual ARP construction and performance is included in the “ARP Risk-Adjusted Returns” section of this article. Data is provided for informational purposes only. Past performance is no guarantee of future results. Sourced October 21, 2021.
For illustrative purposes only. Not based on any specific portfolio advised or managed by Morgan Stanley Investment Management. No representation or warranty is being made that any proposed or actual portfolio will or is likely to achieve a performance record similar to that shown. In fact, there are frequently sharp differences between a hypothetical performance record and the actual record subsequently achieved.
The Equal Risk-Weighted ARP Portfolio
To test the effectiveness of ARPs as an alternative to diversification1 with bonds, we constructed an equal risk-weighted portfolio of well-defined strategies in carry, value, and trend/momentum that are included in Display 2. The portfolio targets 5% annualized volatility, similar to a core bond portfolio or index. Because a majority of our set are countercyclical (although certainly not all, such as equity value and FX carry), and given their equal risk-weighting, the portfolio is designed with a defensive equity tilt.
By adjusting the risk weightings away from equal, investors can tilt the portfolio to one regime or another, depending on their views, investment objectives and risk constraints.
Sources: Morgan Stanley AIP, Goldman Sachs, ICE BofA, Bloomberg, JP Morgan, Societe Generale, Macquarie, for the 10 years ended 8/31/21. The S&P 500 Total Return Index is a commonly accepted benchmark of large-cap U.S. stocks. The Bloomberg U.S. Treasury Index is a total return measure of long-term U.S. Treasury issues. The portfolio comprises equal risk-weighted positions of well-defined alternative risk premia in carry, value, and trend/ momentum that are included in Display 2. The portfolio targets 5% annualized volatility, similar to a core bond portfolio or index. A fuller discussion of individual ARP construction and performance is included in the “ARP Risk-Adjusted Returns” section of this article. You cannot invest directly in an index. Data is provided for informational purposes only. Past performance is no guarantee of future results. Sourced October 21, 2021.
The results showed that the diversified ARP has been an effective bond alternative, delivering strong returns during weak periods for equities (bond bull regimes). But, importantly, the ARP portfolio still preserved capital during bond bear markets. Display 3 shows performance of the portfolio, the S&P 500 Total Return Index and Bloomberg U.S. Treasury Index by bond regime from September 2011 to August 2021. Display 4 shows the same performance over the same dates in 12-month rolling periods.
Sources: Morgan Stanley AIP, Standard & Poor’s, Bloomberg, for December 2005 through October 2021. ARP portfolio construction is detailed in Display 3, and a fuller discussion of individual ARP construction and performance is included in the “ARP Risk-Adjusted Returns” section of this article. You cannot invest directly in an index. Data is provided for informational purposes only. Past performance is no guarantee of future results. Sourced October 21, 2021.
Following are highlights of portfolio performance and constituent ARPs:
ARP Risk-Adjusted Returns2
For another perspective on ARP performance, we analyzed the same strategies over the 2011-2021 period on a risk-adjusted basis, using information ratios (return per unit of volatility), broken into the same four bond regimes. Because information ratios scale the return of each ARP by its own volatility, this analysis offers investors additional insight that may be useful tilting their own portfolios. In contrast, the portfolio discussed above weighted each factor to our desired 5% volatility.
The third column from the right in Displays 5A through 5E shows the information ratio of the equal risk-weighted ARP portfolio, discussed above, for reference. In all regimes except the bear steepener, the portfolio had large information ratios.
Equity low volatility, equity momentum and equity quality strategies are historically highly correlated to U.S. Treasuries (Display 5A). They have done particularly poorly during periods of bear steepening, when investors are anticipating inflation (and equities are often performing quite well). These strategies have no explicit duration risk (being long and short equities only), but like U.S. government rates, they tend to perform well in equity market selloffs and perform poorly in strong bull markets. Thus, high correlation to rates is driven more by the shared countercyclical tilt of the strategies than a common fundamental risk exposure.3 This is evidenced by recent performance of quality and low volatility, which have done well this year despite the poor performance of duration risk.
Source: Morgan Stanley AIP, Goldman Sachs, Bloomberg, for the 10 years ended 8/31/21. Equity low volatility, equity momentum, equity quality and equity value are alternative risk premia indexes published by Goldman Sachs. See Display 1 for description of bull flattener, bull steepener, bear flattener and bear steepener regimes. You cannot invest directly in an index. Data is provided for informational purposes only. Past performance is no guarantee of future results. Sourced October 21, 2021.
Momentum has done poorly this year, not because of rates correlation, but rather the lack of a strong exploitable long-term trend in equities. Conversely, the equity value strategy exhibits negative correlation to rates and historically outperforms in yield widening and curve steepening environments. Value is the most pro-cyclical of our four equity factors. Value stocks, such as financials, utilities, etc., tend to outperform growth stocks in rising rates and steepening yield curve environments.
Multi-asset trend fares relatively well in all four bond regimes thanks in part to its diversification across different markets (equities, FX, rates, bonds) and across different time frames (Display 5B). Long-term trend captures slow and steady changes in rates and bond performance and generates strong performance during flattening yield curve regimes. Short-term trend has strong defensive characteristics during a steepening yield curve environment.
Source: Morgan Stanley AIP, Bloomberg, JP Morgan, Macquarie, for the 10 years ended 8/31/21. Trend (long-term), trend (medium term) and trend (Intraday) avg., are alternative risk premia indexes published by Bloomberg, JP Morgan and Macquarie. Data is provided for informational purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results. Sourced October 21, 2021.
Commodities, as an asset class, are often expected to perform well in an inflationary environment benefiting from expected rise in commodity prices (Display 5C). ARP commodity strategies, however, are market neutral (both long and short positions) and behave differently. Curve carry performs better in bull than bear markets while commodity carry performs better in yield curve flattening regimes. The commodity value strategy, which generally benefits from relative-price mean reversion between like commodities (such as Brent and WTI crude oil prices), produces persistent positive returns in all four bond regimes, as price dislocations can happen in both bull or bear regimes.
Sources: Morgan Stanley AIP, ICE BofA, Bloomberg, for the 10 years ended 8/31/21. Commodities curve carry, commodities value, and commodities carry are alternative risk premia indexes published by BofA/Merrill Lynch. Data is provided for informational purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results. Sourced October 21, 2021.
Rates curve carry is the ARP strategy that typically carries the most explicit duration risk (Display 5D). It can be implemented in a variety of ways but generally has net long-duration risk. As a result, the strategy tends to perform better during bond bull markets. Cross-market carry is focused on spread differences in government bonds across countries, typically at the same tenor or in a duration-neutral manner (although, again, your mileage may vary depending on implementation). As a result, cross-market rates carry strategy delivers positive return both in bull and bear yield environments with better performance in flattener than steepener environments.
Sources: Morgan Stanley AIP, Goldman Sachs, Bloomberg, Societe Generale, for the 10 years ended 8/31/21. Rates carry and rates cross market carry are alternative risk premia indexes published Goldman Sachs and Societe Generale. Data is provided for informational purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results. Sourced October 21, 2021.
Currency value and carry strategies have presented relatively good performance during all four bond regimes (Display 5E). While currency valuations are tied to rates and can be affected by changes in the U.S. rate curve, like cross-market rates carry, the driver of performance is driven by changes in rate differentials across countries, not within tenors of the U.S. rate curve. Both strategies have delivered positive returns during bear markets for bonds.
Sources: Morgan Stanley AIP, Goldman Sachs and ICE BofA for the 10 years ended 8/31/21. Currency value and currency carry are alternative risk premia indexes published by Goldman Sachs and ICE BofA. Data is provided for informational purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results. Sourced October 21, 2021.
Year-to-Date ARP Performance
We began this report with the observation that ARP strategies are likely to hold up better than bonds as rates come under pressure from Fed policy and inflation. So far, this year has underscored the validity of that view, as the equal risk-weighted portfolio discussed above would have returned 6.3% through August 31. In contrast, U.S. government bonds recently suffered through one of the worst performance periods in decades, including a sharp bear steepening to start 2021.
The drawdown in the Bloomberg U.S. Treasury Index (the Index) was its largest since 1994, with a loss of 6% from August 2020 through March 2021. Year-to-date through August 31, the Index is down -1.4%. The U.S. Treasury 10-year yield rose from 0.9% at beginning of the year to 1.3% at the end of August.
During this difficult period for bonds, many ARP delivered positive returns, including equity low volatility and equity quality. This year so far, investors have gravitated to lower volatility stocks and stocks with good earnings quality (which were cheap headed into 2021.) Trend, commodity carry, curve carry, FX value and FX carry strategies are all also positive. Only equity momentum and commodity value strategies have struggled. Display 6 shows 2021 YTD information ratios for ARP factors, U.S. Treasuries, and the S&P 500.
Sources: Morgan Stanley AIP, Goldman Sachs, ICE BofA, Bloomberg, JP Morgan, Societe Generale, Macquarie, for the 12 months ended 8/31/21. A fuller discussion of individual ARP construction and performance is included in the “ARP Risk-Adjusted Returns” section of this article. Data is provided for informational purposes only. Past performance is no guarantee of future results. You cannot invest directly in an index. Sourced: October 21, 2021.
The ARP Hedge Edge
Investors are rightly concerned that bonds may no longer be a suitable hedge for equities in today’s environment. We have shown that a well-designed diversified portfolio of ARP can serve as a viable alternative. This hypothetical portfolio would have delivered positive expected returns with low or negative correlation to equities, but without forcing investors to assume the duration risk embedded in much of the bond market.
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Managing Director
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Managing Director
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