Alternative risk premia offers investors a predicament

Ask an institutional investor what qualities they want to see from a new investment, and they might well say they want it to be cheap to invest into, offer good risk-adjusted returns, and help diversify their portfolio. 

 

Those are the benefits that alternative risk premia (ARP) strategies claim to achieve. And it was something they largely managed – at least until recently. 

 

Early adopted by Scandinavian pension funds, these niche investment solutions are effectively a form of factor-investing, except they can assume both long and short positions on factors like value. Conventional factor-investing tends to be long-only. In theory the strategies offer granular exposure to factors or risk premia, helping investors to further diversify their portfolios. 

 

ARP strategies emerged over the past decade as investment experts tried to develop novel types of solutions to compete with and potentially replace hedge funds, which had largely failed to live up to their promises of outperforming in dropping markets following the global financial crisis. The strategies are generally cheaper, and they also claim to be more transparent. 

 

That investment argument has gained its adherents, and enabled ARP strategies to grow from barely zero 10 years ago to stand at about $150 billion across the world as of today, according to consultancy firm Bfinance. Their typical annual target returns were a 4% to 6% over a risk-free rate, a level that they were broadly meeting before 2018.

 

But then – a performance collapse.  

 

The years 2019 and particularly 2020 have been a gut-punch to the strategies; they lost over 10% on average from the start of the year to November, their worst performance on record. The sudden drop has caused investors to increasingly redeem funds and forced several ARP fund managers to close. 

 

Even adopters such as London-based Pool Re, a terrorism risk reinsurer with £6.5 billion ($8.4 billion) in assets, are growing sceptical about it.

 

“We’d have to see a significant turnaround in performance in the next six to 12 months to definitely say we’re sticking with it,” Pool Re’s chief investment officer Ian Coulman said. “At the moment we’re disappointed, but we’re holding on. We are monitoring [performance],” he said.

 

It is also likely to prove a major hindrance to the growth of ARP strategies in Asia. Some regional investors barely know about ARP strategies and those that are more familiar with them have been put off by the trading behind the products, which is both complex and technical. 

 

Indeed, the plumbing of ARP strategies is so esoteric that one of the region’s most sophisticated investors has been hesitant about putting money into them. 

 

“The theory or back-test of alternative risk premia are very good. But we don’t really understand whether it is really that good when it comes to real investments,” a senior investment executive at China Investment Corporation admitted to AsianInvestor.

 

For all their claimed virtues, ARP strategies have a lot of work to do if they are to regain their lustre and pique the interest of Asia’s asset owners. 

 

FLEXIBILITY FOCUS  

 

ARP strategies essentially attempt to answer an issue that is increasingly plaguing major asset owners: how to diversify their portfolios, using a limited array of financial tools. 

 

Traditionally, institutional investors allocate according to the asset classes of equities, bonds and alternatives. However, the creation of factor-based investing allowed them to choose securities based on attributes associated with higher returns. 

 

To do so they would use measurements called factors or risk premia to beat benchmarks. Typical factors are value, carry, momentum and volatility. These were often long-only positions, mainly in equities, and often passive – although increasingly factor-based investing in bonds has also been developed. 

 

From here, ARP strategies were born, as investors sought more sophisticated means to invest. The strategies typically use quantitative methods (i.e. large amounts of data) to find out what investment opportunities likely exist in the market and then supply the portfolio with multi-asset factor suggestions, both long and short. 

 

“One of the key benefits of ARP is that it is multi-style, multi-asset, and thus allows investors to access premia across equities, fixed income, currency, and commodities,” Toby Goodworth, managing director and head of liquid markets at Bfinance, told AsianInvestor.

 

Asset owners have particularly looked to ARP strategies as lower cost yet similarly rewarding replacements for hedge funds. To make that happen, they were created in a more systematic and scalable fashion. 

 

The strategies typically use computers to trade the portfolios using predetermined rules. In addition, ARP strategies mostly invest in very liquid markets such as equities, bonds, currencies or commodities, whereas some hedge funds invest in smaller niches, such as emerging market corporate debt. 

 

This means ARP fund vehicles are more systematic, transparent and cheaper, Duncan Moir, senior investment manager for alternatives investment strategies at Aberdeen Standard Investments, told AsianInvestor. A typical ARP strategy charges between 0.5% and 1%, whereas hedge funds often charge a 2% management fee and a 20% incentive fee.

 

Goodworth said Bfinance’s clients for ARP solutions are mostly pension plans, some of whom are explicitly attracted to these products because they are cheaper and more balanced in nature, relative to hedge funds which tend to be pricier and more tactical, often using discretionary signals.