Alternative risk premiums present a tough spot for investors | Magazine content
Ask an institutional investor what qualities they want to see in a new investment, and they might well say they want it to be cheap, offer good risk-adjusted returns, and help diversify their portfolio.
These are the benefits that Alternative Risk Premium (ARP) strategies claim to achieve. And that was something they managed for the most part – at least until recently.
Adopted early on by Scandinavian pension funds, these niche investing solutions are actually a form of factor investing, except that they can take long and short positions in factors such as value. Conventional factor investing tends to be only long. In theory, strategies provide granular exposure to risk factors or premiums, helping investors to further diversify their portfolios.
ARP strategies have emerged over the past decade as investment experts attempt to develop new types of solutions to compete with and potentially replace hedge funds, which have largely failed to deliver on promises of outperformance in emerging markets. decline following the global financial crisis. The strategies are generally cheaper, and they also claim to be more transparent.
This investment argument has won its followers and has allowed ARP strategies to grow from barely zero 10 years ago to around $ 150 billion globally to date, according to consultancy Bfinance. Their typical annual target returns were 4% to 6% above a risk-free rate, a level they were reaching overall before 2018.
But then – a performance collapse.
The years 2019 and particularly 2020 were a blow for the strategies; they lost more than 10% on average from the start of the year to November, their worst performance ever. The sudden drop prompted investors to buy more funds and forced several ARP fund managers to close.
Even adopters such as London-based Pool Re, a terrorist risk reinsurer with Â£ 6.5bn ($ 8.4bn) in assets, are increasingly skeptical about it.
âWe will need to see a significant turnaround in performance over the next six to 12 months to say definitively that we are sticking to it,â said Ian Coulman, CIO of Pool Re. âAt the moment we are disappointed, but we are holding on. we watch [performance],” he said.
It is also likely to prove to be a major brake on the growth of ARP strategies in Asia. Some regional investors barely know ARP strategies and those 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 hesitated to invest any money in it.
âThe theory or back-test of alternative risk premia is very good. But we don’t really understand if it’s really good when it comes to real investments, âadmitted a senior investment executive from China Investment Corporation. AsianInvestor.
Despite all their claimed virtues, ARP strategies have a lot of work to do to regain their luster and spark the interest of Asian asset owners.
Essentially, ARP strategies attempt to address a problem that increasingly plagues large asset owners: how to diversify their portfolios, using a limited range of financial tools.
Traditionally, institutional investors divide up equities, bonds and alternatives into asset classes. However, creating factor investing has allowed them to choose stocks based on attributes associated with higher returns.
To do this, they would use metrics called risk factors or premiums to beat the benchmarks. Typical factors are value, carry, momentum and volatility. These were often only long positions, mostly in equities, and often passive, although factor investing in bonds was also developed.
From there, ARP strategies were born, with investors looking for more sophisticated ways of investing. Strategies typically use quantitative methods (i.e. large amounts of data) to uncover investment opportunities that may exist in the market, then provide the portfolio with suggestions of multi-asset factors, at the both long and short.
“One of the main advantages of ARP is that it is multi-style, multi-asset, and thus allows investors to access premiums on stocks, fixed income, currencies and commodities. firsts, “Toby Goodworth, Managing Director and Head of Liquid Markets at Bfinance, said AsianInvestor.
Asset owners have particularly turned to ARP strategies as less expensive but equally rewarding substitutes for hedge funds. To do this, they were created in a more systematic and scalable way.
Strategies typically use computers to trade portfolios using predetermined rules. Additionally, ARP strategies invest primarily in highly liquid markets such as stocks, bonds, currencies or commodities, while some hedge funds invest in smaller niches, such as emerging market corporate debt. .
This means that ARP fund vehicles are more systematic, transparent and less expensive, said Duncan Moir, senior investment director for alternative investment strategies at Aberdeen Standard Investments. AsianInvestor. A typical ARP strategy charges between 0.5% and 1%, while hedge funds often charge a management fee of 2% and an incentive fee of 20%.
Goodworth said Bfinance’s clients for ARP solutions are primarily pension plans, some of which are explicitly drawn to these products because they are cheaper and more balanced in nature, compared to hedge funds which tend to be more expensive. and more tactical, often using discretionary signals.
Yet for all the claims of the merits of the funds, they have failed to demonstrate their value for nearly three years.
In 2018, the ARP composite index compiled by Bfinance posted a negative return of 5.4%. In 2019, it was 3.3%. And the index fell 11% between the start of the year and November. This compares poorly with a 1.42% drop in the MSCI World Index this year.
What didn’t go well?
In large part, the poor performance is due to the fact that many ARP managers have been heavily weighted by underperforming factors such as stock value. Indeed, the value of stocks had a really painful period in the first quarter, with the stock markets first collapsing and then skyrocketing due to Covid-19.
âNaturally, in fairly turbulent times, short-volatility strategies suffer,â Goodworth said.
Chris Reeve of Aspect Capital, a London-based fund manager that offers ARP products, also said stock value was a factor in underperformance, while internal research from the Teacher Retirement System of Texas (TRS) , a $ 160 billion public pension fund, noted that asset outflows accelerated the poor performance of ARP products.
Adding insult to injury, ARP strategies performed poorly, just as the vehicles they were meant to replace generally generated decent returns. Fund of hedge fund manager Arum reported that 155 multi-strategy hedge funds with combined assets of $ 252 billion posted an average return of 0.5% during the year through the end of October.
âARP explains only part of the returns of hedge funds. It cannot explain all the returns of hedge funds. And what we are seeing is that ARP has done a terrible job of completely replacing hedge funds. ARP has significant drawdowns this year and last year hedge funds are on the rise over the same period, âMoir said.
Unsurprisingly, several years of disappointing performance have had an impact. Several U.S. pension plans made major buyouts in 2019 and 2020, said Matt Talbert, senior investment manager at Texas Teachers.
âWe anticipate general exits of alternative risk premia and more concentrated exits in the most affected spaces until performance slows down,â he said. AsianInvestor.
Others could follow. London-based Pool Re could potentially abandon its 2.5% allocation to ARP, said Ian Coulman, chief investment officer AsianInvestor. She has been investing in ARP strategies through three quantitative managers since 2018.
This story was adapted from a feature article on How Asset Owners Think About Alternative Risk Premium Products, which originally appeared in the Winter 2020/21 edition of AsianInvestor magazine.