Risk premia hunters target absolute returns for their clients through long and short positions across a variety of factors and asset classes.
Risk premia can be harvested from exposure to many factors, including momentum, carry or value, across a number of asset classes. Specialists say they are plentiful, transparent and persistent.
K2 Advisors head of risk premia, Paul Fraynt, has been identifying, modelling and “backtesting” risk premia strategies for clients for the better part of a decade.
The New York-based adviser with a background in quantitative science and risk management calls it a commonsense approach to making portfolios robust; there is a broad choice of risk premia sources to identify and exploit, which exist due to structural and behavioural phenomena in markets.
“My objective is to build strategies that will remain attractive for a considerable period of time, and, preferably, indefinitely,” Fraynt says, adding that many premia sources were identified in the ’70s, ’80s and ’90s.
Fraynt says investors reasonably worry about many things, such as overcrowding, timing, benchmarking, management fees, incorporating the latest research and specific portfolio construction methods, but the most important part for risk premia seekers is finding persistent and independent sources of returns and harvesting them effectively at the lowest cost possible.
Working the cycle
“What makes this space so attractive is that it allows investors to step away from complexities associated with predicting the direction of the market,” Fraynt says.
Such strategies appeal to conservative clients with long-term horizons, such as fiduciary pensions in the US and superannuation funds in Australia.
Fraynt says his systematic strategies are alternative beta, and calls predicting the direction of such strategies an area best left to hedge funds.
“Timing should be left to those who specialise in delivering alpha – the hedge funds and the like, investment managers who appropriately charge higher fees,” Fraynt says.
“One of the biggest advantages of a systematic approach to risk premia is building portfolios of strategies that will work over the entire economic cycle, in spite of the market noise. Risk premia strategies offer uncorrelated positive expected returns over the entire economic cycle. As a result, we can spend our time on researching and building strategies, rather than dedicating time and focus to predicting the direction of the market.
“To us, risk premia is a beta product. It’s alternative beta, but still beta. In other words, sources of returns, and typical ways to harvest them, are well known.
And since they are well-known, there’s no alpha remaining. The difference [in expected returns will] have to come from finding the most efficient way to harvest such premia.”
Preparing a strategy once a risk premium has been identified can take months, Fraynt says.
“There are many ideas out there,” he says. “They are published in research journals, presented at conferences and discussed among practitioners. It doesn’t take much to find them, but it does take considerable time to build models and test algorithms in order to find the most efficient way to execute them.
One idea K2 Advisors is taking advantage of is roll yields in commodity markets.
“Would $170 billion invested in long commodity futures create a congestion premium when the entire amount needs
to be rolled over a five-day period? And would returns generated from expecting such congestion be independent from sources of returns driving traditional benchmarks like equities or bonds? We think the answer is obvious,” Fraynt says.
Even after the cost of trading, risk premia should produce attractive excess returns over the entirety of the economic cycle.
“By definition, performance generated by each individual source of premium is subject to considerable and unwelcome noise,” Fraynt says. “Putting together unrelated sources of premia in a portfolio may meaningfully improve risk/return profile.”
What sets K2 Advisors apart from some competitors is its emphasis on the less glamorous, but practical, approach of minimising costs.
“After all, any decrease in costs, whether by finding a less expensive venue for executing trades or by minimising the trading frequency needed to extract a premium, improves future returns,”
Fraynt says. “Meanwhile, reducing costs of rebalancing even by a fraction of a single basis point may have meaningful positive impact on the portfolio returns. Because risk premia strategies may rebalance as frequently as monthly, and some even weekly, savings add up quickly.”
First State Super portfolio manager Zoe McHugh uses a variety of external managers that provide risk premia products as a diversifier to a range of offerings for accumulation and pension members.
The fund oversees $90 billion in super savings and puts risk premia strategies under the watch of its liquid alternative specialists.
McHugh says First Super looks for the most diversified approach that it can, using an array of external managers.
“(We’re) looking for managers that have different skills sets and investment strategies. Multi-asset managers across a broad range of asset classes,” McHugh says.
“My experience is these managers will do well at different times. That’s why we don’t rely on a particular skill set. We have diverse strategies.”
The fund uses these managers in two ways, to help protect pension-phase members against downturns and to diversify returns for members in accumulation phase.
“There’s a desire to protect against equity market drawdown,” McHugh says. “One will have higher beta to the market than the other. In the accumulation phase, in total portfolio, we have a systematic asset allocation that has a large cap and risk allocation to equity markets.”
Risk premia have been used in First State Super’s portfolios in the last five years, since its 2011 merger with Health Super was bedded down and its investment team evolved.
The fund was not using these strategies just because they were growing in popularity with Australia’s super sector.
“I’ve never felt that this is something we’ve had to do for peer relativity,” McHugh says. “This is a strategy we would expect to do well when equity markets are falling and extremely well when there’s an equity crisis. It’s not going to do as favourably at other times. We’re protecting the downside, limiting the left tail. That’s what’s important for pension fund members.
”The fund broadly aims to achieve a CPI-plus return and an objective return but the range of premia that external managers bring to the table will differ. Systematic managers will harvest carry, momentum and value, while dynamic managers are more discretionary, using options to take advantage of volatility, McHugh says.
She expects risk premia managers to harvest across a range of markets and sectors, including bonds, equities, commodities, listed infrastructure and currency. These diversifying strategies are even more important in times of low interest rates, she says.
“The reason I say that is, with a reduction of bond and equity market returns, given how much this market (capitalisation) has rallied, future return expectations look lower. This increases the importance of diversified returns,” McHugh says. “It’s about diversification and being able to access alpha and risk premia.
“The managers we hire and relationships we have with them are to extract externalities if we think they’re valuable. It’s also liquid, which is of value because when markets change, we have the ability to change our strategy quickly.”
Holy grail – with caveats
Travis Schoenleber, managing director of global investment firm Cambridge Associates, hires risk premia specialists to diversify and protect against risk in its equity-based portfolios.
“Where we have had success is trying to capture these premia, earn returns and reduce equity risk,” Schoenleber says. “We use it primarily as a diversification to equity…There is a lot [of] evidence for premia being consistent in equities and less sound and persistent in commodities and currencies.”
He says risk premia are pitched as the “holy grail”, providing excess returns with lower fees.
“We have a caveat on how they’re put together,” he says. “There are very good products and bad products and it’s important for investors to understand the mechanics.”