The expected return contribution from alpha and risk premia strategies has just about doubled from five years ago, says Debbie Alliston, CIO of AMP Capital’s Multi-Asset Group.
While this might only have been around 6 per cent of the CIOs future total return expectation five years ago, Alliston estimates it is likely to represent around 10 per cent going forward on current projections. Also, she notes, there is evidence that some risk premias are currently stretched and look well-placed to offer greater returns as they mean revert.
Active risk from alpha and risk premia strategies only accounts for around 5 per cent of total risk but Alliston claims it has added more in return (typically around 0.60 per cent net in excess return). The time frame for active positions is between 18 and 36 months.
“The 0.6 per cent relates to what we have historically sourced from manager alpha/risk premia alpha,” she explains. “It is return generated over and above a neutral asset allocation benchmark,” she explains.
“At times, we may generate additional alpha from our dynamic asset allocation positions.”
Unsurprisingly then, Alliston remains committed to extracting alpha through active strategies, despite what she calls a “poor result” in 2018 which was a tough year for active managers overall.
“We think alpha can, and should, be a more important driver of returns going forward since returns from the market will be lower. And if you think the market is not going to give you a particularly large return, it makes sense to invest in active strategies and alternatives.”
Alliston, who oversees more than $90 billion in funds, says one of her top priorities has been to scrutinise active strategies in the portfolio to ensure they are not correlated with each other or to specific market conditions and that different sources of returns, are coming through the portfolio.
“We know that many different styles of investing contain some common elements, such as value, so ensuring we aren’t doubling up on similar traits is important.”
Know your manager
Within risk premia, knowing how each of the different managers executes strategy is key to generating above-market returns, according to the CIO. “They’re not homogenous. They execute very differently which can result in potentially different outcomes,” she argues.
With risk premia, she warns, managers can list the exact same factors they seek to capture and it can look as though they’re all following the same strategy, but they come in different flavours.
“For example, one sleeve of a risk premia strategy might lean into value – over time history suggests buying stocks with cheaper fundamentals will outperform stocks that are more expensive. The implementation can vary greatly though. Definitions of value, implementation of the shorts, and consideration of other factors all combine to create some potentially different outcomes.”
As she sees it, relying on one manager – and consequently, one way of executing– is potentially dangerous since it can add too much volatility or at least more than the asset owner is comfortable with. AMP Capital’s Multi-Asset Group currently allocates across three managers and four strategies with correlations averaging between 0.3 per cent and 0.6 per cent.
Alliston is a big fan of risk premia strategies. To her they intuitively make sense. But she sees many investors invest in these strategies without understanding what they’re doing.
“They are not a hedge; they won’t protect you when markets drop but they should be relatively uncorrelated with other asset classes. That doesn’t mean prices won’t fall when equities markets fall – you’re running high volatility so they can have a strong negative performance just like equities”
The addition of these and other strategies and the significant outperformance of direct assets has seen her team sharpen their focus on risk analysis and asset allocation decisions.
Understanding risk
With this in mind, her team has been carrying out new research to more deeply examine risk across the portfolios so they can understand different strategies they are invested in greater detail.
Specifically, Alliston wants to obtain more information about economic and style factors coming through the portfolio, both through beta and alpha exposures. “One of the biggest challenges in understanding portfolio risk – particularly when building more complex portfolios – is knowing where we might be taking unintended or correlated risks,” she says.
“It gets quite tricky.”
Part of the research aims to more accurately measure and understand risk across alternatives (including hedge funds) and illiquid strategies. This, is then combined with manager analysis across listed markets which looks to isolate the factors driving performance to ensure that the portfolios are appropriately diversified by style.
Results so far are quite good, Alliston states.
“It can help identify if you’re picking up too much of a factor that you don’t intend to pick up, she said. “It might tell you that for example in your alternatives bucket – hedge funds and risk premia –that you are getting more market risk than you thought you were getting, or, it might tell you that at a style level you are too heavily weighted to value or momentum.
“It can tell you whether you have enough idiosyncratic risk in your portfolio, whether you perhaps have too much of a particular factor, whether you have more equity beta than you thought, and where it is coming from. There are big implications for how the portfolios are constructed and how we view diversification,” she states.
A second piece of work is improving the execution of dynamic asset allocation tilts.
“Our dynamic asset allocation process is not a pure quant process that spits out an answer and tells you what to do,” she hastens to add.
“We are always looking to get the best prospective return to risk outcome in our portfolios, and incorporating the information from our DAA process into a set of appropriately sized and high conviction tilts away from a strategic asset allocation is a key part of what we do.”
Alliston, who uses dynamic asset allocation across the book thinks asset owners don’t always fully understand the risks. In her view, typical risk systems look backwards and often won’t clock what the risk of that tilt is. Her system basically recommends trades that ex ante should improve return and risk outcomes. It provides detailed risk metrics which quantify the impact on the portfolio, and then stress tests these through a variety of scenarios to explore how the portfolio might behave in different environments.
The CIP argues DAA tilts are only implemented where the position is supported by a high conviction view the fund is adequately compensated for the additional active risk.
“Portfolios are currently neutrally positioned in equities and have recently moved to a small underweight in global fixed interest given the significant move lower in bond yields. Over the past three years alpha from dynamic tilts has been neutral to the benchmark in what was a difficult period for active asset allocation.”
