After a 40 year decline in interest rates, investors have seen a structural change in fixed income and equity correlations, with many managers moving towards alternative risk premia strategies to diversify and protect portfolios.
But speakers at Investment Magazine’s Fiduciary Investors Symposium warned that alternative risk premia investments do not have the same characteristics as fixed income or equities, even if they can mirror their historical correlation.
“Risk premia, as a basket, generally has a convergent profile, not convex,” Anthony Lawler (main picture, left), head of systematic and head of investment solutions, at GAM says.
“So if you invest in diversifiers that are some form of risk allocation, don’t expect them to give you a positive payoff in a bearish environment because they are not designed to do that.”
Alternative risk premia refers to investments that focus on the underlying performance drivers inherent in many asset classes, rather than the asset class itself. The aim is to construct a portfolio that includes exposure to multiple factors, many of which have low correlations to each other.
Popular alternative risk premia currently include merger arbitrage and volatility risk, which carry a risk premium and often explains their greater rates of return.
Lawler points out that when analysing correlation and low correlation options, how correlation changes over time is the most important consideration when constructing a portfolio that will withstand unexpected market ructions, like that from Covid19.
“Correlation is a long term average, but none of us live long term averages, we live the path,” he says.
“It might seem obvious, but many managers didn’t think about that detail in the past, so they had a 20 year average correlation but then in a crisis, it tended to be divergent to risk assets.
“This meant they would basically have a correlation spike to risk assets, and that’s not helpful.”
Jean-Charles Bertrand (pictured, right), chief investment officer, multi-asset, at HSBC agrees, adding if equity markets go down, alternative risk premia will not necessarily deliver positive returns.
“You should expect very low correlation with traditional asset classes, in particular equities,” Bertrand says.
“But low correlation does not mean negative correlation, that is for hedging strategies.”
Bertrand says alternative risk premia fall firmly in the diversification bucket, and are not as useful for hedging.
Lawler agrees, adding investors often make the error of selling diversifiers at the wrong time, because they were mistakenly expecting them to be divergent and act as a hedge to equities.
“When you’re running alternatives, it should be more difficult to predict the expectation relative to the economic cycle, but it’s supposed to be uncorrelated like that,” he says.
“That does make it difficult to explain when things aren’t working though, so managing expectations is critical.”
When selecting alternative risk premia, Bertrand says investors must consider the type of premium they’re looking for, because not all premium is created equal.
“Premium selection really matters,” he says. “Large diversity and diversity of risk premia do not have the same properties.”
He says these alternative investments can perform very differently based on whether they are driven by economic rationale and academic research or by practitioners, like hedge funds or proprietary trading desks.
Using volatility risk premia as an example, where investors try to take the benefit of the difference between the implied volatility and realised volatility, Bertrand explains that over the long run it delivers a positive return and relatively low correlation with traditional asset classes, particularly equities.
“But the premise here is that the correlation is not stable,” he says. “In this circumstance, when equity markets go down, the correlation is going to increase significantly, perhaps at the worst time.”
GAM’s Lawler says duration has been a widespread positive contributor to investor performance over the last four decades.
“But looking forward, that’s just not the expectation,” he says. “So many of the discussions we have are around creating solutions that essentially augment that duration exposure in portfolios.”