Alternative risk premia (ARP) strategies may be part of the answer for asset owners looking for returns in volatile markets, according to Laurent De Greef, head of portfolio strategy at D. E. Shaw Investment Management.
But sizing the strategy to systematically isolate and harvest excess returns from exposure to specific risk factors, should be treated like salt when seasoning food, the New York-based strategist told Investment Magazine’s Absolute Returns Conference, held in Sydney earlier this month.
Too little and it doesn’t taste good; too much and it’s harmful to your health, he said. “The general rule is you can put less volatility on than what the Sharpe ratio would suggest,’’ he said.
Finding alternative risk premia
In volatile markets and lower return environments, asset owners want to rely on something else to generate return and correlation, De Greef said.
“The first place to turn is pure alpha − absolute return,’’ he said. “The challenge you run into is it exists but it’s hard to find and source. ’’
In the pantheon of return sources, alternative risk premia sits between the two extremes of traditional risk premia and pure alpha, but borrows traits from each, he said.
“It’s pure alpha in some forms, because it has a high Sharpe, you can construct it to be market neutral, it can be cash efficient, and you can overlay on the return stream,” he said. “But is has traditional risk premia characteristics in that it has a skewed return distribution.”
“Interestingly we’ve seen this conversation come back to life with investors. If one is capacity constrained on the alpha side and has certain return objectives, this may be part of the answer. I stress the idea of part of the answer.”
Andrew Korbel, senior portfolio manager, debt and absolute returns at one of Australia’s biggest alternative investors, the Victoria Fund Management Corporation (VFMC), said the fund had an advantage of not having fee constraints and employing quality hedge fund managers.
Korbel considered adding alternative risk premia strategies to the Fund at one point but instead focused on the blue-chip hedge fund and private credit portfolio.
About eight per cent of VFMC’s portfolio was in alternatives, equivalent to $5.5 billion of the $70 billion assets under management.
“Its objective is to invest in it for returns and diversification of having a low correlation (low beta) with equities is very important,’’ said Korbel.
“[We aim] for the combination of cash [rate] plus three per cent net of all fees. If they don’t, they don’t warrant a place in the portfolio. “Pleasingly our hedge funds have come to the fore post-Covid and have done really well in 2022.”
De Greef said the Sharpe ratio risk premium can seem “pretty attractive” for ARP, but that the strategy borrows from the worlds of both alpha and traditional risk premia, and has a skewed distribution or “heavy left tail” and thus had a tendency to crash.
“The reason you earn a premium in the first place is probably that you are underwriting that crash risk,’’ he said. “Once you consider this is exactly what you’re getting, you’re underwriting the probability of a crash, it explains why you get the high Sharpe ratio in the first place. That informs how you’d want to use the strategies in the portfolio.’’
Combining a number of risk premia strategies together will increase the Sharpe ratio but still gave skewed distribution, he said.
“As you diversify the premia, you do not diversify your crash risk. There may be an optical illusion with a higher Sharpe ratio but you’re still exposed to that crash which you need to specifically manage,” he said.
Asset managers needed to think about how risk premia perform in different market environments as “that will help build a better portfolio to try to mitigate that left tail”, he said. But hedging that tail was “very expensive” and not a solution because it “eats away all of your Sharpe”.
ARP not popular
ARP has not been a popular strategy in Australia recently. According to wealth adviser Mercer Australia, the majority of ARP strategies had underperformed cash since their inception dates at the end of 2020.
A lot of investors see statistics on Sharpe ratios greater than one and think “perhaps we can increase volatility to get an attractive portfolio?”, De Greef said. “But there are constraints on how much volatility you can run in an ARP portfolio and that constraint is probably lower than what conventional wisdom suggests.”
“This is where the second piece of the argument comes in – a left tail. What happens when that left tail happens? Can you hold onto the strategy? Do you have liquidity? Will you face capital calls? Careful sizing of the strategy can address this.”
Meanwhile VFMC’s Andrew Knobel said it was “never say never” for having an ARP strategy and said it may have better potential as its own asset class with two to five per cent of a portfolio in it.
“I think high quality alpha in hedge funds is relatively scarce. They need to get money away with those managers is hard. Half of ours are hard closed and another 35 per cent are heavily constrained. We are on the lookout for new things and at some point, what’s available compared with ARP may look like the ARP may bear fruit,’’ he said.