The nearly 20% peak-to-trough plunge in the S&P 500 Index last quarter revealed that not all alternative risk premia (ARP) strategies are created equal. Among the 10 largest ARP funds accepting new capital in the SG Multi Alternative Risk Premia Index, for instance, the best strategy beat the worst by more than 10 percentage points. The index also fell by 1.62% during the quarter – hardly the uncorrelated performance many investors expected. Now, as investors evaluate their manager lineup and the role these strategies play in their overall asset allocation, it’s critical to assess key drivers of performance dispersion.
We believe investors in ARP strategies are seeking answers to three key questions:
1. What have been the key drivers of performance?
2. What have been the drivers of performance dispersion?
3. What does this mean for my portfolio?
Drivers of performance
Most equity style factors were out of fashion last year, with value and cross-sectional momentum delivering negative performance. Quality and low beta factors did better, especially during times of equity market stress. The value factor in particular continued its multiyear underperformance in 2018. For example, the U.S. equity value factor, as represented by the Eugene Fama and Kenneth French high minus low value methodology, experienced losses of 8.70% in the 12 months through November 2018, while the same factor in international equities performed even worse, according to the Fama French Data Library. Naturally, managers with concentrations in equity style factors suffered the most.
Another performance detractor was exposure to time-series momentum or trend-following strategies. Managers who ran more responsive and defensively oriented trend-following strategies with explicit constraints on equity beta fared significantly better during reversals in equity markets, particularly at the conclusion of last year.
Finally, volatility risk premium strategies in equity and interest rate markets also delivered underwhelming performance. Not all managers employ these strategies, but those who did were roughed up during the volatility whirlwind of February, which saw the largest-ever one-day move in the VIX–CBOE Volatility Index. These strategies made a comeback, but had a tough fourth quarter as volatility rose again.
While the performance of the ARP category was underwhelming last year, it is important to put it into context and underscore that it is far from extraordinary. As Fama and French point out in their recent paper, “Volatility Lessons,” alternative risk premia are no different from traditional risk premia and can experience prolonged periods of drawdown. Historically, five-year periods of negative returns are far from rare. (Statistically, a strategy estimated to have a 5% expected return and 10% volatility has almost a 1-in-3 chance of experiencing losses in a given year, assuming normally distributed returns.)
While challenging, ARP strategies have potential to reward investors for staying focused on the long term. That said, managers who run more diversified portfolios may deliver less volatility and more consistent returns than those who are more concentrated or overexposed to particular risk premia or asset classes.
Drivers of performance dispersion
In our view, there are three key drivers of performance dispersion across risk premia managers:
1. The overall design objective: ARP strategies are constructed to be long/short and market-neutral and typically have low exposure to traditional risk factors. However, meaningful differences can arise in the details of strategy design. Some strategies are designed to be a hedge fund substitute and focus on maximizing the overall Sharpe ratio. Others focus on diversification, even if it comes with a modestly lower Sharpe ratio. The latter cohort has fared better during recent stress events – as they have been tracking their overall equity market exposure and taking steps to reduce, or eliminate it altogether.
2. Risk premia selection: Some managers tend to “fill the grid” and look to capture major risk premia – value, carry, momentum – in every major asset class. Others take a more selective approach and capture only risk premia they believe have a clear macroeconomic rationale for existence and persistence. The overall design objective, of course, influences which risk premia strategies are selected. For instance, managers focused on diversification might limit exposures to procyclical strategies such as volatility sales and foreign exchange (FX) carry.
3. Portfolio construction and risk management: Some managers seek balance across both asset classes and factors. Others have chosen to stay “close to home” and focus on strategies they consider their core expertise. Some, for example, allocate as much as 70% of the risk to equity style factors, while others earmark half the risk in momentum strategies. Naturally, portfolios that concentrate in certain factors tend to suffer more when those styles are out of favor.
As investors evaluate their allocation to alternative risk premia strategies, we believe the following questions are critical:
1. Are my allocations to ARP strategies consistent with their intended role in the portfolio?
Investors will likely realize the best outcomes by ensuring their ARP strategies are aligned with their intended role within the portfolio. Managers who seek to maximize their Sharpe ratio likely fit best as hedge fund complements, while those who seek to maximize diversification benefits may be better suited for the role of risk mitigation.
2. Have I set appropriate evaluation horizons and other criteria for my allocation?
ARP strategies should not be expected to provide consistent positive returns over short horizons and are best evaluated over longer-term periods. ARP exposure implemented in capital-efficient overlay structures may require a different evaluation approach than allocations with dedicated capital.
3. Do I have the right combination of ARP strategies in my portfolio?
The approach to strategy construction varies significantly across ARP managers, even if they appear similar on the surface. Investors will likely realize better outcomes if they are able to build a portfolio of complementary ARP managers.
We believe ARP strategies offer investors an alternative source of returns that may improve the overall risk-and-return profile of their portfolio. These considerations may help in selecting strategies best aligned with an investor’s objectives and maintaining investment discipline throughout the business cycle.