Exploring the Benefits of Alternative Risk Premia Diversification

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Key Takeaways

Alternative Risk Premia (ARP) provides these extra returns by taking on alternative investment risks, contributing to a well-diversified portfolio that extends beyond stocks and bonds. In turn, this can help generate improved risk-adjusted returns.
ARP strategies aim to deliver distinct return opportunities by capturing return-generating, systematic risk factors like value, momentum, carry and defensive investments.
By adding ARP, you decrease dependence on traditional assets, providing a cushion when markets turn sour and enhancing portfolio durability.
Trend-following and volatility strategies are two popular ARP strategies that have proven effective at exploiting market inefficiencies to bring in supplementary income.
Rigorous risk management and ongoing monitoring are key to successfully integrating ARP strategies into portfolios and ensuring they complement investment objectives.
First, ARP improves portfolio performance by giving investors exposure to new return streams, and second, ARP lowers portfolio volatility through low-correlation investments.

Alternative risk premia offer a way to diversify investment portfolios beyond traditional stocks and bonds by tapping into unique sources of return. These strategies seek to monetize systematic risks across asset classes.

These are markets like commodities, currencies, and interest rates, usually traded with a systematic, rule-based philosophy. Allocate capital to various risk factors. It’s a strategy that lowers your reliance on the overall markets to do well and better positions you to earn steadier returns over time.

This application serves as a powerful tool in unpredictable markets, when conventional investments may not yield desirable returns. We’ll explore the basics of alternative risk premia.

We’ll take a closer look at their mechanisms and why they’re integral to building a well diversified portfolio. If you’re just starting to invest or want to diversify your strategy, this provides actionable ideas to help you get started.

What is Alternative Risk Premia?

Alternative Risk Premia (ARP) are the excess returns earned from bearing alternative, non-traditional sources of investment risk. Compared to traditional strategies heavily investing in stocks and fixed income, ARP strategies leverage idiosyncratic risk factors in multiple asset classes.

These factors like value, momentum, or carry offer sources of return that are frequently uncorrelated with conventional assets. By systematically targeting these risks, ARP provides a systematic approach to diversifying portfolios and enhancing risk-adjusted returns.

1. Define Alternative Risk Premia

More than relative value, ARP harvests risk premiums beyond the usual exposures to equities and fixed income. Equities deliver returns in the form of cash flows attributed to a company’s earnings.

In comparison, ARP looks at broader risk factors, like overall market movements as well as volatility. Such strategies enable investors to benefit from faster-growing, less accessible markets in commodities, currencies, and volatility.

In doing so, they unlock a wider universe of possible returns. Further adding ARP to a portfolio increases diversification even more. Its returns tend to be more stable, decreasing the chance for swings that correspond with long-only markets.

2. Traditional vs. Alternative Risk Premia

Traditional risk premia are closely related to the equity and bond markets, associated with a bet on overall economic growth or an upturn in interest rate cycle. ARP goes beyond equities and fixed income, lessening dependence on traditional market drivers.

For instance, during stock market downturns, ARP strategies like momentum can still perform well by exploiting price trends in unrelated assets. Second, this multi-asset approach improves the chances of earning higher returns by capturing varied market dynamics.

3. Sources of Alternative Risk Premia

Value: Buying undervalued assets based on intrinsic worth.
Momentum: Capturing profits from sustained price trends.
Earning returns from yield differentials, such as interest rates.
Defensive: Focusing on low-risk assets offering stable returns.
Size: Investing in smaller assets with growth potential.
Liquidity: Exploiting inefficiencies in less-traded markets.

Each factor uniquely enhances portfolio diversification properties while managing risk premia strategies.

Why Diversify Beyond Stocks and Bonds?

Limiting your risk management capabilities by relying only on stocks and bonds. This is particularly the case during times of economic uncertainty or market decline. Stocks and bonds have formed the foundation of investment portfolios for decades.

Their weaknesses become apparent in the depths of systemic market dislocation, with both equities and fixed income falling together. Branching out into ARP allows you to take advantage of less-correlated return streams. This minimizes your dependence on traditional markets and makes your entire portfolio more resilient.

Limitations of Traditional Diversification

Why typical diversification doesn’t cut it. It largely just diversifies within an asset class, going across asset classes that are in and of themselves still highly correlated.

For example, for financial crises, stocks and bonds can both drop in value at the same time, defeating the whole purpose of diversification. That reality underscores the need for creative approaches, like ARP, to leapfrog traditional thinking to best address systemic risks and promote greater stability.

Benefits of Alternative Investments

Alternative investments provide unique benefits, such as greater diversification and access to risk factors outside those in traditional markets. By incorporating ARP strategies, you can enhance risk-adjusted returns and tap into opportunities that traditional investments might miss.

For instance, investments like commodities or volatility arbitrage provide diversification from stocks and bonds to make a more balanced portfolio.

Reduce Portfolio Volatility

Adding ARP strategies diversifies portfolios to create more consistent return streams and lower volatility. Investments like managed futures and currency carry trades that have little to no correlation to stocks and bonds.

One reason is that they often provide consistent, reliable performance in times of market duress. This provides a smoother long-term investment experience.

Enhance Risk-Adjusted Returns

ARP strategies seek to exploit well-researched and documented, and thus widely accepted, risk premia—like value or momentum—thereby maximizing the risk/reward trade-off.

Finding the right balance among these factors leads to a well-diversified portfolio with better long-term performance potential.

Access New Return Streams

Diving deep into ARP reveals plenty of opportunities to access previously unreachable return streams. Equity market-neutral strategies and merger arbitrage can expose income generating opportunities that other more conventional investments may miss.

These strategies help you stay nimble and flexible.

Explore Alternative Risk Premia Sources

Alternative risk premia (ARP) provides a methodical approach to diversifying portfolios in ways that you cannot achieve with traditional stocks and bonds alone. Through its emphasis on unique, quantifiable sources of return, ARP deepens the investable universe and seeks to mitigate identifiable risks.

Next, we take a closer look at the 4 major ARP sources and what they mean for your portfolio.

Value

Value strategies primarily seek to identify those securities that are trading at a discount to their intrinsic value. By focusing on assets that are undervalued by the market, value investing seeks to provide steady returns over the long haul.

After all, one of the common factors, value—represented as buying stocks with low price-to-earnings ratios—has outperformed over long horizons in long-only portfolios. These strategies do come under strain during severe market drawdowns, particularly when the mispricing is still playing out.

Momentum

Finally, momentum strategies take advantage of current price directions, allowing the strategy to profit as assets increase and decrease in price. This makes them shine when the market is trending, and assets are directional movers.

As an example, buying stocks that have done well in the recent past performs extraordinarily well. Market timing and changing market conditions are everything. Surprise reversals can make or break performance.

Carry

Carry strategies take advantage of variations in yield between assets – like currencies or fixed income. To achieve this goal, by investing in higher-yielding instruments, investors can create a predictable stream of income.

For instance, there is an opportunity to borrow in currencies with low interest rates and invest in currencies with higher bond yields. These investments can be riskier in volatile markets, as unexpected rate increases may lead to substantial losses and decreased returns.

Defensive

Defensive strategies aim to preserve capital in times of market turbulence by investing in low-volatility assets. These strategies are effective in both smoothing out a portfolio’s volatility as well as cushioning the fall in a market correction.

Incorporating defensive ARP sources, such as utility equities or cash-like instruments, fortifies the goal of prudent risk-taking.

Size

Size-based strategies are concerned with the performance disparity found between small-cap and large-cap stocks. Historically, smaller companies have delivered higher returns under certain environments, providing an added boost of growth.

Including some size factors helps improve diversification and increases expected return.

Liquidity

Liquidity strategies exploit pricing discrepancies between liquid and illiquid assets. Just like investing in less-traded bonds during periods of market stress can be a value-releasing strategy.

Illiquid investments need to have a close watch because they are riskier in times of severe market turmoil.

Constructing ARP Strategies

In our experience, building effective alternative risk premia strategies is an iterative and heavily mechanical process that ideally requires a blend of art to achieve diversified returns and performance. These risk premia strategies aim to isolate specific asset class risk factors beyond traditional investments like stocks and bonds, ensuring alignment with broader investment goals and adaptability over time.

Factor Identification and Selection

In other words, the foundation of any ARP strategy is rooted in recognizing the risk factors that matter. Using the empirical analysis, we try to understand how value, momentum and carry work. This still wide-ranging evaluation includes every asset class.

A disciplined factor-based approach makes sure that chosen factors have strong historical performance and low correlations among each other. Figure 1 Pairwise correlation of ARP Composite (EUR) with constituents at a time when ARP averages an average pairwise correlation below 0.4. This underscores the well-known diversification benefits of well-chosen factors.

This level of analysis tackles the “data dilemma,” prioritizing existing empirical data to maximize tangible returns and minimize portfolio overlap.

Portfolio Construction Techniques

At the end of the day, diversification comes from intentional portfolio construction. Methods such as equal-weighting or risk-parity provide an even exposure to the factors chosen. Asset allocation is key, ensuring that accepted risk-return profiles are met while ARP strategies are used alongside traditional investments.

Through the example above, if you invest $107 million in ARP, you would achieve benefits of $42 million. This strategy would beat investments in smart-beta trend-followers or diversified growth-focused active funds. This evidence underscores the complementary role of ARP to maximize performance.

Risk Management Considerations

Risk management remains core to executing an alternative risk premia strategy. Setting explicit risk guidelines, tracking exposures, and adjusting within guidelines continuously protects taxpayer and investor capital. Ongoing evaluation is key to adapt and be robust, especially when correlation between risk premias can change over time, as in late 2018.

Implementation Challenges

Implementing alternative risk premia strategies involves navigating complexities like compounded risk factors and existing system infrastructure. Strong systems facilitate the deployment of these liquid diversifiers, ensuring that strategies remain robust in challenging operational environments.

Performance and Market Environments

As with most ARP strategies, ARP strategies excel due to their diversification benefits and sensitivity to different stages of the business cycle. To maximize ARP’s impact, it requires a special focus on what these strategies look like across economic boom and bust cycles.

Second, think about how they react to macroeconomic drivers and correlation with legacy assets. Beyond political pressures, management style goes a long way toward ensuring the ARP is used to its fullest potential.

ARP Performance Across Cycles

ARP strategies operate countercyclically or less effectively during boom times. During periods of economic expansion, some ARP strategies—such as momentum or carry—may deliver stronger returns due to favorable market trends and liquidity.

On the flip side, during recessions, defensive ARP strategies, such as value or volatility, typically offer downside protection. For example, a volatility premium strategy would perform best in disorderly markets where they take advantage of mispriced options.

Looking at past performance data can show some key trends. This type of analysis provides valuable insights for investors seeking to understand which ARP strategies may be more resilient across varying market cycles.

Impact of Macroeconomic Factors

Fundamentally macroeconomic drivers such as interest rates, inflation and overall GDP growth are primary driving factors for ARP performance. Increasing interest rates can have a drastic impact on carry strategies tied to debt instruments.

Concurrently, today’s inflationary pressures are advantageous to commodity-related ARP strategies. By tracking these trends, investors can use current economic conditions to inform their investment strategies and set themselves up for strong returns regardless of the market environment.

Correlation with Traditional Assets

Because ARP strategies tend to be negatively correlated with stocks and bonds, they can serve as a powerful diversifying asset. For example, even in a portfolio significantly tilted to equities, adding ARP strategies may decrease volatility without sacrificing return potential.

Grasping these inverse relationships is the bedrock foundation to improving risk-adjusted performance.

Active vs. Passive Management

Both active and passive management make sense in ARP. Active strategies provide customization—more focused response to changing market conditions—while passive strategy delivers cost savings.

Fulfilling the intent aligning the choice with your goals will help you create the best possible synergy with your overall portfolio strategy.

Potential Pitfalls and Challenges

While alternative risk premia (ARP) strategies offer true diversification due to their non-cyclical nature compared to traditional assets, many investors must navigate the complexities inherent in these alternative investments. Identifying potential pitfalls and challenges is essential for informed decision-making regarding their investment products.

Implementation Costs

Despite their relatively small size, implementing ARP strategies typically comes at significant costs, such as management fees and trading expenses. These fees are highly variable depending on the complexity of the strategy and the churn (trading frequency) that is entailed in executing the strategy.

For instance, a momentum-based ARP strategy may call for more aggressive portfolio rebalancing, resulting in increased trading costs. These costs can eat away at total returns, especially in the current low-return environment where every basis point counts.

Investors should carefully weigh whether the benefits that ARP strategies promise are worth the expense. Finally, they need to make certain that the net returns are appropriate for their institutions’ financial objectives.

Complexity and Transparency

ARP strategies rely on intricate models and algorithms, often making them difficult to fully grasp. Clear communication from investment managers is crucial to ensure transparency about how these strategies work and what risks they entail.

Without a solid understanding, investors may struggle to evaluate performance or identify potential problems. For instance, strategies rooted in volatility arbitrage may be harder to track, requiring detailed explanations and consistent reporting to maintain trust.

Capacity Constraints

Certain ARP strategies face scalability issues due to capacity constraints. For example, illiquid markets or niche opportunities can limit the number of participants, impacting both performance and accessibility.

Investors should assess whether their chosen ARP fund can sustain its strategy as assets under management grow, avoiding dilution of returns.

Data and Modeling Issues

Good data—the higher the quality, the better—is the foundation for successful ARP strategies. Poor or missing data can miscalculate risk and expected returns, resulting in a flawed decision.

We’re going to need strong, flexible models that are able to shift to various market realities. These models will ensure our strategies remain focused and effective for the long-term.

Real-World Examples and Case Studies

These alternative risk premia strategies have become a favorite among institutional investors and hedge fund portfolios as they seek to diversify their asset portfolios away from traditional asset classes. These approaches provide concrete examples and insights learned, demonstrating their success on the ground.

Institutional Investor Applications

Institutional investors, like pension funds and endowments, widely implement ARP strategies as a way to diversify and stabilize their portfolios.

In practice, a U.S.-based pension fund applied ARP strategies such as trend-following and volatility carry to its portfolio. Building scenario analysis into the investment process allowed them to responsibly reduce exposure to equities and still create consistent returns during market downturns.

Aside from serving risk management goals directly, ARP strategies further serve these goals when they match institutional mandates that prioritize stability and long-term performance. By combining ARP with their traditional investments, institutions can better achieve their goals without having to depend as much on market beta.

Hedge Fund Strategies

Hedge funds often rely on ARP strategies to boost returns and mitigate market fluctuations.

One large multi-strategy hedge fund recently got particularly aggressive, putting a significant amount of its capital to work in equity market neutral as well as carry trade strategies. This decision resulted in stable alpha generation.

These strategies helped the fund deliver strong relative performance during market turbulence and highlight the power of ARP in turbulent times. Hedge funds’ capacity to deploy several ARP strategies is a testament to their flexibility and worth in attaining unparalleled risk-adjusted returns.

Portfolio Optimization Scenarios

In terms of portfolio construction, when deployed strategically, ARP strategies can deliver an attractive risk-adjusted return profile.

For example, adding ARP strategies such as momentum and merger arbitrage into a traditional balanced portfolio increased returns with less drawdown. Scenario analysis, like stress testing to prepare for potential market downturns, calls attention to ARP’s part in maximizing performance.

This proactive, bottom-up approach helps us keep portfolios resilient and aligned with the goals of our investors.

Integrating ARP with Traditional Investments

Incorporating alternative risk premia strategies (ARP) into traditional investments provides structural diversifiers that improve risk-adjusted return profiles. By blending ARP with conventional assets like stocks and bonds, investors can create a more balanced portfolio that leverages uncorrelated return sources, enhancing the overall diversification properties of their asset portfolios.

Strategic Asset Allocation

Strategic asset allocation is the basis for the overall approach to integrating ARP with traditional investments. It’s about finding the ideal mix of ARP tactics in the total investment portfolio to meet defined distance, time or cost savings targets.

A traditional investor seeks to lower overall equity exposure and risk, while continuing to earn similar returns. For one, they would deviate 20% of their overall portfolio investments toward ARP strategies built on trend-following or carry trades.

These decisions have a direct and pronounced impact on the portfolio’s overall risk and return profile, underscoring the importance of periodic reevaluations. Adjustments must be made to respond to both new and dynamic market conditions, keeping the portfolio in close alignment with long-term goals.

Dynamic Allocation Strategies

Dynamic allocation strategies directly reduce ARP exposure by reallocating assets according to current market conditions and macroeconomic factors. Then, especially during times of increased volatility in the equity market, achieve outsized returns by allocating more strategically to ARP strategies.

Volatility arbitrage, in particular, would be very good stabilization. Flexibility in how dollars can be allocated gives investors the ability to react before an event, keeping returns high and risk low.

Timeliness of decision making is vital in this regard, as slow decision-making can result in lost opportunities or increased exposure to downside risk.

Risk Budgeting Framework

Strategically, risk budgeting assists in the efficient distribution of risk through portfolios by determining acceptable levels of risk for various asset classes, ARP included.

For example, an investor might assign a 30% risk budget to ARP strategies, ensuring they contribute meaningfully without overshadowing traditional assets.

Integrating risk budgets with overarching goals creates a more unified strategy, one that provides a better balance of growth and protection.

Academic and Industry Research

As investors look for ways to diversify and be more resilient outside of traditional asset classes, alternative risk premia (ARP) strategies have grown in popularity. As you know, academic research has played a vital role in informing our understanding of ARP’s various mechanisms.

Studies like Ilmanen and Kizer (2012) highlight how factor investing emerged post-2008 as institutional investors moved toward systematic risk factors to mitigate concentrated exposures. Industry research further highlights that systematic factors have replaced stock-picking as the primary drivers of portfolio performance, with alpha becoming a relic of investment history.

This change further underscores the importance of ARP to prioritize resources strategically.

Empirical Evidence of ARP

Empirical findings confirm ARP’s effectiveness in improving returns. For instance, data reveals that five principal components explain over 90% of the variance in the traditional risk premia (TRP) universe.

Low volatility, typically less than 2%, of well-diversified ARP portfolios further demonstrates that ARPs tend to be very attractive for risk-adjusted returns. Portfolios utilize equity index futures, government bond futures, commodities, and FX forwards.

These industry examples together paint a rich tapestry of market dynamics. Adding ARP to investment portfolios has proven to decrease drawdowns and increase stability, as seen through science-backed data-driven analysis in large-scale studies.

Factor Persistence and Robustness

Persistence and stability of these risk factors may prove essential to ARP’s long-term success. The US volatility carry premium shows skewness 13 times that of US equities.

In doing so, it proves its shared strength and resilience across a myriad of market cycles. By understanding the stability of factors, investors can pursue ARP strategies with more confidence that performance will hold up over time.

Ongoing Research and Developments

Research is still being done today to improve ARP methodologies. Trends such as new systematic factors (e.g. COVID-19) and increased data analysis opportunities are further evolving the field.

Keeping a finger on the pulse of these changes will help investors position themselves to best capitalize on these emerging opportunities.

Conclusion

Diving into alternative risk premia leads to new opportunities for strategies that extend far outside the typical universe of stocks and bonds. You not only increase the ways you can manage risk, you pursue returns across varied market conditions. These strategies introduce new diversity to your portfolio while offering the ability to smooth short-term highs and lows over a longer investment horizon.

When you mix ARP with traditional investments, you get a more holistic approach. This combination can be a key to maintaining balance when markets change direction unexpectedly. It’s not about gambling, it’s about preparing for disruption, understanding the state of play, and investing wisely.

Looking to diversify your portfolio like never before? If you’re looking to diversify beyond stocks and bonds, look to alternative risk premia to help you go deeper. The right tools and strategies used in tandem can dramatically improve outcomes.

Frequently Asked Questions

What is alternative risk premia (ARP)?

Alternative risk premia (ARP) represents the return of exploiting these non-traditional risk sources through various diversifiers. These liquid diversifying strategies utilize factors such as value, momentum, and carry, extending beyond traditional stock and bond investments.

Why should I diversify beyond stocks and bonds?

Diversifying beyond stocks and bonds not only lowers overall portfolio risk but also enhances the risk/return profile by incorporating alternative risk premia strategies, which offer uncorrelated returns and improve risk-adjusted returns across all market conditions.

What are common sources of ARP?

Some common alternative risk premia strategies include value, momentum, carry, volatility, and trend-following. Such strategies fund themselves by exploiting inefficiencies across various asset classes, including equities, credit, commodities, and currencies.

How do ARP strategies perform in different markets?

ARP strategies, known for their diversifying characteristics, demonstrate strong relative performance in low-return or volatile regimes. These alternative risk premia strategies rely on diversified sources of return, making them resilient across various market risks.

What are the risks of using ARP strategies?

Furthermore, alternative risk premia strategies (ARP) are susceptible to challenges like crowded trades, implementation costs, and underperformance at times. However, with the right research and diversified approach, investors can avoid these risks.

Can ARP be integrated with traditional investments?

True, alternative risk premia strategies diversify the traditional portfolio by introducing uncorrelated returns to stocks and bonds. Pairing them alongside a more traditional stock and bond portfolio can significantly augment a portfolio’s diversification properties and stability.

Are there real-world examples of ARP success?

The short answer is yes; institutional investors, such as pension funds and hedge funds, have heavily employed alternative risk premia strategies (ARP). Notably, momentum and carry strategies, often used as liquid diversifiers to power the engine of a diversified portfolio, have historically returned excess returns over time.