Factor investing may be better suited to
constructing risk parity portfolios rather than replicating hedge funds, according
to EDHEC-Risk Institute (ERI).
“The relevant question may not be, ‘Is it feasible to design accurate hedge fund clones with similar returns and lower fees?’” Previous studies of factor investing—dubbed “alternative
risk factors” by ERI—suggested hedge fund exposures can be broadly
replicated by passive products tracking factors such as value or momentum.
ERI took issue with this position in a report, finding out-of-sample replication weaker than studies’ in-sample conclusions.
“Our results also suggest that risk parity
strategies applied to alternative risk factors could be a better alternative
than hedge fund replication for harvesting alternative risk premia in an
efficient way,” wrote Jean-Michel Maeso, ERI’s quantitative research engineer, and Director Lionel Martellini.
“In the end, the
relevant question may not be, ‘Is it feasible to design accurate hedge fund
clones with similar returns and lower fees?’, for which the answer appears to
be a clear negative, but instead, ‘Can suitably designed mechanical trading
strategies in a number of investable factors provide a cost-efficient way for
investors to harvest traditional but also alternative beta exposures?’,” the
investing methods to asset classes outside of equities—particularly fixed income,
currencies, and commodities—remains a “key challenge” for the investment
industry, Maeso and Martellini added.
The results “question the role of alternative risk premia in a low or negative interest rate environment,” said Thierry Roncalli, head of research and development at Lyxor Asset Management, which partnered with ERI on the research.
Researchers already understood alternative risk
premia as diversifiers, “but this study shows that they are potential
candidates as performance assets,” Roncalli said. “Therefore, this research
opens a door for reconsidering the traditional equity/bond asset mix policy.”
Related: Replacing Hedge Fund ‘Alpha’ with Smarter
Beta & Cliff Asness Defends Risk Parity