When Risk Parity Meets Risk Premia

Hedge fund replication may not be the optimum use of factor investing strategies, research shows.

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 authors argued.

Applying factor 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

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