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Oft-Touted Risk Premia Strategies Show Their Weak Side

Meant as hedge fund replacements, they haven’t kept up with the market, though they’ve improved this year.

Art by Martin Gee

This year has been a comeback for risk premia, an investing approach that aims to profit from the market’s inefficiencies. Last year showed this method’s limits, when equities uniformly took a pounding.

According to data from eVestment, aggregate return for risk premia strategies through the end of 2019’s second quarter was 7.79%, up from -5.14% at the end of last year. Still, they overall trail the S&P 500 this year, and last year lost more than the benchmark index.

The strategies, which seek to capture uncorrelated returns from the broader market, have grown in popularity with asset owners in recent years, as investors pivot to more defensive portfolio positioning late in the economic cycle.

An example of how they work: You buy an S&P 500 index product weighted by a behavioral factor—stocks that exhibit low volatility, for example—and sell another one that uses the index’s customary market cap weighting. You profit from the difference in their performances. To choose investments. risk premia strategies often use factors like quality, momentum, low volatility, and small market value.

Aside from factors, common risk premia strategies include long/short, trend-following, or managed multi-asset. They can be used in portfolios without requiring a specific target allocation and supporters of risk premia tout the diversification benefits. However, these funds are still relatively new—many are under 10 years old—which raises questions about how battle-tested they really are.

Last year could provide a window into how risk premia strategies can impact portfolio performance if markets go sideways and managers miss the mark. Now that investors are taking stock, the way investors think about risk premia is beginning to change. Investors “came to risk premia almost as a hedge fund replacement or as something that would work alongside hedge funds,” says Reino Ecklord, a Chicago-based research consultant for hedge funds at NEPC. “But after 2018, people took a step back and they’ve started to realize that risk premia may not be a complete replacement for hedge funds in a portfolio.”

Meanwhile, comparisons, the key to evaluating any investment strategy, turn out to be hard for risk premia. The difficulty for investors, Ecklord says, is that while there is a strong case for individual factor performance in market data, risk premia strategies are typically unique interpretations of how to construct portfolios in order to capture desired premias. The end result is that it can be difficult for investors or consultants to compare strategies or to fully understand how they work in a given market environment. That’s largely been the case for investors over the past 18 months as they evaluate their own portfolios and try to understand why premias underperformed.

Angus Sippee, a multi-asset portfolio manager at Schroders, argues that risk premia investors should put more focus on long-term downside risk management to avoid an overreliance on estimating correlations or diversification to bolster performance. “The jury is still out about the drivers of risk factors or premias over the short term,” he explains. “Most risk factors are designed to work over the long term.”

Pensions, foundations, and endowments typically bring a long time horizon to their investment strategies, which could help them hold on during periodic drawdowns as we saw in 2018.  The broad idea around risk premia strategies is that some factors will work well while others fall out of favor in a given market environment.

The value factor, for example, can underperform for months or years if markets are in a persistent rally, which can make it difficult to find cheap investments. Trend followers, which have played a big role in the risk premia rebound this year, are coming off years of lackluster returns. Long-term investors are more likely to ride out those cycles and reap the benefits as factors fall back into favor.

Toby Goodworth, managing director and head of risk & diversifying strategies at investment consultant bfinance, says that 2018 was a wake-up call for some investors to deepen their understanding of factor performance and make adjustments. The 2019 rebound is also bringing new investors to the space. “We have seen a strong uptick in the conversation around multi-asset broadly and alternative risk premias,” Goodworth said. However, allocators are taking a much closer look at their investment goals in an effort to try and balance some of the complexity that comes along with uncorrelated return streams against more pragmatic concerns like ensuring more consistent total return.

In practice, that could mean overall allocations shift such that risk premia serves as more of a compliment alongside other absolute return strategies rather than a complete replacement. Investors may also shift their use of risk premias to be more tactical. NEPC’s Ecklord explains it this way: “I’m not in this space because I’m a believer in just owning the factors. What we think through with our clients is how to identify factor exposures that persist over time so that I can roll in and out of them as necessary based on the investment objectives of a portfolio.”

Some strategies may start to fade out as new ones come to the fore. Some investors suggest there is less of a focus on single stock equity exposures than there was when risk premia started to gain popularity with investors.

The use of factors in fixed income is also growing and could provide new perspectives for bond investors. In a recent paper, Brad Camden, head of fixed income at Northern Trust, outlined how factors can work in bond portfolios—an approach which could provide new options to yield-starved investors. Camden’s research showed that a multi-factor combination of quality and value as tilts in a corporate bond portfolio can improve performance.

Last year was a big one for new risk premia fund launches across strategies, and next year those funds will be hitting the three-year track record milestone most institutions look for in 2020. Ecklord notes that those funds are “more articulate” about their approach, objectives, and what investors can expect.

“What we’ve seen is that those managers were able to work around a bit of what happened in 2018,” Ecklord said. “Strategy-wise, there is more of a push away from factor box style allocations where managers are just ticking off certain factors. It’s a bit more nuanced.”

Those tactical adjustments could help investors manage better if markets enter a global slowdown as some forecasts suggest. Schroder’s Sippee says he expects a continuation of geopolitical tensions that have been a feature of 2018-19, including uncertainty around trade, monetary policy, and elections in the US and elsewhere. In order for investors to be successful managing through a slowdown, they’ll have to be willing to look dynamically at risk management and closely monitor their exposures.

Related Stories:

When Risk Parity Meets Risk Premia

Can Risk Premia Really Capture Alpha?

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