Alternative Risk Premia (ARP) – What Are They? (Examples)
Financial markets are immense but small at the same time.
While there are hundreds of thousands of things you can buy, there are really only a few standard asset classes that people look to for yield:
Things like private assets and real estate will tend to fall in the bonds (credit) or stocks (equities) bucket.
Commodities are viable but many types of market participants don’t use them due to a lack of outright yield.
You can mix and match the assets together to create a balanced portfolio, but there’s a limit to how good it can get in terms of reward relative to risk.
The traditional 60/40 asset allocation mix is not likely to perform as well as it has in the past going forward if inflation volatility is larger.
So, in recent years, traders have broadened their search for returns by looking for non-traditional, or ‘alternative’ risk premia (ARP).
Many alternative risk premia (ARP) strategies have been implemented by institutional investors like hedge funds.
These entities look to develop asset allocations to mitigate mark-to-market volatility and can potentially profit from the market going in either direction through long-short portfolio strategies.
In this article, we’ll cover a few of the latest developed in the ARP space in a Q&A type format.
Key Takeaways – Alternative Risk Premia (ARP)
- Diversification Benefits
- ARP strategies are designed to capture broad, persistent sources of returns that are different from traditional stock and bond returns.
- This helps in diversifying portfolio risks – particularly during periods when traditional assets might underperform.
- Systematic Risk Exposure
- ARP provides exposure to a range of systematic risk factors such as value, momentum, carry, and volatility.
- By trading or investing in these risk premia, traders can potentially enhance returns and reduce portfolio volatility.
- Via exposure to a different set of factors that drive asset returns.
- Cost-Effective Alternative to Hedge Funds
- ARP strategies can be implemented through relatively liquid, transparent, and cost-effective vehicles compared to traditional hedge funds.
- This accessibility allows traders to tap into hedge fund-like strategies – without the high fees and lock-up periods typically associated with hedge funds.
What Are Alternative Risk Premia Strategies (ARP) and Why Are They Becoming Popular?
Alternative risk premia are similar in concept to “smart beta” strategies, which most traders and investors are familiar with.
Smart beta is designed to outperform a market cap weighted stock index by having higher returns at the same risk, the same returns at less risk, or some permutation where the risk-adjusted returns are superior to the traditional all-stocks portfolio.
Smart beta is generally accomplished by re-weighting stocks in an index based on common investment themes.
For example, an index might overweight the less volatile utilities and consumer staples stocks relative to cyclicals or consumer discretionary stocks. This is a standard left-tail risk mitigation strategy on its own outside of ARP.
Factors
Based on research done among both academics and institutional investors, the idea behind building smart beta portfolios follows the fact that certain traits or “factors” associated with certain assets lead to better risk-adjusted returns, especially when blended together well.
This might include factors like:
- low volatility (comparable returns at lower risk)
- value (lower P/E, or higher earnings or cash flow relative to price)
- size (bigger companies are more diversified with more stable cash flows)
ARP strategies have similar roots.
They involve isolating common investment themes by alternative asset managers.
They, however, typically differ from the more passive smart beta strategies by looking at the forward returns of various asset classes, then layering factoring investing on top of it.
Long-Short
Portfolios are generally long-short as opposed to the more typical long-only strategies in smart beta allocations.
This generally means ARP strategies have a beta of around zero (i.e., agnostic on asset class direction) by having a long-short slant to the portfolio. In turn, this also creates a new type of asset class.
And it’s also why alternative asset managers vie to create quality products around them. Their investors don’t want to pay for beta, which is free.
They also work across asset classes, outside equities and fixed income, and into currencies and commodities.
Namely, ARP strategies look to go outside the confines of traditional equity and fixed income investing toward sources of returns (i.e., risk premiums) that are uncorrelated with these markets.
Over the last decade, ARP strategies have attracted over $200 billion in assets.
Lists of Alternative Risk Premiums & Strategies
ARP offers a variety of strategies, each with its own risk reward profile and underlying rationale.
We look into ARP strategies across the following asset classes:
- equities
- fixed income
- currencies
- commodities
- combining asset classes
- additional strategies
Equity-Based Strategies
Value
This strategy capitalizes on the tendency of undervalued stocks to outperform overvalued ones in the long run.
It involves buying stocks with low valuation metrics (e.g., P/E, price-to-book ratio) and shorting those with high valuation metrics.
Momentum
This strategy exploits the persistence of existing trends in stock prices.
It involves buying recent winners and selling recent losers, assuming that trends will likely continue.
Carry
This strategy aims to capture the risk premium associated with holding riskier assets.
In equities, it can involve buying high-dividend yield stocks with supported earnings yields and selling low-dividend yield stocks with low earnings yields.
Quality
This strategy focuses on investing in companies with strong fundamentals, such as stable earnings, low debt, and consistent profitability.
The assumption is that these companies are more likely to weather market turbulence and deliver steady – or at least steadier – returns.
Size
This strategy bets on the outperformance of small-cap stocks compared to large-cap stocks over time.
It capitalizes on the higher growth potential and potential for mispricing in the small-cap space.
Combination
A trader might combine all these, such as defining their criteria as:
- small cap companies
- low P/E (better earnings per dollar invested)
- healthy dividend yield
- stable or growing earnings
- low debt
Equities are fertile ground for ARP strategies because of their liquidity and diversity, but other asset classes also have opportunities.
Looking at ARP strategies across various asset classes and considering combinations can help traders potentially expand their opportunity set and construct diversified portfolios that try to achieve their desired risk-reward profile.
Let’s look at some examples:
Fixed Income
Term Premia Harvesting
This strategy exploits the slope of the yield curve.
It involves buying longer-term bonds and selling shorter-term bonds when the yield curve is steep.
The goal is to profit from the higher yield of longer-term bonds.
Conversely, when the yield curve is flat or inverted, the strategy might involve the opposite approach.
Credit Premia Harvesting
This strategy aims to capture the spread between yields of bonds with different credit qualities.
It can involve buying high-yield bonds and selling low-yield bonds.
This assumes that the risk premium compensates for the default risk.
Roll-Down Strategies
This strategy capitalizes on the tendency of bond prices to rise as they approach maturity.
It involves buying bonds with a certain time to maturity and holding them as they move down the yield curve, profiting from the price appreciation.
Currencies
Carry Trade
This classic strategy involves borrowing in a low-interest rate currency and investing in a high-interest rate currency, trying to profit from the interest rate differential.
However, it carries exchange rate risk.
It also tends to correlate with broader credit cycles.
Value Strategies
Similar to equities, value strategies can be applied to currencies.
It might involve identifying undervalued currencies based on fundamental factors and purchasing them with the expectation of appreciation.
Momentum Strategies
Currency trends can be exploited using momentum strategies.
This could involve buying currencies that have recently appreciated and selling those that have depreciated, expecting the trend to continue.
Commodities
Trend-Following Strategies
These strategies aim to profit from sustained price trends in commodities.
This may involve buying commodities that have been experiencing upward price movements and selling those with downward trends.
Contango/Backwardation Strategies
These strategies capitalize on the shape of the futures curve in commodities markets.
In contango, futures prices are higher than spot prices, while in backwardation, the opposite is true.
Different strategies can be employed depending on the market condition.
Commodity Roll Premia Strategies
A sub-strategy of the above.
These strategies try to profit from the difference between spot and futures prices in commodity markets, a phenomenon known as roll yield or roll premia.
Related: Contango and Backwardation Strategies
Unique Asset Classes & Strategies
Illiquidity Premia Strategies
These strategies look to capture the premium associated with investing in less liquid assets.
This could involve investing in less-traded securities, private markets, or assets with lockup periods.
The illiquidity premium is the additional return investors demand for such holding assets that are relatively illiquid and can’t be easily converted into cash without a significant impact on their price.
Less liquid assets carry higher transaction costs and face higher price volatility due to lower trading volumes.
Traders require compensation for taking on this increased risk and reduced liquidity in the form of an illiquidity premium, which is the expected excess return over more liquid investments with similar risk characteristics.
Capturing the illiquidity premium is a strategy employed by some alternative risk premia approaches.
Insurance-Linked Strategies
These strategies involve taking on insurance risk, such as natural catastrophe risk, by investing in instruments like catastrophe bonds (CAT bonds) or insurance-linked securities.
The goal is to earn premiums by providing insurance capacity.
Alternative Lending Strategies
These strategies involve lending to borrowers who may have limited access to traditional financing sources, such as peer-to-peer (P2P) lending, marketplace lending, or direct lending to small and medium-sized enterprises.
The goal is to capture the illiquidity and credit risk premia associated with these lending activities.
Real Estate Strategies
Real estate investments, such as direct property investments or real estate investment trusts (REITs), can provide exposure to various risk premia, including illiquidity, value, and carry premia.
Infrastructure Strategies
Investing in infrastructure projects, such as renewable energy, transportation, or utilities, can provide exposure to illiquidity and inflation-linked risk premia.
Intellectual Property Strategies
These strategies involve investing in intellectual property rights, such as patents, trademarks, or copyrights, with the goal of capturing the associated risk premia.
This can also include things like books and music.
Factor Timing Strategies
These strategies attempt to dynamically adjust exposures to various risk premia factors (e.g., value, momentum, carry) based on market conditions or other signals, with the goal of enhancing risk-adjusted returns.
Crypto Strategies
With the emergence of cryptocurrencies and decentralized finance (DeFi), there are opportunities to capture risk premia in these markets, such as lending, yield farming, or liquidity provision strategies.
Style Premia Strategies
These strategies try to capture premiums associated with specific investment styles or factors beyond traditional factors like value and momentum factors.
Examples multi-factor strategies that combine multiple style premia, like mashing up many of them.
Carbon Trading Strategies
With the increasing focus on sustainability and carbon emissions, strategies that involve trading carbon credits or participating in carbon markets can provide exposure to environmental risk premia.
Merger Arbitrage Strategies
These strategies involve taking positions in companies involved in mergers or acquisitions, with the goal of capturing the spread between the current market price and the expected deal price.
Convertible Arbitrage Strategies
These strategies involve taking positions in convertible bonds and hedging the equity and credit risk components to capture the convertible bond’s optionality premium.
Risk Transfer Strategies
These strategies involve taking on specific risks from other market participants, such as insurance companies or banks, in exchange for a premium.
Examples include longevity risk transfer or credit risk transfer strategies.
Esoteric Strategies
These are strategies that exploit niche or less-known risk premia, such as those related to weather derivatives, mortality bonds, or other specialized markets.
Related:
Combining Asset Classes
Multi-Asset Value
This strategy involves identifying undervalued assets across various asset classes and constructing a portfolio with a value tilt.
This can potentially offer diversification benefits and capture value premia from different sources.
Multi-Asset Momentum
Similar to the above, this strategy applies momentum principles across asset classes, creating a portfolio that is tilted towards assets experiencing positive price trends.
Risk Parity Strategies
This approach focuses on allocating risk equally among different asset classes rather than focusing on capital allocation.
This can help diversify the portfolio and reduce dependence on any single asset class.
Additional Strategies
Volatility
Strategies like selling volatility try to profit from the difference between implied and realized volatility.
This is called volatility arbitrage.
Correlation
Strategies that exploit the relationship between different asset classes, like merger or capital structure arbitrage and convertible arbitrage, fall under this category.
Important Things to Know
Risk Management
ARP strategies aren’t without risk.
Strong risk management and diversification are important.
Market Environment
The effectiveness of each strategy can vary depending on the current market environment.
Complexity
Combining asset classes increases complexity.
It requires careful consideration of correlations and risk management.
Research & Expertise
Implementing these strategies effectively often demands in-depth research and understanding of the underlying assets and market dynamics.
It may require specialized knowledge and tools.
What Are the Benefits of Alternative Risk Premia Strategies to Traders?
The biggest risk in most people’s portfolios is equity risk.
Even among many institutions, like pensions, they will typically allocate their money in equities or equity-like asset classes (e.g., private equity, real estate) up to a level of volatility they can stand, then sprinkle in other asset classes – mostly bonds – for the remainder.
Even if the portfolio is something like 60-65 percent stocks and 35-40 percent fixed income securities, the equities portion is more volatile and thus constitutes about 90 percent of the portfolio’s overall risk despite it seeming more or less balanced in basic capital allocation terms.
Alternatives to Equity-Centric Approaches
So, investors like pension funds and others following equity-centric approaches are looking for a few different things:
- i) Wanting to diversify away this equity risk, which tends to be concentrated.
- ii) They want to reduce portfolio volatility. Or if they do take on higher volatility, they want to be sure they’re getting returns commensurate for taking on that risk.
- iii) Find additional sources of returns. And naturally when you find sources of returns that are ideally as uncorrelated as possible to other types of returns, then your reward relative to your risk goes up in terms of the ratio. We explained the mathematical nature of this in a separate article.
ARP portfolio strategies look to deliver returns that are independent of the equity and fixed-income markets to provide this source of diversification.
Example
An example:
An ARP strategy that’s designed to go after the low volatility premium – i.e., that low volatility stocks provide superior risk-adjusted returns to high volatility stocks – would:
- a) go long low volatility stocks
- b) hedge out the equity risk by shorting high volatility stocks
Hedging out the equity risk would effectively get rid of the beta in the portfolio.
However, the investment manager may not necessarily hedge them based on equal dollar amounts but rather based on their risk.
For example, let’s say the “low volatility” stocks group has an annualized volatility of 15 percent while the “high volatility” group has an annualized volatility of 30 percent.
In terms of the raw dollar amount, the manager could own twice as much of the low volatility stocks relative to the high volatility group and effectively hedge out the equity beta to turn it into a portfolio exclusively of the “low volatility” factor.
And let’s say the low volatility group has an expected return of four percent per year. (The four percent expected returns might seem small, but in comparison to cash and its zero returns, the Sharpe ratio of four percent equity returns off 15 percent volatility is 0.27 (4 divided by 15)).
And let’s say the high volatility group has an expected return of six percent per year.
So, our expected returns would be, following the idea we’d buy twice as much of the low vol stocks as the high vol stocks given the expected volatility differential
Expected returns = 0.04*2 – 0.06*1 = 2 percent
Two percent doesn’t seem like much, but that ARP strategy is essentially trying to be market-neutral. Plus investment managers typically use leverage, with 4x to 6x leverage being common among hedge funds.
By pursuing this type of strategy, the investment manager is trying to isolate the “low volatility” factors so that investors are only exposed to that type of premium.
And of course, the actual returns figure is likely to be a bit different than two percent. There will be times when the high volatility shorts outperform the low volatility longs (and vice versa).
ARP strategies are intended to be transparent and liquid – at least more liquid that what you often see in many alternative asset management portfolios (e.g., private equity, venture capital).
This further enhances their attractiveness as part of a diversified portfolio.
How Can Alternative Risk Premia Products Be Evaluated?
Bloomberg and Goldman Sachs Asset Management recently came out with the Bloomberg GSAM Risk Premia Indices.
The indices not only keep track of a representative sample of ARP strategies but are also investable.
The idea behind the benchmark is that investors lacked a way to evaluate how ARP products are doing relative to other styles to help ascertain their risk and return.
Alternative risk premia indices currently exist in the marketplace, but they tend to aggregate the returns of various ARP managers. This creates more of an overview of various peers, not a true benchmark that has the transparency that investors want in one.
The idea of indexing ARP is new.
Equities went from being indexed to going more into smart beta. Comparing smart beta to an index was easy because various equity indices already existed (e.g., S&P 500, NASDAQ, Dow Jones, Russell 2000, etc.).
ARP went into execution before a standard benchmark or index was developed unlike traditional equities.
Accordingly, investors have been unsure as to how to benchmark ARP investment managers when it comes to their performance and how to analyze their strategies for return and risk potential.
Would it be appropriate to index them to standard equities strategies, or is the risk and return different to a point where ARP deserves its own index?
For example, fixed income managers are often indexed to the following:
- Barclays Capital US Aggregate Bond Index
- Barclays Capital US Corporate High Yield Bond Index, or
- Barclays Capital US Treasury Bond Index…
…depending on what they do. A strategy based on developed market government bonds is very different than distressed credit.
Indexing fixed income strategies to the S&P 500, the standard performance comparison index for equities managers, would not be appropriate.
Moreover, with ARP, there is a wide dispersion in how these strategies are implemented.
Naturally, this means there’s a wide dispersion in returns.
Some ARP investment managers apply it with respect to different asset classes. Some may apply it singly to equities, fixed income, or others.
Others may mix different asset classes, such as risk parity without the individual beta in each asset class. There are numerous different ways the strategy can be applied while still fitting into the ARP category.
Bloomberg partnered with Goldman Sachs as a way to design a range of indices that could help address the challenges associated with benchmarking ARP strategies.
This is done by deriving a consensus of how to define manager performance and how it can be measured.
If ARP indices are transparent and replicable, they can help to understand performance of alternative risk premia strategies over time as well as offer low-cost beta to the asset class.