March 10, 2021


Executive Summary

  • Alternative risk premia (“ARP”) strategies are a category of hedge fund strategies that aim to systematically isolate and harvest excess returns from exposure to specific risk factors, or returns arising from behavioral or structural market anomalies. 
  • While alternative risk premia are not a novel phenomenon, the onset and availability of conveniently packaged, multi-factor, multi-asset offerings has drawn increasing investor attention and capital flows.
  • Their popularity has been underpinned by a number of features, including plausible theoretical and academic backing for the existence of the risk factors exploited, as well as their low-cost structures and liquidity relative to other types of hedge funds.
  • Despite the theory, investor experience over recent years has been disappointing. To the end of 2020, the majority of ARP strategies have underperformed cash since their inception dates. 
  • We believe it is still too early to pass final judgment. We do not rule out the possibility that what we have been through recently has just been an unusually poor period for these strategies.
  • If recent performance is not representative of long-term prospective returns, then ARP strategies may still have a role to play as a partial allocation in an alternatives portfolio, especially for constrained investors looking for diversification.
  • Still, we do not view ARP strategies as a substitute for a diversified portfolio of hedge funds. Further, Mercer’s highest conviction, bottom-up ideas likely exclude ARP strategies as an essential component of a hedge fund portfolio.
  • For investors facing few governance or fee constraints, we believe there are hedge fund strategies that offer the potential to capture these risk premia in a more sophisticated and forward-looking manner, while also benefitting from market awareness and idiosyncratic opportunities, potentially improving returns, controlling risk and enhancing diversification.

We take this opportunity to recap the theory behind ARP, review how related strategies have performed, and build on our original work[1] by sharing our latest thinking on the application and use of ARP strategies.

 

Recap of ARP and the case for allocating

Alternative Risk Premia strategies aim to systematically harvest excess returns from exposure to specific risk factors, or returns arising from behavioral or structural market anomalies. The theory is that these excess returns can be attributed to some combination of alternative risk premia or factors, which in turn have predictive power over an asset’s future returns.

 

A number of these factors can be harvested in long-only as well as long-short format (for example, value and momentum[2] are widely exploited by long-only equity managers), but the factor exposure will be diluted and potentially also distorted[3] when accessed in a long-only strategy. ARP strategies introduce additional risk factors typically captured within hedge fund strategies (for example, trend and merger arbitrage[4]) and also extend the application of commonly known factors to a wider range of asset classes. Importantly, with the use of leverage and long-short positioning, ARP strategies seek to isolate and extract the desired premia at meaningful levels of exposure but with theoretically little market sensitivity. In fact, ARP strategies tend to run with more leverage than most other types of hedge fund strategies, because they focus on exploiting “spread” factors that have fairly low volatility in their unleveraged forms, and need to be amplified with leverage in order for them to make meaningful contributions to returns. Lastly, by combining multiple, uncorrelated risk premia, these strategies seek to achieve an attractive risk-adjusted return profile over time.

 

The attractions often cited for an allocation to ARP strategies include:

 

  • Low correlation to traditional asset classes (albeit no lower than for many other types of hedge fund strategies)
  • Fee structures much lower than for most other types of hedge funds
  • More liquid terms than many other types of hedge funds
  • More transparency than many other types of hedge funds
  • Conceptual simplicity of accessing the returns associated with risk factors. The historical profitability of these risk factors being supported by credible theoretical and academic rationales
  • Backtests suggestive of strong potential performance, supported in some cases by early periods of live performance that were good (or at least reasonable).

Review of recent performance

The performance of ARP strategies has been disappointing, with few exceptions. The market crisis ensuing from COVID-19 dealt a blow to an already injured investment strategy, on the back of a very difficult 2018 and a slightly better but still challenging 2019. Worryingly, ARP strategies have shown a tendency to correlate on the downside with risk assets, despite their promised diversification benefits.

 

Table 1 shows general performance characteristics of ARP strategies. We represent the performance of ARP funds with the SG MARP index[5]. We can see that ARP strategies have generated negative returns since the index launched in 2016. Much of this negative performance has occurred since the start of 2018. Prior to this, ARP strategies experienced modestly positive and relatively stable returns.

Table 1. Performance characteristics of ARP strategies — January 1, 2016 to January 31, 2021

 

Source: SocGen, Thomson Reuters Datastream, MercerInsight. Performance in US dollars.

Below we list the most frequently observed detractors from ARP performance.

 

Equity value

Much has been written about the performance of value[6] and why this style of investing has struggled. The historical persistence and pervasiveness of this factor resulted in a prominent position within a typical ARP portfolio. While equity value has struggled quite broadly over the last decade, it’s most painful moments have occurred more recently, exacerbated by periods of crisis. Setting aside arguments of how to measure value, even value portfolios with multiple themes/measurements or industry-neutral implementation have suffered.

 

Trend following

Although trend has not been a major detractor, investors may have hoped for better results, particularly during risk-off events. The majority of trend-following systems found in ARP strategies are medium- to long-term in nature. Therefore, these strategies deliver best during sustained trends, but struggle with sharp reversals. Both 2018 and the majority of 2020 proved difficult for trend-following strategies.

 

FX carry

Currency carry often suffers at times of heightened economic uncertainty and market stress.  A flight to quality increases demand for lower interest rate “safe haven” currencies (for example the Swiss Franc), which are generally the funding leg of the FX carry trade. Recent negative performance has also been exacerbated by idiosyncratic drivers, most prominently the oil price shock, which had material impact on currencies of commodity-linked economies, often forming the long side of the carry trade.

 

Short volatility

The volatility risk premium is based on the premise that implied volatility is persistently priced above realized volatility as market participants are willing to pay a premium to purchase derivative contracts that act as insurance. These strategies lose money during periods of market stress, when actual volatility realizes above the level at which it was sold. This was a meaningful contributor to losses in 2020 for those ARP strategies that include it.

 

Equity risk & behavior in risk-off environments

It would be remiss to discuss performance and not comment on the timing of the losses, which occurred as risk assets, such as equities, sold off. Although meaningful losses in ARP strategies have occurred during periods of market stress, we believe that the underlying risk drivers are generally different to equity risk. ARP strategies have historically shown limited loading on equity risk and continued to do so in recent periods. The behavior of certain factors in risk-off environments is worth exploring, however. Over the long term, individual risk factors have shown low correlation to equities and to each other. Many risk premia appear to perform well during periods when risk appetite is consistent. However, when risk tolerance falls, these same premia may re-price alongside equities, at the same time. Thus, alternative risk premia can experience higher correlations, both to equities and each other, at the worst possible time, although this need not apply to all. Risk premia premised on behavioral or structural anomalies (such as momentum or quality) tend not to exhibit such relationships, and their presence in portfolios should provide some offset. 

 

Guidelines for the use of ARP strategies

We believe ARP strategies can play a complementary role within an investor’s alternatives allocation, although we caution those that view it as a potential low-cost substitute for a broadly diversified hedge fund portfolio. An allocation to ARP can increase liquidity and lower overall costs, but may limit the potential return drivers and exacerbate drawdowns if done to the exclusion of other alternative strategies.

 

We remind readers of the potential benefits of ARP strategies and balance these with ARP’s limitations. We also extend three points of consideration for investors building an ARP allocation.

 

ARP strategies can be complementary to other types of hedge funds…

…but they are not a substitute: ARP is not able to capture the full breadth of risk/return drivers on offer. Nor does it allow investors exposure to idiosyncratic risk-taking or market timing. Further, the focus on providing a low-cost solution often leads to relatively basic model construction and omits insights that could lead to better quality returns and risk management.

 

…and nor are they a “one-stop shop” for a liquid alternatives solution: The outcome of ARP as one component of a liquid alternatives allocation can be vastly different to ARP as the only component.

 

ARP may still have potential to contribute a positive return over the long-term…

…but it is not an absolute return strategy: We do not view ARP as an absolute return strategy as part of which investors can expect to steadily achieve cash plus returns over shorter rolling periods. ARP should be viewed just as one would other traditional risk premia — with the potential to generate positive returns over time, but also having the drawbacks of pro-cyclical behavior and potentially meaningful drawdowns. Combining multiple uncorrelated risk premia across asset classes should theoretically provide some counter to this issue, although realized experience has been less robust.

 

…and nor has it proved suitable for investors with shorter time horizons: ARP strategies aim to capture long-term, slower-moving effects which, although expected to be positive over time, can experience short-term periods of underperformance. Investors should consider their time horizon before allocating; too short a horizon will mean the timing of an allocation can have a meaningful impact on realized results.

 

ARP is diversifying…

…but it is not defensive: ARP strategies are expected to be uncorrelated to other (traditional) risks found in an investor’s portfolio, particularly equity risk. This means that their performance should not be related to the price direction of risk assets in the rest of the portfolio, over the long-term. Although certain risk factors may be more defensive in nature, most multi-factor, multi-asset funds are designed to be market neutral, rather than negatively correlated. Further, as we have seen in practice, some risk premia can fall along with equities. An ARP allocation can diversify but should not be expected to serve as a hedge in a risk-off environment.

 

We suggest some points of consideration for investors looking to build an ARP allocation:

 

1.      Understand the underlying exposures: Unlike generally accepted definitions of traditional risk premia, such as the equity risk premium, there is no consensus on how to measure or access any given alternative risk premium. Nor is there consensus on which premia should be in an ARP fund. Based on Societe Generale’s universe of 40 ARP programs,[7] the authors show only one factor (FX carry) that is common across all offerings.

 

Table 2. MARP funds exposure matrix

Source: SGCIB, 2019. Directional Momentum & X-Sectional Momentum in original paper renamed to Trend & Momentum respectively.

 

Most ARP offerings incorporate both macro premia (applying factors across asset classes including equity and bond indices, currencies and commodities) as well as equity premia (applying factors to single-name stocks). Other offerings focus on macro factors only,[8] which will have been an advantage over recent years given the poor performance of alternative risk premia within equities, but may or may not be an advantage going forward.

 

2.      There is a “cost” to lower fees and better liquidity: ARP strategies seek to systematically capture risk factors typically found amongst hedge fund strategies, and at lower fees and better liquidity. However, there is a trade-off that results in a limited ability to capture alpha, that is, idiosyncratic risks found in hedge fund strategies that cannot be explained by typical risk factors. One key issue to consider is that many ARP portfolios are constructed in a static manner, with strategic risk allocations to each factor changing only marginally over time. Other types of hedge funds will typically be more dynamic and responsive in their exposure management, even if capturing the same risk premia.

 

3.      Be wary of backtests: Past performance is not indicative of future performance, especially if the past performance was paper performance. The universe of multi-factor, multi-asset products is a nascent one, with most strategies yet to build a meaningful live track record. Investors can be presented with simulations and backtests, which are prone to bias and overfitting. As common risk premia become more commoditized in their access, it seems prudent to expect there to be some compression in forward-looking returns. One study[9] conducted reported a median 73% deterioration in risk adjusted return between backtested and live performance periods for the 215 alternative beta trading strategies in their sample.

 

So how should investors use ARP?

Overall, Mercer views ARP strategies to be complementary to other types of hedge funds and multi-asset solutions, offering another option in the hedge fund toolbox.

 

Having said that, for unconstrained investors, Mercer’s highest conviction, bottom-up ideas likely exclude ARP strategies as an essential component of a hedge fund portfolio. For investors facing few governance or fee constraints, we believe other types of hedge fund strategies offer the potential to capture these risk premia in a more sophisticated and forward-looking manner, while also benefitting from market awareness and idiosyncratic alpha, potentially improving returns, controlling risk and enhancing diversification.

 

For constrained investors, we do believe ARP strategies can serve a purpose, although they should not be seen as a “one-stop shop” for a liquid alternatives allocation. ARP offers broad diversification and capture of alternative risk factors in a market neutral construct. The expectations are for a relatively independent return profile, albeit one that is susceptible to risk-off environments. As such, depending on the mandate and objectives, we suggest a satellite weighting (as opposed to core), alongside other liquid diversifiers. Investors may also wish to avoid exposure to certain factors, depending on their sensitivity to downside risk and any overlapping exposure elsewhere in their portfolio. ARP’s role is primarily low-cost, liquid capture of alternative risk factors that we expect to diversify over the long term. In a forthcoming paper, we will explore the constrained framework more fully.

 

When selecting ARP strategies, we encourage a balance of breadth (of risk premia) and depth (sophistication of factor construction), as well as an assessment of factor suitability. We see merit in blending multiple managers, as correlations between different ARP strategies are often low to moderate.

 

As the risk premia space evolves and providers adapt to the commoditization of more common risk factors, we expect to see further evolution in the skill and implementation of approaches: there is likely to be a greater focus on dynamic allocation between factors as well as smarter portfolio construction that looks to incorporate different macro regimes and appropriately budget for tail risk. Still, we anticipate there being a limit to the positive effects of future research and development, due to both the price point and the liquidity characteristics of ARP strategies. New and innovative ideas are more likely to find themselves in traditional hedge fund offerings before they become well known and start their transition into commoditized risk factors.

 

Conclusion

The fundamental premise of ARP is to provide transparent, low-cost access to alternative risks, often found across hedge fund strategies. In practice, achieving this is nuanced, and the sacrifice of alpha and dynamic risk management that comes with traditional hedge fund strategies can lead to a materially different risk profile and investor experience.

 

Investor experience over recent years has been disappointing. Having said that, we do not rule out the possibility that what we have been through recently has just been an unusually poor period for these strategies. Nonetheless, there are clearly some lessons about whether certain factors fit well into ARP strategies if an investor is expecting diversification on the downside, and the current offering of strategies may need to adapt quickly.

 

We emphasize the fact that that the universe of ARP solutions spans a broad range of different approaches which can lead to materially different performance outcomes, and manager selection is key to understanding the type of exposures comprised in any particular offering. Overall portfolio construction is also critical. ARP strategies are not a complete answer as a diversifying alternatives portfolio, nor are they likely to rank among the best ideas for investors with the flexibility to run a diversified hedge fund program.


Author

Dev Vrat Singhvi, CFA, CAIA
Dev Vrat Singhvi, CFA, CAIA
Senior Investment Research Specialist, Diversifying Alternatives

[1] Mercer primer on ARP (2018).

[2] The value premium is the result of buying undervalued assets and selling overvalued assets (valuation being defined by some measure of intrinsic value relative to price), where the former tends to outperform the latter over long periods. Momentum investing capitalizes on the tendency for securities to exhibit persistence in their relative performance for some period of time.

[3] Factor exposures can be distorted in long-only strategies because they are constrained from implementing the short positions that long/short strategies will hold, and this in turn places constraints on the long positions that they can hold.  For example, long-only strategies cannot hold meaningful underweight positions in small cap stocks that have small or zero index weightings, and cannot hold meaningful overweight positions in small cap stocks either without also holding a meaningful overweight exposure to the small cap factor.

[4] Trend is similar to momentum, however is directional in its implementation and exploits the tendency for an asset’s recent absolute performance to continue for some period of time. Merger arbitrage attempts to capture “deal risk” or the risk that the deal will fall apart, evidenced by the spread between the share price of the target company and the acquisition price, where the share price usually trades at a discount.

[5] The SG Multi Alternative Risk Premia Index is an equally weighted peer group index, rebalanced and reconstituted annually on January 1, of the ten 10 largest multi-factor, multi-asset ARP strategies that are open to new investment and report net of fees returns on a daily basis.

[6] Including Mercer. See Mercer’s “Is there still a case for value?” paper from June 2020: https://www.mercer.com/content/dam/mercer/attachments/private/gl-2020-is-there-still-a-case-for-value-paper.pdf

[7] “Understand Multi Alternative Risk Premia Strategies” (2019) – Societe Generale Prime Services.

[8] Although investors may find similar factors applied to equity-only offerings, these are generally narrower and would be categorized within our market-neutral equity universe.

[9] Suhonen, Lennkh and Perez, “Quantifying Backtest Overfitting in Alternative Beta Strategies,” Journal of Portfolio Management, 2017.

  • Important notices >

    References to Mercer shall be construed to include Mercer LLC and/or its associated companies.

    This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity without Mercer’s prior written permission.

    This does not constitute an offer to purchase or sell any securities.

    The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results. Mercer’s ratings do not constitute individualized investment advice. The value of investments can go down as well as up, and you may not get back the amount you have invested. Investments denominated in a foreign currency will fluctuate with the value of the currency. Certain investments, such as securities issued by small capitalization, foreign and emerging market issuers, real property, and illiquid, leveraged or high-yield funds, carry additional risks that should be considered before choosing an investment manager or making an investment decision.

    This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances. Mercer provides recommendations based on the particular client’s circumstances, investment objectives and needs. As such, investment results will vary and actual results may differ materially.

    For Mercer’s conflict of interest disclosures, contact your Mercer representative or see http://www.mercer.com/conflictsofinterest.

    Information contained herein has been obtained from a range of third-party sources. Although the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in the data supplied by any third party.

    Mercer does not provide tax or legal advice. You should contact your tax advisor, accountant and/or attorney before making any decisions with tax or legal implications.

    Not all services mentioned are available in all jurisdictions. Please contact your Mercer representative for more information.

    Investment management and advisory services for US clients are provided by Mercer Investments LLC (Mercer Investments). Mercer Investments LLC is registered to do business as “Mercer Investment Advisers LLC” in the following states: Arizona, California, Florida, Illinois, Kentucky, New Jersey, North Carolina, Oklahoma, Pennsylvania, Texas and West Virginia; as “Mercer Investments LLC (Delaware)” in Georgia; as “Mercer Investments LLC of Delaware” in Louisiana; and “Mercer Investments LLC, a limited liability company of Delaware” in Oregon. Mercer Investments is a federally registered investment adviser under the Investment Advisers Act of 1940, as amended. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Mercer Investments’ Form ADV Parts 2A and 2B can be obtained by written request directed to: Compliance Department, Mercer Investments, 99 High Street, Boston, MA 02110.

    Certain regulated services in Europe are provided by Mercer Global Investments Europe Limited and Mercer Limited. Mercer Global Investments Europe Limited and Mercer Limited are regulated by the Central Bank of Ireland under the European Union (Markets in Financial Instruments) Regulation 2017, as an investment firm. Registered officer: Charlotte House, Charlemont Street, Dublin 2, Ireland. Registered in Ireland No. 416688. Directors: Sylvia Cronin, Michael Dempsey, Tom Geraghty, Abhishek Krishan, Deborah Mintern, Bruce Rigby (British) and Vincent Sheridan. Mercer Limited is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 984275. Registered Office: 1 Tower Place West, Tower Place, London EC3R 5BU.

    Investment management services for Canadian investors are provided by Mercer Global Investments Canada Limited. Investment consulting services for Canadian investors are provided by Mercer (Canada) Limited.