Laurent De Greef (left), David Bell and Andrew Korbel
Alternative risk premia (ARP) strategies could be part of the answer for asset owners looking for yield in volatile markets, according to Laurent De Greef, head of portfolio strategy at DE Shaw Investment Management.
But sizing the strategy to systematically isolate and harvest excess returns from exposure to certain risk factors should be treated like salt when seasoning food, the New York-based strategist said The investment magazine Absolute Returns Conference held in Sydney earlier this month.
Too little and it doesn’t taste good; too much and it’s harmful to your health, he said. “The general rule is you can use less volatility than the Sharpe ratio suggests,” he said.
Look for alternative risk premiums
In volatile markets and lower-yield environments, asset owners want to rely on something else for yield and correlation, De Greef said.
“The first avenue to go to is pure alpha – absolute return,” he said. “The challenge you run into is that it exists, but it’s hard to find and procure. ”
In the pantheon of sources of return, alternative risk premia lie between the two extremes of traditional risk premia and pure alpha, but borrow characteristics from both, he said.
“In some forms it’s pure alpha because it has a high Sharpe, you can engineer it to be market neutral, it can be cash efficient, and you can overlay the yield stream,” he said. “But it has traditional risk-premium characteristics in that it has a skewed distribution of returns.”
“Interestingly, we’ve seen this conversation with investors come back to life. On the alpha side, if one has capacity constraints and has specific return targets, that may be part of the answer. I emphasize the idea of part of the answer.”
Andrew Korbel, senior portfolio manager, debt and absolute returns at one of Australia’s largest alternative investors, Victoria Fund Management Corporation (VFMC), said the fund has the advantage of not having any fee caps and employing top-tier hedge fund managers.
Korbel considered adding alternative risk premia strategies to the fund at one point, but instead focused on the blue-chip hedge fund and personal loan portfolio.
Approximately eight percent of VFMC’s portfolio consisted of alternatives, representing $5.5 billion of its $70 billion in assets under management.
“Its goal is to invest in it for yield reasons, and diversifying low correlation (low beta) with stocks is very important,” Korbel said.
“[We aim] for the combination of cash [rate] plus three percent net of all fees. If they don’t, they don’t warrant a place in the portfolio. “Encouragingly, our hedge funds have come to the fore post Covid and have done really well in 2022.”
De Greef said the Sharpe ratio risk premia may seem “pretty attractive” for ARP, but the strategy borrows from both the world of alpha and traditional risk premia and has a skewed distribution or “strong left tail” and therefore has the tendency to crash.
“The reason you deserve a premium at all is probably because you’re insuring that crash risk,” he said. “Once you consider that this is exactly what you get, you assume the probability of a crash, this explains why you get the high Sharpe ratio in the first place. This provides insight into how you intend to use the strategies in the portfolio.”
Combining a range of risk premia strategies will increase the Sharpe ratio but still result in a skewed distribution, he said.
“When you diversify rewards, you don’t diversify your crash risk. There might be an optical illusion with a higher Sharpe ratio, but you’re still subject to that crash that you have to specifically deal with,” he said.
Money managers need to think about how risk premia perform in different market environments, as “that will help build a better portfolio to try and mitigate that left wing,” he said. But securing that tail was “very expensive” and not a solution because it “eats all the Sharpe away”.
ARP not popular
ARP has not been a popular strategy in Australia lately. According to wealth advisor Mercer Australia, the majority of ARP strategies have underperformed against cash since inception in late 2020.
Many investors see Sharpe ratio stats greater than one and think, “Maybe we can increase volatility to have an attractive portfolio?” De Greef said. “But there are limitations to how much volatility you can have in an ARP portfolio, and that limitation is likely less than what conventional wisdom would suggest.”
“This is where the second part of the argument comes in – a left tail. What happens when that left tail happens? Can you stick to the strategy? Do you have liquidity? Will you face capital claims? Careful dimensioning of the strategy can counteract this.”
Meanwhile, VFMC’s Andrew Knobel said it’s “never say never” to have an ARP strategy and said it may have better potential as a distinct asset class at two to five percent of a portfolio.
“I think quality alpha in hedge funds is relatively scarce. It’s hard to make money with these managers. Half of us are tightly closed and another 35 percent are severely restricted. We’re looking for new things and at some point what’s available compared to ARP might look like ARP might bear fruit,” he said.