October looks set to be another awful month for alternative risk premia funds and products, which seek to harvest lasting premia from things like stock price momentum and foreign exchange carry trades.
The period since February has been so bad that Cliff Asness, co-founder of AQR Capital Management – and one of the principal architects of the investment approach – has taken to writing notes to clients that reference Ragnarök, the Viking myth about the end of the world.
Asness doesn’t think this is Ragnarök, to be clear. AQR and other alt-premia managers say periods of underperformance are to be expected – even of this length.
Nevertheless, the episode exposes things about investing in alternative premia that have drawn little attention before now.
One is that alternative premia funds and products are highly diverse – a topic we explore here in more depth. Their similar labelling masks big differences in risks and sensitivities, and so the likely path of funds’ returns.
Another is how alternative premia can become closely correlated to mainstream assets and markets.
Diversification from traditional asset classes is seen as one of the main benefits of alternative risk premia investing but it tends to play out over the medium to long term, experts say.
Typical portfolios contain upwards of 10 strategies, but over the short term can have an outsized risk contribution from just a couple of drivers.
Alternative risk premia strategies may be somewhat more alternative than liquid hedge funds, our research shows, but you cannot escape links to traditional asset classesAntti Suhonen, Aalto University School of Business
At times, strategies that are expected to offset each other fail to do so. That was the case during the first week of February, when US stock markets sold off but both medium-term trend following strategies and shorter-term mean reversion strategies were caught long the market.
Correlations for some common components of alternative risk premia portfolios have been at extremes this year.
The correlation between trend following and equity markets, as an example, has been in the 83rd percentile compared with history, Deutsche Bank research shows. The correlation between equities and equities short volatility strategies has been the highest ever.
Some changes in correlations are just down to luck. But the truth is that most traditional alternative risk premia strategies are poorly equipped to handle sharp market reversals, says Spyros Mesomeris, head of quant research at Deutsche Bank.
Strategies such as investing in quality or low-beta stocks, or trend following across asset classes rely on a prolonged period of volatility or drawdowns before they start to work. “There needs to be a rotation before they kick in,” he says.
Antti Suhonen, a professor at Aalto University School of Business and consultant with MJ Hudson Allenbridge, is currently researching how alt premia’s beta to core equity and bond markets changes over time. Initial findings show the sensitivity has been quite persistent, yet volatile, he says.
Work Suhonen has done to break down the source of returns in diversified portfolios of alternative premia strategies shows that up to two-thirds can be explained by reference to traditional asset classes. “Alternative risk premia is not in a world of its own,” he says.
“Alternative risk premia strategies may be somewhat more alternative than liquid hedge funds, our research shows, but you cannot escape links to traditional asset classes.”
Ragnarök or not, the lesson for investors seems clear. “Don’t rely too heavily on the diversification potential of these investments over a short horizon,” Mesomeris says.