Risk premia refers to the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset.
Equity market exposure is the best-known risk premium, rewarding investors for taking exposure to long-only equity investments. Other risk premia include the size factor, where small-cap stocks tend to outperform large-cap stocks, and the value factor, where cheap stocks tend to outperform expensive stocks. Risk premia also exist in asset classes outside of equities, although academic research into the source of the premia tends to be less robust.
Factor investing aims to harvest above-market returns from specific risk premia regardless of market conditions. Long-only risk premia strategies are known as smart beta, and attempt to outperform the market by using alternative weighting schemes such as volatility weighting or factor tilts in the index construction process.
Meanwhile, long/short risk premia strategies generate returns by buying a factor-based portfolio and short-selling another. Unlike smart beta strategies, they are not typically measured against a benchmark. Strategies that seek to replicate the premia of hedge fund strategies are known as alternative risk premia.
Risk premia used to be the domain of hedge funds, but since the financial crisis factor investing has become more popular as a method of diversifying portfolio construction by offsetting losses associated with core equity and fixed income strategies.
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