Risk premia strategies do not reward downside

One reason investors give for hanging on to alternative risk premia strategies that have largely slumped this year is that taking the downside risk will pay off once things turn around.

Except according to new research – it won’t.

A study by Bernd Scherer, head of portfolio management at private bank Bankhaus Lampe, and Nick Baltas, head of research and development for systematic trading strategies at Goldman Sachs, has confirmed that risk premia strategies suffer when core markets struggle. Worse, the study also suggests investors are not getting paid for the added exposure.

“The evidence seems to indicate that downside risk is penalised, as opposed to being rewarded,” the authors state. When markets sag, the strategies that are most exposed deliver lower returns, they say, while those that protect against downturns appear to earn a premium – as if investors were being paid to buy insurance.

The products are based on systematically trading well-known patterns in markets – momentum, market trend or mean reversion, for example – and are typically designed to be market neutral. But the study, which looked at 262 strategies from six global investment banks over 10 years, found they lost about –1.5% on average in the worst quintile of months for equity returns and about –0.5% in the worst months for bonds.

“Many risk premia products have downside risk packaged into them,” says Scherer, speaking to Risk.net. “What looks uncorrelated in pitch books is not necessarily uncorrelated in tail scenarios.”

The authors showed that a model that incorporates betas to equities and bonds when the markets were struggling did a better job of explaining returns than a conventional capital asset pricing (CAPM) model applied to the full 10-year sample, suggesting downside risk is a key driver of performance.

The CAPM model explained about 10% of the cross-sectional variation of realised returns, whereas accounting for downside risk increased the figure to nearly 45%.

But when the authors examined whether the strategies earned a premium for this extra risk, they found the results were the opposite of what economic theory would suggest: riskier strategies had lower realised returns, while safer strategies returned more.

What looks uncorrelated in pitch books is not necessarily uncorrelated in tail scenarios

Bernd Scherer, Bankhaus Lampe

“It’s as if you buy insurance and get paid for having it, which doesn’t square with what you would expect,” Baltas says.

The authors offer two hypotheses for the surprising results. One is that the histories available for the products are still too brief, which could mean a rebound is yet to come – that investors will one day be rewarded for the extra risk.

But the findings could also point to data mining by the banks, the authors argue. “If [a strategy] looks too good, it probably is,” they say in the paper.

Creating strategies that in backtests have “high risk-adjusted returns with positive skewness, small downside betas and positive uncertainty beta is difficult [for banks] to resist”, the paper states.

Scherer says investors and managers need to think carefully about how they combine alternative premia and to use models incorporating factors such as beta to Ted spreads, skewness and tail correlations to understand the strategies’ conditional exposures better.

The authors found a model including the above factors explained alternative risk premia returns better than other models they tried, for example.

“If you look for highly correlated groups of alternative premia you won’t find anything, because in normal times they’re not highly correlated,” Scherer says. “But if you look for things like exposure relative to things like Ted spreads, which will detect if a strategy is highly leveraged, you get a much better clustering and separation of strategies.”

“We don’t have a lot of out-of-sample data for these strategies, which ultimately are morphing into something like banks’ old proprietary trading strategies. We really know very little about their risk and return profile,” he says.

“Investors must take care in how they combine these strategies and how they combine them with traditional assets,” he concludes.