What’s in the box? Bad year reveals alt premia’s gaps

Average fund is down almost 5%, but gap between best and worst performers is 14%

Alternative risk premia managers are struggling to make sense of a year from their nightmares – a period that has exposed big differences between funds, even though they carry similar labels and employ the same well-known rules-based strategies.

Portfolios across the sector have shed nearly 5% on average since January through a series of month-on-month convulsions – the Vix blowup in February, a value-stocks slide in the early summer, emerging market turmoil in August, and market reversals in October.

Underperformance, though, has been uneven across funds, leaving investors asking why. The reasons put forward by the 23 managers and others that Risk.net spoke to hinge on how funds are constructed and make clear how mixed this corner of quant investing is.

“It’s increasingly clear these funds do very different things,” says Antti Suhonen, a professor at Aalto University School of Business and consultant with MJ Hudson Allenbridge, advising investors on fund selection. Some say it makes choosing these funds no different from selecting traditional discretionary hedge fund managers. 

Decision trees

Alt premia funds draw on a well-established body of academic theory about the premia they seek to harvest, which has helped attract large numbers of investors. Long/short risk premia funds account for about $140 billion in assets, with a further $180 billion invested in alternative risk premia products offered by investment banks, according to MJ Hudson.  

But while an inflow of assets in recent years may imply this is a close-knit family of products, managers say putting the academic theory into practice involves choices that produce high levels of variation.  

Decisions range from the criteria firms use to filter securities to how they measure a stock’s value or momentum, to whether to sort assets by quintile or decile.

How risk is defined – using volatility or drawdowns as a measure, for example – also makes sizeable differences to allocations between different strategies in what are multi-strategy portfolios. Across the board, small decisions can lead to big differences because the funds are typically leveraged.

One manager describes the process as a decision tree in which firms have to decide between two approaches at each node.

At the end of the decision tree you get portfolios that are “pretty different in the details”, he says. “Implementation is not innocuous. There will be good alternative beta managers who implement these factors in an optimal way and less good ones that in the long run will probably underperform.”

The number of choices available are greater in some strategies. Value metrics, as an example, are linked to accounting measures, making for numerous ways to filter stocks that are undervalued.

Matthias Lennkh, founder of Clear Alpha, which collects data on bank alternative risk premia indexes, says performance drivers for value strategies, even in good times, are more dispersed than for other strategies as a result.

These differences have been flagged before. Academics at Haute Ecole de Gestion Fribourg released a working paper last year looking at differences in performance of alternative risk premia indexes. “Performance is provider dependent,” the authors wrote. “Investors should take no shortcuts.”

This year has hammered the point home, managers say.

The spread in fund returns has yawned to 14 percentage points from best to worst, with a 10-point gap in volatility opening between the most and least volatile, data from MJ Hudson shows (see graphs). Less than a third of the pair-wise correlations of return across 26 funds are higher than 0.5 for the year.

Poor performance overall comes from funds being pummelled by a series of idiosyncratic events, managers say (see box, What just happened?). But the wide spread in fortunes they put down largely to one of the variables in how funds are put together: in this case, their weighting on equity value.

“From our point of view the challenges this year are disproportionately due to one factor in one asset class and that’s value-investing in equities,” says Sara Shores, head of investment strategy for factor investing at BlackRock.

“Just about everything else has been positive for the balance of the year. Momentum continues to do exceptionally well. Quality continues to do well and in fact has been doing even better in recent months. Carry has largely been positive. Every other asset class has largely been positive. It’s value investing in equities that has disproportionately hurt portfolios.”

Some funds have been more exposed – with a spread of about 10 percentage points between typical firms in the portion of the portfolio they invest in single-name equities, for example.

The effect of a heavier weighting on equity value hit extra hard, firms say, for funds that choose not to neutralise negative exposure to growth in their stock filtering. That led them to short the stock market’s big winners earlier this year – stocks like Amazon, Apple, Facebook, Google and Netflix. Some firms avoid this problem by shorting an index rather than single names.

“More academic implementations of value got killed on their shorts. That has been a really big part of the difference,” says Anthony Lawler, co-head of GAM Systematic. Alternative risk premia strategies are market neutral, but can be caught out by such market moves if one half of the portfolio adjusts more sharply than the other.

At BlackRock, Shores says the fund suffered after the first quarter earnings season when growth stocks “knocked it out of the park”, exceeding earnings expectations. Ordinarily, value strategies would benefit when companies with frothy stock prices release numbers that deflate the hype, she explains: “Exactly the opposite happened in the first quarter earnings season.”

Surfacing risks

For investors, the differences raise clear questions. “Imagine if you went to invest in an S&P index fund but the five different funds you could invest in were wildly different,” says Andrew Beer, managing partner at Dynamic Beta Investments.

“If no-one can agree on the appropriate way to build these things, then really you’re making your own calls as an allocator as to which portfolio managers do a better job of predicting which models will work better and how to put them together.”

The hidden risks in individual funds that are “only now coming to the surface” make investing in them “no different from investing in leveraged single-manager macro funds,” he argues.

A particular worry is the apparent sensitivity of some alt premia funds to falling equity markets because investors – rightly or wrongly – often choose risk premia to offset equities exposure elsewhere.

You have to consider what’s the most suitable fund for each investor given their overall circumstances

Antti Suhonen, Aalto University

Investment consultants see recent months as sharpening the focus of fund selection, forcing allocators to realise they must look beyond the labelling to understand what funds really do.

“You have to consider what’s the most suitable fund for each investor given their overall circumstances.” That means looking further than a buy list of just two or three sector champions, says Aalto University’s Suhonen.

Alt premia funds and strategies are so different from each other investors could also consider hiring a bigger number of managers than usual, managers say.

Ordinarily the diversification effects of using multiple managers in a sector fades after adding two or three. But if risk premia funds have so little in common, that reasoning doesn’t hold. 

Nerves holding

As they pick through the rubble of the past months, though, managers will be heartened to see few signs yet of investors yanking existing allocations from the sector.

Toby Goodworth at consultant bfinance, who advises asset owners on the selection of diversifying strategies, says mandates have slowed this year, but those already invested in alt premia seem to be holding their nerve. Both AQR and BlackRock are understood to have seen net inflows year to date.

Recent underperformance is not extraordinary when considered in the long-term context, Suhonen says. He expects “some re-evaluation of positioning” where investor expectations have been “overly optimistic”, but not a wholesale rush for the exits.

In a few isolated instances, managers tell Risk.net that investors have upped allocations to take advantage of what they see as a buying opportunity with funds so cheap. 

Even so, most managers are looking at ways to guard against something like this happening again.

Sara Shores

Sushil Wadhwani at Wadhwani Asset Management says interest has picked up in more refined versions of alt premia strategies.

Strategies that make some effort to time weightings to different risk premia have performed better in 2018, he says. “The experience this year is consistent with the notion that these sorts of bells and whistles are important.”

Wadhwani doesn’t trade pure value for example, preferring a version that’s “conditioned” on the macro environment. “If an equity market is undervalued because the macro picture is lousy, there’s no sense in buying it,” he explains. In such circumstances the firm reduces its allocation to the strategy.

Shores says BlackRock has started research into possible enhancements to its strategies that would guard, for example, against classifying high-performing tech stocks as value duds and so shorting them.

We understand there is a lot of disruptive technology out there. Many of those stocks that have been breakaway names have assets that are intangible in nature and are not particularly well captured in more traditional fundamental metrics

Sara Shores, BlackRock

Specifically, BlackRock believes traditional valuation methods may not fully capture the intangible value of certain companies. The firm is now evaluating several ways to help identify companies that are “expensive for a reason”, she says.

“We understand there is a lot of disruptive technology out there,” Shores adds. “Many of those stocks that have been breakaway names have assets that are intangible in nature and are not particularly well captured in more traditional fundamental metrics. Part of the issue with the measurement of value is that perhaps it’s not properly capturing the true value of these companies.”

At asset manager Unigestion, Olivier Blin, head of systematic strategies, says the firm is mulling the addition of defensive strategies such as short-term trend strategies to its alt premia funds. Unigestion is also looking at ways to identify when to dial up or down its allocation to specific stocks by tracking investor sentiment through short-sellers’ activity and positioning.

At the same time, firms are also trying to educate investors on the need to think about investments in alternative risk premia as commitments for the long term.

Strategies with low Sharpe ratios – which alternative risk premia are – should expect to see drawdowns of this size relatively often, says Jean-Philippe Bouchaud, founder of Capital Fund Management.

A fund with a Sharpe of 0.5 and volatility target of 10% should see a drawdown of 20% every few years, he points out. “There’s nothing you can do. It’s just statistics.”

“These strategies have periods when they underperform. They have to,” says Ronen Israel, who runs AQR’s alternative premia group. “For example, one explanation of these strategies is [that investors are] being compensated for holding a risk others don’t want to bear. If that risk never appears, why would anyone avoid it?”

AQR founder Cliff Asness wrote a 23-page note to clients in September setting out the long-term case for the investment approach alongside a discourse on the difficulties of defying the human urge to overreact.

The firm wants to be open-minded to anything that could indicate something has changed, Israel says. “But you have to balance that with abandoning things too quickly and overreacting to short-term performance. Nine months is not a very long period compared to a hundred years of history.”

Of course, whether investors will appreciate that point remains to be seen. Funds continue to suffer a torrid time.

And the real test for alternative risk premia will come when equities enter into a long-term slide, Goodworth at bfinance says: “If risk premia fails to deliver in a prolonged period of falling equity markets, then more questions are going to be asked.”

Don’t blame crowding

The synchronised slump in a string of different risk premia this year has revived talk of crowding – the idea that too many investors are investing in the same way, eating away the available premium in a trade and exacerbating market reversals when everyone tries to exit positions at once. Value, which has done especially badly in 2018, is often cited as the potentially most crowded strategy.

Unsurprisingly, managers keep a close eye on this – monitoring prices, correlations, short interest, losses, options markets, sentiment surveys, and positioning data, for signs of crowding. Mostly they say they’ve found nothing extraordinary. 

AQR famously suffered big losses in the 2007 “quant quake” when quant funds were caught up in the rapid unwinding of crowded positions.

But the firm sees little to worry it today, says Ronen Israel, who runs the alternative premia group at AQR. If investors were crowding into risk premia trades, you would expect to see tightening spreads in the pricing of assets that have high factor scores versus those with low scores, he says.

The spread between high- and low-ranking stocks for value should narrow, for example. But that’s not happened. Nor have transaction costs gone up over time, another sign that trades are getting crowded. “If there’s crowding, it hasn’t shown up in the prices,” Israel says.

At AllianceBernstein, co-head of systematic strategies Vikas Kapoor says losses and correlations are “well within historical norms”. If value were crowded, value investors would have seen at least a couple of years of “spectacular” returns before they tailed off, Kapoor contends. Again, that’s not been the case. Value did well in 2016, but otherwise has seen mediocre returns every year since the global financial crisis.

Managers also dismiss talk of a possible repeat of the quant quake.

Christopher Reeve from Aspect Capital says quant funds have learned from the past and are now set up to avoid such a forced selloff. “Our system’s response this year hasn’t been a massive, immediate dumping of positions in the teeth of a selloff, making that selloff worse. That’s not how we trade. We size our positions and schedule our trades to take liquidity into account and we believe our peers do the same thing.”

All that said, not everyone agrees crowding is playing no role. Some think crowding exists but is hard to spot because it has built up over decades rather than months. 

Sushil Wadhwani at Wadhwani Asset Management believes the widespread adoption of ideas central to risk premia investing – including by non-systematic investors – must have diminished the size of the premium available. Value is not the best example to look at, since it might not be a crowded strategy right now, he says.

“The fact business schools teach these things when they taught something very different 30 years ago really matters,” he says.

“The rationale for any of these products was always that there was a type of behavioural bias among players on one side of the market and people willing to take the other side could earn a risk premium. If there are a lot more people willing to take the other side, the reward you get must have diminished.”

As an example, the trend in 10-year averages for foreign exchange carry returns since the mid-1970s is relentlessly down, he says, citing research by Petri Jylhä and Matti Suominen of Aalto University that shows the Sharpe ratio for these trades fell from 0.37 to 0.09 when comparing a period up to 1992 with a period after 2001. Assets under management in hedge funds, many of which traded carry, rose five-fold between the two spells.

What just happened?

Societe Generale’s index of alternative risk premia funds has this year registered six of its worst 12 months since initiation in 2016. February saw the index’s biggest loss ever. October currently lies in second place.

Some of the managers Risk.net spoke to see a unifying force – a Trump factor, for example – at play in the slump. Mostly, though, they think it is just bad luck. “We haven’t found a smoking gun,” says Ronen Israel, head of the alternative premia group at AQR Capital Management.

The bad-luck thesis says alt premia funds have simply taken four big, random hits this year.

The spike in equity volatility and sharp selloff in February hurt trend following and short volatility strategies that are a common feature of these funds.

Equity risk premia strategies have bled badly most of the year, particularly value and particularly in the US, while the shortfall has not been covered by strong performance in other factors.

Matthias Lennkh at ClearAlpha points to a –3.1% correction in momentum in June and July, for example, partly attributable to a short-term slump in high-momentum technology stocks following disappointing earnings results from Facebook.

Emerging market turmoil in August caused negative performance in foreign exchange carry strategies that go long high-yielding currencies versus short positions, typically the US dollar.

And most recently, the equity market reversal in early October again caused pain in trend following strategies that had taken long positions in previously booming US stocks.

Some, though, think there must be wider forces at play.

“It’s been very weird,” says Jennifer Bender, who heads research for global equity beta at State Street Global Advisors. “Value and momentum both fell in March and June this year, which is really unusual.”

Markets are being propelled by two contradictory narratives, she says. On one hand, the US economy looks strong, with unemployment falling and the Federal Reserve gradually hiking rates. That favours value and small-cap stocks. On the other, Trump’s trade rows are making investors question whether the economic growth story is “real or not”, Bender says.

“You see it in the factors. You see investors suddenly going defensive and moving huge allocations into safer, defensive, high-quality/low-volatility stocks in reaction to a Trump announcement.”

Jean-Philippe Bouchaud at Capital Fund Management says fundamental valuation metrics have been “wrong-footed”, which explains the coincidence in underperformance of macro and single-stock value strategies.

“The world is in a kind of disorientated state because of geopolitical events,” he says. “Valuation metrics are for the moment in a transient period. It’s no longer necessarily true that the usual valuation metrics are meaningful because people think we are entering a new world. It’s indicative of the peculiar excess volatility characteristic of the Trump era.”