Alternative Risk Premia

In the world of alternative risk premia, style premia have dominated. But they do have limitations. Investors should consider using a wider variety of strategies.

Style premia strategies are the most well-known and popular of the alternative risk premia (ARP) strategies. That’s why many investors’ portfolios are exposed primarily to this part of the ARP universe. These strategies aim to add value by allocating to well-known risk factors, within and across asset classes. However, an exclusive reliance on style premia can leave investors vulnerable in certain environments: for instance, when market conditions become volatile and unpredictable with rapid switchbacks, as in 2018. In the following simplified example, we show how and why the inclusion of just one differentiated ARP strategy can start to address this weakness.

Event-Driven—a Highly Differentiated Strategy

Event-driven ARP strategies identify securities that are subject to activist, merger arbitrage, acquisition or spin-off activity. These strategies create portfolios systematically, based on securities with the most positive characteristics and conforming to specific cost, risk and liquidity criteria. Event-driven premia have historically been uncorrelated and even negatively correlated with the style premia complex of value, size, quality, momentum and low volatility (Display).

Time Factor—an Important Diversification Property

Event-driven strategies mostly have a relatively short time horizon, geared to the completion or non-completion of a specific corporate event. As a result, the pay-offs from a portfolio of event-driven strategies come in frequent, discrete “wins” at short intervals. By contrast, style-driven strategies are subject to wider thematic influences and pay-off over longer time horizons. Their “half-life”—the point at which investments lose half their value-adding potential—can extend from three months to two years for the most popular style strategies (as we show in the Display, below).

This means it may take investors months or even years to reap the benefits of these allocations. This difference in time horizons helps explain why event-driven strategies are so complementary with style premia.

Beware Of Event-Driven Risks

Event-driven strategies do, however, introduce different risks—primarily through cross-over holdings with hedge funds and therefore exposure to the leveraging and de-leveraging decisions of the hedge-fund community. To help offset that exposure, we think a robust ARP portfolio should include additional diversifying strategies over and above event-driven.

These comprise not only style premia, but also a wide range of hedge-fund premia including: global macro; structural premia including mean reversion and volatility strategies; and cross-asset premia based on arbitraging factors across multiple asset classes. In our view, using the complete ARP opportunity set can create more robust portfolios with strong return-generating potential that can help investors transcend style turbulence.