Alpha

Alternative risk premia and a fundamental explanation

Written by innote September 22, 2018 0 comment

Numerous portfolios are mostly dominated by equity market risks. In the face of global economic crisis, this may not be favourable to the various investors. Thus, it is usually advisable that investors seek other sources of returns into their portfolios. The savvy investors therefore recognise the need to include alternative sources of return that completely avoid these market risks (market-neutral alternative sources), to complement their portfolios.

Coming through the years, investment has been having a continuous growth spurt. This has given the opportunity to previously novel investment strategies such as Alternative Risk Premia to take the front stage in investment. Alternative Risk Premia or Alternative Risk Premium (as it was formally called) is fast becoming a veritable option as opposed to Traditional Risk Premia. Alternative risk premia involves a myriad of systematic approaches applied to investing, that have the ability to generate profitable returns in various markets and assets groups in the long run.

Alternative Risk Premia

Alternative risk premia is founded on the belief that human behavior is essential in driving of asset prices that result in systematically exploitable opportunities; these opportunities commonly have no connection to wider macro fundamentals.

Alternative Risk Premia basically is an upgrade on the Factor Investing Approach common in equities which gives investors and asset owners a better understanding of how diversification of portfolio works and capturing new sources of returns. As can be immediately deduced from the name, Alternative risk premia are alternatives to traditional risk premia and can take the form of both long and short investment.

While traditional risk premia are limited in scope to only long investments with just one given asset class, alternative risk premia however, are quite complex, they can be found in all asset classes including equities, rates, credit, commodities, etc.

Alternative risk premia constantly have some interactions with traditional risk premia despite their differences. However, when it comes to exposure to macro risk factors, alternative risk premia are exposed to a wider range. Some of these risk factors to which alternative risk premia are exposed include: behavioural biases, human preferences, investment styles and investor constraints. Despite this, various research, statistics and investor experiences have proven that alternative risk premia can still offer enticing risk-adjusted returns, even over multiple, asset groups regardless of whether or not they are related, and in various locations.

ALTERNATIVE RISK PREMIA

Types of alternative risk premia

The various Alternative risk premia and the fundamental justification for their existence

MOMENTUM

Momentum indicates the likelihood for an investment to maintain its recent trend in performance. It is the possibility that an investment which has been performing well recently will continue to perform well, or that an investment which has been doing poorly of late will continue that trend. It proposes the continuation of trends as opposed to sudden jumps or dips in performance.

VALUE

This is one of (if not) the most commonly known alternative risk premia. It covers the possibility for relatively cheap assets to do better performance-wise, than expensive assets. It is based on the premise that humans tend to view cheap things as second rate to their expensive counterparts. This creates a situation where most investors rush at the expensive assets, thereby causing an overload and reducing returns, while conversely leaving the cheap assets to the really brave investors. Due to their lesser number, these brave investors get to earn greater returns for their relatively cheaper investment.

CARRY

This is the possibility for higher yielding assets to generate higher returns than lower yielding assets. You would oftentimes find this type of alternative risk premia applied to currencies and markets for fixed income. Carry may take place where there are inconsistencies in capital supply and/or demand or where there is the presence of actions of the central bank actions are.

DEFENSIVE

This alternative risk premia covers the chances of low-risk, high quality assets to produce higher (risk adjusted) returns. The advent and continued existence of this type of alternative risk premia could be attributed to the phenomenon known as ‘leverage aversion’ which in turn induces investors to go for assets with higher risks and greater potential for higher rewards.

TREND FOLLOWING

This type of alternative risk premia is focused on the recent trends (especially as relates to price) of an asset whether positive or negative, and the possibility of this trend to continue in the future. In the beginning, it might appear like the definition is similar with Momentum but there is a thin but essential difference. Whilst trend following takes into cognisance only the recent overall performance of the asset, momentum on the other hand, takes into cognisance only the relative performance. In simpler terms, trend following considers the general statistics and thus sells whatever is experiencing a negative downturn, while buying whatever is trending positively in the market. Momentum on the other hand considers only the history of the asset in question and not its standing in the general market. As such, it buys whatever is doing well in recent times relative to its past performances, and sells whatever is having a bad time in recent times compared to its usual performance. Trend following may also be known as Time-series momentum.

VOLATILITY

This type of alternative risk premia takes advantage of the risk preference and behavioural prejudices of the investors by systematically selling options to underwrite financial insurance. These insurance risk premium rooted in options reflect the risk aversion of the investors and their propensity to overestimate the chance of significant losses.