In pursuit of returns and diversification, growing numbers of investors are turning to alternative risk premia (ARP) strategies, which offer access to well-known sources of excess return potential – such as value, carry and momentum.
As this space is still outside the mainstream and rapidly evolving, the most common questions posed by investors considering ARP strategies can be challenging to answer: Which strategies should I allocate to, and in what amount? How important are strategy design and implementation? And how do I ensure appropriate risk management?
In the following Q&A, PIMCO strategists Brad Guynn and Ashish Tiwari provide insight into these questions.
Q: More than $300 billion of assets were invested in alternative risk premia strategies globally as of 2016.1 What’s driving their adoption?
Tiwari: Alternative risk premia strategies seek to provide investors with systematic exposure to well-known sources of excess return, such as value, carry, momentum and risk aversion, obtained across all major asset classes. These risk premia have been utilized by active managers, including PIMCO, for decades to seek a complementary source of alpha alongside traditional alpha sources (such as bottom-up selection and sector rotation).
They are fast gaining popularity as stand-alone investments because portfolios combining multiple alternative risk premia are among the few investment options that offer not only high return potential but also meaningful portfolio diversification. Generally lower fees and better liquidity terms than traditional hedge funds further add to their appeal. Finally, investors also value the transparency of these strategies, which may be easier to understand and monitor than traditional, qualitative investment strategies.
Q: How should investors determine which ARP strategies will best meet their objectives?
Guynn: It can feel overwhelming to sort through the cornucopia of potential alternative risk premia strategies.
More than 300 alternative risk factors have been identified in academic literature, according to a paper by Campbell R. Harvey, Yan Liu and Heqing Zhu titled “… and the Cross-Section of Expected Returns.”2
Other publications have cast doubt on the performance of many alternative risk factors. In their working paper, “The History of the Cross Section of Stock Returns,” Juhani Linnainmaa and Michael Roberts show that out-of-sample results for many equity-based alternative risk premia are significantly less compelling than (or even contrary to) in-sample results.3
When contemplating an ARP allocation, we believe investors should be highly selective. First, they should eliminate strategies that lack a reasonable economic explanation for their existence or a long history of persistent returns. Recently discovered factors should be approached with healthy skepticism. Second, investors should consider limiting allocations to only those strategies that can potentially deliver positive returns after making conservative assumptions for transaction costs. Finally, investor