Alternative risk premium strategies could see rise despite set-up costs

Risk premiums are defined as rewards for taking on risk unwanted by other investors. Alternative risk premium strategies offer the ability to go both long and short on securities, rather than just long.

By going long on a security, an investor obtains profit if the asset grows in value. If they go short, they will receive profits if the security falls in value.

I wouldn’t want to see it being a large proportion of a portfolio

Scott Edmunds, Quantum Advisory

Schemes can take advantage of low fees

The research paper, by consultancy Aon, lays out the three types of strategies used by alternative risk premium funds: momentum, value and carry.

In a momentum-based strategy, the investor will trade securities offering consistent performance on an absolute or relative basis.

Value strategies see investors buying undervalued securities and selling overvalued assets. With a carry strategy, the scheme will borrow low-yielding assets and use the proceeds to invest in higher-yielding securities.

Matthew Towsey, principal at Aon, said that while the approach had been around for “about a decade”, it has grown in popularity in two areas over the past three to four years.

“One has really been the quantitative hedge fund firms, who have launched products in this space and obviously have existing expertise in a lot of the strategies these funds will use,” he said.

“We’ve also seen some of the traditional asset houses launching products in this space… they may bring a more top-down skill set to this area,” he added.

Towsey said that the schemes currently involved in this space are allocating up to 5 per cent of scheme assets to alternative risk premiums. Management fees range from 0.5 to 1 per cent a year, with no performance fee.

“We’re seeing money being allocated by clients who maybe have no alternative asset exposure, no hedge fund exposure, because they’re not keen on the types of fees that hedge funds might charge,” he said.

“We’ve also seen some clients who already maybe have some liquid alternatives… absolute return bond funds, diversified growth funds,” Towsey said.

Alternative risk premium strategies have lower correlation

The report observes that these strategies have low correlation to mainstream sources of return, liquidity terms that can be better than those in traditional hedge funds, and offer a good entry point for investors to access further alternative strategies.

Joan Lee, investment manager on Unigestion’s alternative risk premium fund, said: “One of the benefits of diversifying across several alternative risk premia is that it can allow investors to achieve improved risk-adjusted performance without significantly increasing a portfolio’s beta to traditional equity markets.”

She added: “Combining various alternative risk premia in a single portfolio can also result in lower costs through the netting of trades as some instruments might be present in more than one risk premium.”

The report says that alternative risk premium strategies use approaches that are similar to some hedge funds in a systematic manner.

But Daniel Banks, director at consultancy P-Solve, observed that Aon’s own figures do not suggest that alternative risk premium strategies offer a clear route towards imitating hedge fund performance at lower cost.

Aon’s figures indicate a 0.29 historical correlation between hedge funds and an alternative risk premiums portfolio.

“They said that effectively, it’s a relatively easy way to achieve greater access to hedge funds [type strategies]. There’s limited correlation there,” he said.

The data show a very high correlation with equities and an equity/bond portfolio, but low correlation with the value and carry alternative risk premium strategies.

According to Banks, this implies that hedge funds are not necessarily using these alternative risk premium strategies. It does, however, imply they are using a lot of the equity risk premium.

"I do agree with them, that I think it potentially can be a cheaper way to get access to some of the things that hedge funds are doing," he added.

Implementation costs are high

Despite their rising popularity, alternative risk premium strategies have yet to register on the portfolios of most schemes.

Scott Edmunds, senior investment consultant at Quantum Advisory, said that his clients had yet to move into this space but were holding discussions on the strategy. “There is a place for alternative risk premia in pension scheme portfolios,” he said.

Edmunds cited high implementation costs and the importance of reviewing manager performance as key risk factors.

“For those reasons it does need to be scaled appropriately, I wouldn’t want to see it being a large proportion of a portfolio,” he said.