Improving the Odds
Backed by our investment research and supported by our investing philosophy, we believe including a systematic alternative risk premia strategy can improve the odds of a portfolio’s meeting its long-term return hurdle. Such a strategy harvests robust factor premia, such as carry, value, and momentum, via long–short exposures to liquid futures contracts in a straightforward, systematic, and transparent portfolio design. For instance, we estimate a 20% allocation to such an approach3 more than triples the Average Advisor portfolio’s probability of clearing the 5% return target, improving the odds from 1.5% to over 5%, and an aggressive allocation of 40% moves this probability to over 21%. Importantly, the alternative risk premia strategy includes exposures absent from most advisor portfolios, so the increased return comes along with improved portfolio diversification, lower portfolio-level volatility, lower higher-order moments, and reduced downside risk.
Robust Risk Premia
According to the 2018 JPMorgan Institutional Investor survey,4 approximately 36% of the 214 respondents (pensions, insurance companies, endowments, funds of funds, consultants, and banks) plan to invest in alternative risk premia strategies in 2018. Increasingly, these strategies are available to retail investors. These strategies can take a variety of approaches, but generally seek to capture a collection of risk factors, or risk premia, largely uncorrelated with major markets and to each other, and are implemented across multiple asset classes and styles. By gaining exposure through cheap and liquid implementation in a systematic and robust manner, these strategies tend to harness risk premia at a lower cost and with greater transparency than traditional alternative structures, such as hedge funds.
A risk premium is likely to persist when based on a robust factor. Beck et al. (2016) find that a factor’s robustness is characterized by being 1) grounded in a long and deep academic literature; 2) robust across minor perturbations in the factor’s various definitions; 3) robust across geographies; and 4) implementable, with trading costs that do not threaten to erode returns. In the alternatives space, Brightman and Shepherd (2016) describe carry, value, and momentum as the most well-known, theoretically sound, and empirically robust factors. Our research findings consistently remind us why emphasizing robustness, liquidity, and implementation quality, while removing unnecessary complexity, is vital to helping investors reap and keep the rewards offered by these alternative sources of risk premia.
Let’s look more closely at the three factors of carry, value, and momentum.
- Carry refers to a long position in a relatively higher-yielding asset financed by a short position in a lower-yielding asset. As Brightman and Shepherd (2016) discuss, often this yield premium—especially absent an underlying directional market exposure—serves as compensation for the risk of shifting spot prices. The well-documented currency carry trade serves as a good example. The trade persists because investors who hold high-interest-rate currencies seek a yield premium to offset the crash risk that comes with negative spot price movements concentrated in economic downturns (Lustig and Verdelhan, 2007). And as Keynes’ (1930) theory of normal backwardation describes, the commodity carry trade delivers a yield premium in order to encourage speculative capital to provide price volatility insurance to producers with large upfront costs (say, when corn seed is planted) and with uncertain future revenues (when the crop is harvested and brought to market). Augmenting carry strategies with other robust factors designed to determine changes in spot prices, such as value and momentum, leads to greatly mitigated volatility, lowered skewness, and insulation against large drawdowns.
- Value is another well-established, robust factor with a long history of academic exploration. One of the first factors identified, value’s origins can be traced to the work of Graham and Dodd in the 1930s. Value refers to the tendency of relatively cheap investments to outperform relatively expensive ones over a longer holding period, so that value investors tend to be compensated for patiently holding uncomfortable, contrarian positions. Value often requires taking on maverick risk (Arnott, 2003), which makes it particularly well suited for a systematic investment strategy inherently immune to the behavioral tendency of investors to buy high and sell low.
- Momentum can be viewed as the mirror image of value. While momentum and value both aim to predict spot price movements, they do so over different time horizons, and therefore serve as excellent complements to one another. Also known as trend following,5 momentum involves buying assets whose prices have been recently rising and selling those whose prices have been recently falling. Short-term momentum suggests that prices initially underreact to a news event, allowing for the continuation in the directional price movement and creating a self-reinforcing trend. In some markets, momentum can be perpetuated by institutional frictions or actions, such as central banks intervening in the currency markets to stabilize exchange rates and mitigate volatility.
In the spirit of “no free lunches” we encourage investors to come to a deep understanding of the sources of risk that drive their expected returns prior to committing their investment dollars; some type of risk is almost always present in an investment whether obvious or not! Having an awareness of the investment risks associated with alternative risk premia strategies, which commonly involve the use of leverage, derivatives, and both long and short exposures, and which require a high degree of skill in implementation, is of particular importance.
Once satisfied that carry, value, and momentum strategies are robust and should continue to deliver a desirable return stream to complement traditional portfolios, the next step is knowing how to best access these premia and combine them in a portfolio. We favor using the combination of carry, value, and momentum because these factors have complementary exposures with clear empirical and theoretical support and which address the different building blocks that make up the total return of any investment (Brightman and Shepherd, 2016). As previously stated, carry is the yield differential earned on a long higher-yielding position and paid on a short lower-yielding position; value can exploit potential price adjustments over longer horizons; and momentum targets short-run impacts on spot prices.
Generally, the initial benefit of combining factors in an alternative risk premia strategy shows up as volatility reduction.6 Thus, the correlations of the component factors must maintain their diversifying properties in order for the strategy to deliver on its promise. We analyze the correlation levels of all combinations across three factors—carry, value, and momentum—across four markets—bonds, currencies, equities, and commodities—from February 1989 through December 2017. The average pairwise correlation of these 12 sleeves is 0.03, which means they are essentially uncorrelated. Furthermore, the time variation of these average pairwise correlations has typically been quite low, even over short horizons, with rolling one month (22-day) correlations wavering between −10% and +10%, although we have observed several meaningful rises in these correlations over the last 10 years. These short-lived periods of spikes in correlation are a warning sign of the danger of the risk and leverage in these strategies and a reminder that they need to be assumed with a degree of humility, not with blind adherence to the historical data and the output of overly calibrated models.