This article was written by Nicolas Salloum (pictured), partner at Geneva-based CdR Capital. It originally appeared in the May 2018 edition of Citywire Switzerland.
Over the past few decades, there has been growing criticism of traditional asset allocation methods, which use the past performance of individual asset classes to determine future asset allocations.
But what is the alternative? How should investors think about asset allocation in general and particularly when faced with elevated equity valuations or a turning point in the interest rate cycle?
One alternative approach that some of the most sophisticated institutional investors around the globe have adopted constructs portfolios around the drivers of return and risk, rather than asset classes.
This trend started with what is now known as risk premia investing (or factor investing), based on the ‘harvesting’ of persistent returns from underlying securities and then building portfolios with allocations to different risk premia, as opposed to different asset classes.
Risk and reward
In these portfolios, returns are effectively rewards for exposures to well-defined sources of risk that a section of the market wants to insure against and for which they are willing to pay a premium to those market participants who are prepared to provide that insurance.
Initially, factor investing focused on long-only equities and was typically referred to as ‘smart beta’ or ‘primary’ risk premia. This very quickly became a challenger to active equities. The quest for returns in a low-yield environment and the need for a low-cost alternative to sit alongside hedge funds (the ‘traditional’ portfolio diversifier) prompted the next iteration of factor investing: alternative risk premia.
Like hedge funds, alternative risk premia have the freedom to harvest non-traditional risk premia across more securities, including bonds, currencies, commodities and credit, as well as equities. It also frequently requires more elaborate techniques such as shorting, leveraging and frequent trading, as well as trading more complicated instruments such as financial derivatives (for example, options and futures).
Alternative risk premia investing allows investors to look at their portfolios from a risk budget rather than a capital budget perspective. It also allows investors to achieve enhanced diversification across their portfolio as they continue to move away from ‘asset class’ buckets and towards ‘sources of risk/return’ buckets. Sizing these risk/return drivers is therefore key to managing the associated risks and becomes an important factor in the portfolio proposition.
Flexibility across markets
Some of the pioneers in this space have made significant strides in implementing alternative risk premia strategies across developed markets. These strategies capture a significant portion of the returns offered by the hedge fund market, allowing investors to spend the remaining 2% and 20% budget on the true alpha strategies offered by specialist managers.
A promising recent trend has been to extend these strategies into more esoteric markets, where the risk premia appear to be even richer – as long as the execution is done with care and all-in execution assumptions can be validated and relied upon. In terms of the implementation, alternative risk premia investing provides a high degree of flexibility by allowing the investor to combine one or more strategies across one or more asset classes.
At CdR Capital, we view premia as a way to provide added flexibility at the asset allocation stage and also to add a tactical dimension to our existing manager allocations.
There are many types of risks faced by investors in today’s volatile world, and with alternative risk premia they can at least ensure that they are rewarded for the risks they take.