Managing Downside Risk with Factor-Based Investment Strategies

A reprinted article from May/June 2018

By Monique Miller and Ray Joseph MAY FEATURE JUNE 2018

Managing Downside Risk with Factor-Based Investment Strategies

By Monique Miller and Ray Joseph

ith equity valuations at as value investing, momentum (trend hedge fund strategies that exploit those historically high levels following), or carry (exploiting rate dif- risk premia. Wand market volatility ferentials) across asset classes. These are relatively low, advisors are looking for the same types of strategies that active Risk premia strategies are rules-based, ways to diversify client portfolios to managers have used for decades, but transparent, and flexible, allowing inves- protect against equity market declines. they now are offered in a fee-efficient tors to use the strategies as building Historically investors diversified and transparent implementation. blocks by choosing the factors or expo- across asset classes and geographical sures required to achieve specific regions. But as we learned from the Smart beta strategies are long-only investment outcomes. This allows inves- financial crisis, in times of extreme factor strategies. These strategies are tors to construct portfolio overlays such market volatility, many traditional asset constructed by creating a transparent as risk mitigation or defensive portfolios classes can become highly correlated. objective and alternatively weighted or portfolios to protect against a specific In addition, because of the current index, based on value, dividends, macroeconomic event (e.g., inflation). low-interest-rate environment and momentum, volatility, market inefficien- The strategies provide the opportunity with central banks poised to raise rates cies, and other investment factors. for investors to gain access to differenti- in the future, there could be a further Alternative beta or risk premia strategies ated returns across a variety of asset breakdown in correlation between stocks are similar to hedge funds in that they classes that typically were restricted to and bonds as interest rates rise. employ leverage, include both long and investors without considerable invest- short positions, and may target a certain ment size, scale, resources, and expertise. Alternative strategies, such as hedge risk level or include drawdown controls. funds, are often used to diversify portfo- Table 1 highlights various risk premia, Risk premia investing provides options lios. Macro and commodity trading how they are implemented, and the for investors that are: advisor (CTA) strategies, in particular, can be good diversifiers through pro- longed market downturns. But often Table RISK PREMIA STRATEGY EXAMPLES hedge funds and liquid alternative strate- 1 gies have high fees, offer very little to no Strategies That transparency, and in many cases have Risk Premium Return Type Implementation Employ Factor Equity hedge/long- delivered disappointing returns. For Value Convergence Long undervalued assets short equity/ macro these reasons, some advisors are scaling Long higher-yielding Macro, back their hedge fund allocations. Carry Yield assets, short lower- commodity, FX yielding assets As a result, advisors increasingly are Trend following, long using new tools for portfolio diversifica- Momentum Persistence recent outperformers, short CTA, Macro tion. One new technique that many recent underperformers Long assets undergoing advisors rely on is factor-based invest- Event Catalyst Event-driven an event ing. This involves evaluating the Short implied volatility— Volatility Premium Macro underlying risk factors or investment providing insurance styles that drive risk and return and then Mean Providing liquidity Liquidity Macro, arbitrage allocating to strategies that can effec- reversion to the market tively capture those factors. These Long or short assets factor-based strategies are based on Structural Congestion with supply and Macro, arbitrage well-established investment styles, such demand imbalances

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AA frustrated with the high cost, risk pro- $250 billion, up from approximately After the characteristics of the portfolio file, and disappointing performance $175 billion a year ago. are determined, the advisor selects strat- of active management over the past egies based on their risk and return several years. RISK PREMIA INVESTING attributes that can deliver the desired AA concerned about the volatility of their There are three main ways that advisors outcome. For example, momentum- equity returns. Strategies that utilize utilize risk premia: (1) as building blocks based strategies (trend following) tend minimum or targeted volatility are to construct outcome-oriented portfo- to be uncorrelated with equity markets designed to create more consistent lios, (2) as a complement or replacement in periods of sustained market draw- returns over the long term than invest- for higher-fee active manager alloca- downs, but certain carry or liquidity ing in traditional equity strategies. tions, or (3) as a benchmark, either to strategies generally are uncorrelated AA disappointed with higher overall assess manager performance (i.e., is the throughout the entire market cycle. active management fees that erode manager adding alpha over a passive excess returns. index?), or to better understand the Because risk premia strategies are sys- AA attempting to gain access to fixed factor exposures inherent in manager tematic and transparent, advisors often income opportunities outside the returns or the overall client portfolio. use them to express a view on markets traditional space of Treasuries and or tilt portfolios to access certain expo- U.S. corporate bonds, including OUTCOME-ORIENTED PORTFOLIOS sures. Portfolios can be designed to emerging market debt, sovereign There are several considerations when access a diverse set of risk premia, debt, and high yield. designing outcome-oriented portfolios. which tend to be uncorrelated, allowing Advisors must first determine the role of investors to achieve more stable risk and The risk premia industry is growing the risk premia strategies in the portfo- correlation benefits. rapidly. In addition to hedge fund man- lio. If, for example, the goal is risk agers offering lower fee, factor-based mitigation, the advisor must identify the HEDGE FUND COMPLEMENT strategies, most major banks also are specific risks that should be hedged. OR REPLACEMENT offering risk premia indexes. These Some investors prefer to have protection In analyzing hedge fund manager indexes span asset classes and invest- against large sustained drawdowns in returns, much of what was previously ment styles and are available for much equity markets and are willing to accept thought of as manager alpha or outper- lower fees than traditional hedge funds. slightly negative performance when formance now can be attributed to beta, The bank strategies are structured equity markets are positive. Others pre- smart beta, and alternative beta (risk as rules-based indexes, are fully trans- fer to not pay a premium for the hedge premia); see figure 1. For instance, parent, and offer daily liquidity. We or insurance and prefer a portfolio of excess returns above a traditional, long- estimate that bank-sponsored assets uncorrelated strategies that can perform only benchmark such as the S&P 500 under management are in excess of in up or down markets. can be attributed to certain smart beta

2.125” x 2.25” 4.25” x 2.25” 6.7” x 2.25” Figure DISSECTING MANAGER RETURNS USING SMART BETA AND RISK PREMIA 1 High Low High True Alpha Outperformance

Alternative Capturing style risk premia (such Beta as momentum, value, carry, (Risk Premia) volatility, etc.) across asset classes Traditional Risk-Adjusted Returns

“Alpha” Strategy Capacity Content/Style Designed to outperform traditional Strategy Cost Smart Beta asset beta by adding an overlay to long-only investments Long-only investments in traditional assets: equities, bonds, FX, Traditional Traditional commodities Asset Asset Beta Beta Low High Low

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risk factor exposures such as value, qual- Figure REGRESSION OF2.125” A CTA x 2.25” TREND BASED ON CUMULATIVE4.25” RETURNS x 2.25” ity, or low volatility. Alternative beta or 2 Cumulative Returns risk premia strategies incorporate lever- 2.00 age and long-short strategies and also 1.75 Ex-Post Alpha can be used to capture a significant por- Manager Return tion of what was previously thought of 1.50 Risk Premia Return as hedge fund manager alpha. Smart 1.25 beta and risk premia have higher capac- 1.00 ity, are more transparent, and have lower 0.75 fees than hedge fund strategies. For this 0.50 reason, many advisors use smart beta as the core of their traditional portfolios 0.25 and risk premia as the core of their 0.00 alternative portfolios and add only those –0.25 active managers that they believe can –0.50 add persistent alpha over time as the satellite allocations. –0.75 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 BENCHMARKING MANAGER AND PORTFOLIO RETURN Risk premia strategies also can be used providers are designed to capture the CONCLUSION to assess which managers provide alpha same risk premia. However, the risk and Advisors are looking for new ways to versus those that (expensively) provide return profiles of the individual strate- diversify client portfolios and to custom- exposure to passive benchmarks. By gies can vary. ize solutions to achieve specific regressing manager returns to smart beta investment outcomes. They also are con- and risk premia indexes, it can be deter- Advisors use the same techniques to sidering both asset class and factor mined which factors a manager is perform due diligence on risk premia exposures when allocating to diversify- exposed to. For example, figure 2 shows investment strategies as they would in ing strategies. Factor-based strategies a regression of a CTA trend-following analyzing quantitative managers. are a flexible tool for constructing over- manager. Based on this analysis, almost Because many of the strategies are lays, hedges, and outcome-oriented all of the manager’s performance can be based on simulated results, there is a portfolios. Because they offer lower fees, explained by passive risk premia indexes, risk that a strategy can be overly opti- more transparency, and more flexibility such as commodities momentum, equity mized to a particular time period or than active management, they are index momentum, foreign exchange (FX) market event. Many strategies are increasingly being included in both momentum, and rates momentum. In designed to outperform in crisis periods, institutional and retail portfolios. fact, this portfolio of passive risk premia such as the 2008 financial crisis. factors performs better than the manager However, the next market downturn is Monique Miller is a managing director at over the time period. In this case the unlikely to be exactly the same as the Wilshire Associates Incorporated, Santa Monica, California. She earned a BS in finance manager’s alpha is negative, thus not previous one. Strategies should be from Syracuse University and an MBA from the warranting hedge fund fees. robust through a variety of market envi- Stern School of Business, New York University. ronments. Strategies that are prone to Contact her at [email protected]. A similar analysis of an investor’s portfo- tail risk, such as volatility selling strate- Ray Joseph is a vice president at Wilshire lio can be performed to determine what gies, should be sized appropriately in a Associates Incorporated, Santa Monica, factors the portfolio is most exposed to. portfolio. California. He earned a BS in finance and Strategies can then be added to either management information systems from SUNY gain exposure to factors not present in Investors also should be cognizant that at Buffalo and an MBA from the Johnson School of Business at Cornell University. the portfolio or to hedge certain factor there is a potential that the effectiveness Contact him at [email protected]. exposures. of a given factor or strategy can be arbi- traged away or can become capacity CONTINUING EDUCATION DUE DILIGENCE constrained. It is important for advisors To take the CE quiz online, As with any investment strategy, due to periodically review performance of www.investmentsandwealth.org/IWMquiz diligence is critical when investing in both managers and risk premia to make risk premia. As a result of rapid industry sure risk and return parameters are in growth, many strategies across multiple line with expectations.

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