Making the most of risk premia strategies

For institutional, expert and accredited investors only. 

With risk premia opening up potential for a multitude of complex cross‑asset investment strategies, they have become an area of interest in the investment world. However, questions remain about how to get the best out of risk premia. Yoram Layani, managing director and head of institutional sales, Asia ex-Japan, at BNP Paribas discusses the most effective ways investors can use specific risk premier strategies.

Why does risk premia investing remain such a hot topic?

Yoram Layani, Managing Director and Head of Institutional Sales, Asia ex-Japan, BNP Paribas

Yoram Layani: The combination of prolonged underperformance and hefty fee structures of hedge funds – 1/10 or 2/20, depending on the manager – has been the driving force behind the growth in risk premia, which emulate hedge fund-style returns, while gaining exposure to the same underlying risk factors.

Risk premia are to hedge funds and alternatives what exchange-traded funds have been to index funds, or what smart beta has been to traditional stock‑picking mutual funds. 

Financial innovation and technological improvements have made it possible for global investors to gain exposure to these systematic risks in a more transparent, liquid and cost-effective manner. There is a growing realisation among institutional and professional investors that a large part of the long-term return provided by hedge funds comes from taking exposure to certain systematic risks – such as equity momentum and foreign-exchange carry. In contrast, risk premia use rules-based investment strategies, designed to isolate exposure to specific systematic risks. As investors know the exact rules behind the strategy, they can make more informed decisions or question unreasonable fees. 

Risk premia started as a handful of simple stock-selection strategies, and a decade later offer thousands of diverse and increasingly sophisticated cross‑asset investment strategies, which can be accessed through a variety of products. As research and live track records have accumulated, investor interest worldwide has increased. 

 

Is it possible to develop rules-based risk premia funds?

Yoram Layani: The asset management industry is certainly trying. We have seen a lot of activity, with certain institutions hiring entire teams to develop and run their own internal models, and others buying existing specialist quant boutiques. Over the past 18 months, quant funds have emerged as the winners in terms of fund inflows versus other managers. 

BNP Paribas Asset Management has also rolled out its highest conviction strategies in a fund format – which is compliant with the Ucits directive – under the THEAM Quant umbrella. An example of this is BNP Paribas’ award-winning THEAM Quant multi-asset diversified fund, a cross‑asset momentum strategy with almost $5 billion in assets under management, which recently won best performing fund in the quant macro category over a two-, three- and five-year period in The Hedge Fund Journal’s Ucits Hedge Awards for 2017.

Success in the risk premia business requires cutting-edge quantitative capabilities and extensive investment in infrastructure and technology. With global execution capabilities, and a liquidity provider running a global derivatives book, BNP Paribas can efficiently price and trade these strategies in a transparent and liquid format. The breadth of our capabilities enables us to service fund managers in this space by handling the execution strategies that run their internal risk premia models, or providing off‑the-shelf and customised strategies to managers with limited resources. 

 

Where do risk premia strategies fit into a portfolio asset allocation, and how do you allocate between strategies? 

Yoram Layani: Certain investors have simply been replacing some of their alternative or hedge fund allocation, while others required our help to build a portfolio of single strategies that fit predefined constraint versus their broader portfolio. For instance, we have seen investors who are keen to achieve an absolute return portfolio with close to zero correlation to main market drivers, while others specifically aim for a negative correlation with equity or credit markets to complement the rest of their traditional allocation. Ultimately, risk premia exposure serves as a powerful diversifier that sits between market beta and pure discretionary alpha, which cannot otherwise be captured by systematic trading strategies. 

Allocating between risk premia strategies is a challenge and unfortunately no solution has so far prevailed. The most common approach is to diversify across risk premia and asset classes. The difficulty lies in risk premia exhibiting low correlations with traditional asset classes as well as between themselves. These correlations are unstable over time and are hard to estimate. Consequently we find that a number of classic models – mean variance, equal risk contribution, efficient frontier, and so on – that require correlation as an input would not be optimal. 

These strategies commonly show low volatilities, but are also susceptible to large drawdowns. Any good risk premia portfolio allocation needs to factor in this fat-tail distribution, as well as standard risk metrics such as volatility. We have developed maximum drawdown-driven solutions that address this characteristic. Asset managers operating in this space add value through their discretionary element in due diligence, analysis of strategies and dynamic allocation of premia. The jury is still out, however, on whether this discretionary involvement adds any significant value to performance compared to purely systematic approaches.

 

Is risk premia implementation in fixed income the next phase?

Yoram Layani: Risk premia are very much a fixed-income topic, and have been since the outset. Once a risk factor has been identified for inclusion in a portfolio, asset classes are almost irrelevant. For instance, harvesting carry can be done in equities through dividends, in commodities through the futures carry premia, in rates through the interest rates curve premium, in forex though forward rates, and so on. Carry across currencies is possibly one of the oldest and most widely traded premia.

Risk premia are definitely a cross-asset topic, and exposure to each factor should be diversified across various sources.

From inception, risk premia have been widely acknowledged across asset classes, but the development of well-designed implementations has been relatively slow for fixed income. However, this has changed over the past few years, as increasingly sophisticated strategies have provided access to a wide range of premia observed in fixed-income assets. This has been – and remains – a major focus for BNP Paribas. 

 

How can investors determine the risk premia strategy that best meets their objectives?

Yoram Layani: Risk premia indexes are built based on well-known strategies and persistent sources of return – typically, they are not temporary arbitrages. They reward investors for taking risks that are systematically accessible, beta-neutral and persistent. It is important that investors realise this and avoid frequent activation/deactivation. It is expected that market signals are built into the investment models. 

Investors should understand that these strategies are designed to generate returns from exposure to specific systematic risks over the long term. The returns from individual strategies generally vary over time. Instead of trying to time the returns, investors should maintain a stable exposure to a well-diversified portfolio of risk premia strategies. When selecting strategies, investors should consider multiple factors – including simplicity, transparency, basis in research and academia, live track record, explicit and implicit costs, correlations with other strategies in their portfolio and independence of the calculation agent. 

Do transaction costs have meaningful implications for strategy design and implementation?

Yoram Layani: Absolutely. The primary objective of risk premia investing is to offer a cost-efficient, transparent and liquid alternative to hedge funds. A premium may seem attractive in theory but if the cost of accessing it is too high, then it may not be worth pursuing. BNP Paribas focuses on premia that offer significant long-term returns, after factoring in the costs associated with accessing them. It is therefore vital that all costs are explicit, justified and transparent. 

The portfolio construction process is important to the return generation of any given strategy. With any investment model, going from theory to practice comes with some performance slippage. To minimise this, investors should look for a robust implementation – timing risk, public and auditable pricing references, and execution commitments, for example. They should be aware of overfitting or backtest optimisation by stress-testing parameters and assumptions, in particular transaction costs. 

Recognising the importance of providing such guarantees to investors, BNP Paribas undertook an extensive independent audit exercise that earned it a service organisation controls 1 (SOC 1) certification – an international standard certification that testifies to the robustness and quality of the full value chain behind our quantitative investment strategy platform – the validation process, stress testing, Chinese walls, infrastructure quality and the independence of publication, trading and research functions. This is all as important as the investment research itself.

 

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