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A true long-term perspective on alternative risk premiums

A true long-term perspective on alternative risk premiums

19-11-2019 | Insight

Alternative risk premium (ARP) solutions have shown significant performance dispersion over the past two years. Some of them, including ours, achieved positive performance. But most failed to deliver on their promise and did not provide the expected diversification benefits, in particular during the equity market crash in the last quarter of 2018. In this paper, we provide a long-run perspective on the benefits and risks of ARPs.

  • Guido  Baltussen
    Guido
    Baltussen
    Co-head Quant Allocation
  • Thibault Lair
    Thibault
    Lair
    Portfolio Manager / Researcher
  • Martin Martens
    Martin
    Martens
    Head of Quant Allocation Research

Speed read

  • Short-term ARP performance has been erratic in many cases
  • Historically ARPs provide persistent returns and strong diversification
  • ARP solutions can help improve portfolios

Many ARPs delivered a disappointing performance in 2018 and parts of 2019. For instance, the average return of the Eureka Hedge Multi Factor Risk Premia Index and the SG Alternative Risk Premia Index (in USD) was -7.7% in 2018. To a large extent, these disappointing returns were caused by a very poor last quarter in 2018, when the equity market tumbled heavily, and the ARP industry suffered as well. 

ARP solutions are rules-based strategies that aim to harvest premiums across different asset classes, backed by vast empirical evidence and supported by numerous academic studies published over the last 50 years. They offer a diversifying stream of returns at attractive costs. As such, they can be used as strategic portfolio enhancers for traditional investment approaches and hedge fund allocations.

Many investors had hoped that the low long-run correlation of ARP returns with equity markets would serve as a buffer for the negative equity performance. They felt that the diversification they had been promised failed to materialize when it was needed most. But it is probably too early to draw conclusions from this specific unfortunate episode, as it might simply be an outlier.

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A long-term perspective needed

We believe that it is important to provide some perspective using long-term evidence. In fact, our research shows that the correlation between equity and ARP returns over the 217-year period from 1800 to 2016 has been just 0.1. Such a low correlation means ARP solutions typically offer strong diversification benefits when combined with an equity portfolio.

Yet, despite having a low correlation, it is also true the 12-month equity returns and ARPs can sometimes be negative at the same time. This happened in 6% of the 12-month subperiods from 1800 to 2016. In other words, both equities and ARP simultaneously experienced negative annual returns around once every 16 years. 

What is more, a positive 12-month ARP return has coincided with a negative 12-month equity return about twice as often (13% of the time). Of course, the most common case is that both post positive returns, which happened 60% of the time. After all, both equities and ARPs strategies are expected to provide strong positive returns in the long-run.

As the holding horizon increases, the probability of simultaneous losses diminishes significantly

The investment horizon matters

Finally, the investment horizon matters. because as the holding horizon increases, the probability of simultaneous losses diminishes significantly (dropping to 3% and 1% for three and five-year holding periods, respectively). Therefore, investors with a longer-term perspective can substantially reduce their chances of losing money.

Yet, as 2018 showed, not all ARP solutions are created equal. When selecting an ARP strategy, investors need to bear in mind the possible tail risks embedded in many ARP solutions. They should look under the hood and critically evaluate different factor strategies and their diversification benefits.

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