Focus on alternative risk premiums: how to understand them and use them the way they are allocated?

A traditional risk premium refers to the remuneration of a long-term investment on different asset classes: equity risk, credit or duration bonuses. As these asset classes are themselves subject to extreme risks or unstable correlation, investors wish to diversify the nature of these premiums in their portfolio.

In hedge fund strategies, performance drivers are of three types: market exposure (Beta), exposure to alternative risk premiums and the skills of the manager (the Alpha).

These alternative risk premiums are therefore derived from non-linear factors (unlike traditional assets). For example :

“Carry” factor: high-yielding assets outperform those with a low rate of return;

“Momentum” factor: assets whose price has risen and continues to rise and vice versa;

“Value” factor: assets with low valuations outperform assets that are already heavily valued;

“Size” factor: small capitalizations outperform large ones, paying for liquidity risk;

“Quality” factor: better quality assets (stability of profits and low debt) outperform those of lower quality.

The investment solutions to benefit from these factors are based on systematic strategies including long and short positioning on different financial instruments and asset classes.

Market size and players

The market for alternative risk premiums was USD 600 billion at the end of 2016 and its potential size is estimated at USD 1,200 billion in 2019 and USD 1,600 billion in 2021 (source: Citi Prime Finance). Investors can access it through a variety of formats: hedge funds, ETFs, UCITS funds and tailor-made products structured by investment banks. Today, 26% of investors use these risk premiums in their portfolios according to a Deutsche Bank study (against 20% at the end of 2016 and 15% at the end of 2015). The most known actors are Anglo-Saxon (Two Sigma, AQR, BlackRock), but also French (La Française Investissement Solutions, ERAAM, AXA).

Recommendation by Cedrus Partners

We are enthusiastic about the development of this new concept, which allows us to exploit part of the performance drivers of hedge funds at a lower cost. However, this market bears extreme risks that have not yet materialized in an environment of low volatility and there is a lack of feedback. These premiums generate a reasonable performance for the investor only because they are individually very risky; but this volatility is reduced by a significant diversification effect when assembled in a portfolio. What will happen if these unlinked properties evaporate in a market stress scenario? Finally, these strategies require an important part of systematic management and we must make sure not to invest in a “black box” which effects are measured only afterwards. For these reasons, Due Diligence is required prior to any investment.