Derivatives: Asset managers catch on to risk premia strategies
With yields compressed and equity volatility at a historically low level, hunting for consistent returns has been a challenge for asset managers and institutional investors alike. But as Costas Mourselas reports, the meteoric rise of risk premia strategy, a type of passive investing, promises to at least partially alleviate those woes.
Risk premia strategy, a form of passive investing, is gaining ground among asset managers as they turn to the product for a steady source of yield and a tool for hedging uncertain macroeconomic conditions.
This type of investing relies on ideas — many of which are derived from academic papers — that have consistently delivered returns, and are expected to do so into the future.
Risk premia strategies generally create exposure to multiple asset classes, and do not rely on markets going in any particular direction, remaining neutral by delivering yield in the long run while protecting against events such as an equity market crash.
“There is a philosophical debate around different types of risk premia strategy. Some people argue that you are profiting from taking a risk, while others say you are taking advantage of a consistent anomaly in the market,” says Shane Edwards, global head of structured products distribution at UBS in London. “Philosophy aside, this rule-based form of passive investment is unbelievably topical and we held a record number of events talking about it in 2017.”
The basic underpinnings of this investment strategy are a few identifiable risk premia, including value, momentum and carry.
Value takes advantage of the way cheaper assets generally outperform more expensive ones. Momentum takes a view on an asset’s relative performance, wagering that well-performing assets will continue to do well. A carry strategy depends on high yield assets, based on the logic that they will in the long run provide better returns.
All these strategies are, perhaps, overly simplistically compared with the stock picking abilities of some hedge funds, and are vulnerable to wider macroeconomic factors, especially in the short run. But combining multiple risk premia strategies in a portfolio across asset classes can provide tantalising sources of return — even if a couple of them turn out to be bad eggs.
Investors are gaining exposure to all these ideas by signing up to the index platforms provided by banks such as JP Morgan, UBS, Deutsche Bank and Goldman Sachs.
With these customisable indices, clients can get exposure to baskets of securities, applying weightings to take advantage of particular risk premia.
Smaller fish can pick up an “off the shelf” index solution giving exposure to a certain risk premium for six to 12 months, while larger clients mix and match various strategies.
The ideas behind these strategies are quite well known, and can be carried out without banks. However, they can be quite difficult to execute without the help of larger institutions.
“A typical transaction with a client involves combining individual strategies that each give exposure to a particular risk premia into a single parent portfolio index,” says Thomas Leake, head of equity structuring EMEA at Goldman Sachs in London. “We then trade an index swap, certificate, fund or option that references this portfolio index.”
Asset managers galore
The investible index platforms at the big banks are seeing sharp growth, as more and more clients flock to gain reliable returns that are well hedged against macroeconomic conditions.
In November, of Deutsche Bank’s $50bn index platform, $21bn was allocated to risk premia strategy, almost double the amount a year before. New clients in risk premia at Goldman was just north of 30% in 2017, while JP Morgan’s $40bn index platform saw 30% year-on-year growth.
The numbers are extraordinary, and seem to be fuelled, in part, by new asset managers entering the complex field.
Deutsche has typically worked with pension funds and sovereign wealth fund clients since its risk premia operations picked up in 2011. But last year it won business from asset managers and endowment funds, as well as Australian, Canadian and US pension funds.
“We give asset managers access to market-neutral strategies that are difficult to implement with their own operations, and do it for them, to the point where we are almost running a synthetic prime brokerage-type service,” explains Sean Flanagan, global head of equity structuring and quantitative investment strategy at Deutsche Bank in London.
“We deliver all the infrastructure and operations to them and change a strategy that could have represented hundreds of trades a year to something they can access with a single line swap booking in their fund.”
Of Goldman’s 30% increase in new clients, 40 of them were European asset managers.
One of the more vanilla risk premia strategies is selling equity volatility — and it remained a bedrock of risk premia allocation in 2017. The idea is fairly simple, and based on the relationship between two different ways of measuring equity volatility — implied and realised.
Implied volatility depends on options prices, and paints a picture of how investors expect stock prices to lurch up or down in the future. The famous Vix index, which measures this type of volatility for the S&P 500, is one such indicator.
In the first half of 2017, implied volatility was quite high, as populist political candidates threatened to rip up the established order.
But once these elections returned the mainstream parties to power, implied volatility hit historically low levels.
Realised volatility, on the other hand, is a historical measure of how volatility actually played out in the markets. The spread between realised and implied allows investors to extract some quite hefty premiums.
“Last year, just selling volatility on the S&P 500 was the best of the factor strategies, simply because volatility was realising at very low levels compared with where it was priced in the options markets,” says Arnaud Jobert, head of equity derivatives structuring at JP Morgan in London.
Shorting volatility was a consistent theme raised by numerous market contacts of GlobalCapital throughout 2017, demonstrating remarkable staying power.
Should these market conditions continue, investors will carry on exploiting this trade. And should volatility jump because of unforeseen political risk, or a crash in equity prices, investors can rely on the other risk premia in their portfolios to hedge themselves.
Risk premia will fix it
Mixing risk premia into highly customised portfolios has also proved to be a popular way for larger investors to solve very specific problems with their investment strategies.
Some Swiss wealth managers, frustrated with the returns of medium-term bonds in their portfolios, turned to this strategy. For them, the bonds were meant to generate yield, while also being defensive on the assumption that there would be rate cuts in Switzerland during stressed equity markets.
But with European rates held down at low levels last year, these clients did not expect much negative correlation with equities to occur.
To deal with this conundrum, the Swiss clients used risk premia, combining some carry strategies as well as equity quality strategies to gain yield and negative correlation with equities during a potential period of market stress.
Equity quality strategies involve adding weighting to stocks with a low debt load and steady returns.
The investors in essence created a fixed income-type instrument that fulfilled the traditional role of five year bonds in their portfolios.
Edwards observed similar trends in 2017, saying that with investment grade bond yields so low, investors did not necessarily see them as an “attractive safe haven asset”.
“This has encouraged clients to become ever more open-minded, and we are seeing increasing interest in multi-asset risk premia portfolios, aiming for uncorrelated returns and low volatility,” he says.
Active versus passive
Against the backdrop of the active versus passive investment management debate, it could be tempting to suggest that risk premia investing is another example of passive investment strategy winning out. That is especially so when considering that many risk premia strategies are labelled “hedge fund replacements”.
But the bankers who spoke to GlobalCapital were quick to bat away suggestions that there was not room for both types of investing.
“Hedge fund strategies that use high frequency models, or that involve judgement calls based on the macroeconomic environment, generally cannot be systematically replicated, so they offer access to returns that can’t be obtained through risk premia strategies,” says Flanagan.
Leake adds that he has observed large institutions under fee pressure “using systematic strategies to allow them to keep their preferred active managers”.
Risk premia strategies are unlikely to squeeze active asset management out of business. But their growth in popularity is indisputable, and given uncertainty as to how long bullish conditions will last, risk premia strategies seem increasingly attractive.
“Some of the returns from equity markets in 2017 were incredible, but there is a big question mark as to how long some of those trends can last,” says Edwards. “But I think that plays well into the hands of risk premia strategies that offer robust, liquid portfolios that aren’t entirely dependent on one type of equity market cycle prevailing.
For more on the impact of MiFID II on the derivative markets click here: Survival of the fittest as MiFID II burdens derivatives market