Punishing year for risk premia strategies prompts self-reflection

Risk premia strategies — a growing form of quantitative passive investing — performed poorly in 2018, with many flagship funds and strategies under investor scrutiny. Experts in the space have been soul searching and are looking for a reprieve in 2019. Costas Mourselas reports.

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The risk premia strategy market faces a testing 2019, as specialists try to convince investors that this quantitative form of passive investing still has an important role to play, despite poor performance in 2018.

Risk premia strategies offer a way to profit from market inefficiencies in a hedged way, but they are no panacea — investors can still suffer if markets perform in unexpected ways. As 2019 begins, markets are particularly hard to read, with conflicting bullish and bearish signals.

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Risk premia strategies rely on investment ‘factors’, or ideas, that drive returns (see box). Factors include, ‘quality’, ‘trend-following’ and ‘value’. 

In their most basic form, factors can be applied by buying a benchmark index exchange traded fund (ETF), such as the S&P 500, with a weighting bias to quality or value stocks. These index ETFs fall within the smart beta category, and can be found on major exchanges around the world. 

The specialist investment managers, such as AQR and banks, use sophisticated risk premia strategies employing a range of factors across multiple asset classes in a single portfolio. A lot of their strategies are market-neutral, meaning they are designed to perform relatively well under all market conditions. A simple market-neutral strategy could see a fund manager take long exposure on an S&P 500 ETF with a tilt towards value, while selling a standard S&P 500 ETF. By doing this, if the S&P 500 does fall, they still make a return if the long exposure performs better than the short exposure. 

However, diversified strategies that try to take advantage of many of these factors in a single portfolio have performed poorly in 2018. 

“While I haven’t seen evidence of institutions giving up on risk premia the poor returns across much of the industry are not encouraging,” says Anthony Morris, the global head of quantitative strategies at Nomura. “It’s much easier to sell an allocation internally at a large institution or an asset manager if there is a tailwind rather than a headwind.”

AQR, an investment manager entrusted with more than $200bn by clients, had seen the class I shares in its alternative risk premia fund drop 6.4% by November 19. The class I shares in the style premia alternative fund were down 9.8%. AQR declined to comment for this article. 

Many strategies managed by banks have not fared too well either. The Eurekahedge multifactor risk premia index, a proxy for bank strategies, measured a return of minus 10.2% for 2018 on November 20, compared with 0.14% the previous year. However, it is difficult to gauge the performance of banks in this sector due to the varied and private nature of their business in the space. Like AQR, they offer off-the-shelf funds. 

But the majority of interest in the space comes from asset managers and pension funds looking to build bespoke risk premia strategies with investible index platforms operated by the banks. Clients build the indices they desire, encompassing multiple factors in a portfolio, and then the bank trades an index swap or option to provide the desired exposure. 

Despite the lack of performance metrics for many of these private strategies, most risk premia bankers agree it has been a tough year. 

“2018 was a very strong year for the Investable Index business at JP Morgan, with revenues and client balances growing more than in 2017,” says Arnaud Jobert, head of EMEA equity derivatives structuring at JP Morgan in London. “This came despite some risk premia portfolios having a rather challenging year, with many multi-asset, multi-style and market-neutral portfolios failing to deliver positive absolute return performance this year, unlike in 2017.”

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‘Embrace the suck’

The negative performance in 2018 has led to a lot of rigorous testing by those in the risk premia space to make sure that the academic research that informs the logic behind factors is still sound. 

In September, Cliff Asness, managing principal of AQR, published an article called ‘Liquid Alt Ragnarök’, defending the recent poor performance of many risk premia strategies. The paper became the talk of the town among strategists. In it, Asness stated that investors should stick to their investing principles. 

“The realistic goal for any of us is not to eliminate the pull of irrationality,” said Asness in his paper. “That’s usually impossible. The goal is to set yourself up to weather your own biases and profit from those of others.”

Thomas Leake, the head of equity structuring EMEA at Goldman Sachs in London, broadly agrees with Asness’ conclusions.

“Like all investing, factor investing is a statistical process,” he says. “You take exposure to something that you believe will on average have a positive return, but there will be periods of underperformance.”

But experts insist there are lessons to be learned from 2018’s events. 

One involves carrying out due diligence to make sure you truly understand the exposure you are taking on when constructing a risk premia portfolio. For example, adopting a trend-following strategy in February 2018 would have led to investors going in long equities, short in fixed income and long in energy, says Jobert. However, any investor on a bank index platform that employed a commodity value strategy, would have gained long energy exposure as well. So these investors were piling into “pretty much the same risk”, raising questions about diversification. The price of WTI Crude Oil is down 5% year-to-date, thought its poor performance is due to a price crash in recent months. 

“For us, the big takeaway going into 2019 is that you need to take into account the large concentration risk that can build up in risk premia portfolios, especially during a year with large, idiosyncratic moves,” says Jobert. 

Spyros Mesomeris, global head of quantitative and global investment solutions research at Deutsche Bank, agrees with this, saying that players are thinking more carefully about portfolio construction. He notes that some factors in risk premia portfolios, such as volatility selling, trend-following and commodities strategies, can leave investors with an uncomfortable amount of long equity exposure during a sell-off. 


Jittery markets

The poor performance of short-volatility and some equity trend-following strategies also plays into a wider theme observed by most strategists in the space: the fact that markets are jittery and do not fit into bullish or bearish trends. This makes it hard to position properly. 

Markets whipsawed on numerous occasions in 2018, as concerns over trade wars, the viability of tech stocks in the wake of the Cambridge Analytica scandal, and worries about rate hikes took their toll. However, many investors and economists thought that the fundamentals in the US and Europe were good, leading to an uncertain investing climate. 

In 2017, selling implied equity volatility was an profitable strategy and often meant the difference between average and exceptional returns in a risk premia portfolio. A common iteration of this strategy came in the form of systematically selling implied equity volatility on the S&P 500. 

This strategy came under significant pressure this year, especially during an unexpected market crash in February, resulting in the implosion of popular short volatility exchange traded notes operated by firms including Nomura and Credit Suisse. Many client risk premia portfolios at the banks took a big hit during the event. 

The ProShares Short Vix short-term futures ETF, which gives short exposure to S&P 500 implied volatility, has lost almost 90% of its value since the beginning of 2018. 

Some trend-following strategies, which rely on markets going in one direction to make returns, also suffered as a result of the jumpy markets. Most market participants have some sort of allocation to trend-following strategies, and this strategy performs well during periods where trends develop without reversals, and poorly when there are several reversals. 


Pockets of success

But while 2018 was overall a disappointing year for many risk premia portfolios, the sector showed resilience. Like in 2017, more asset managers continued to show interest in these strategies, says Leake, with some using bank platforms to launch their own risk premia products. 

Nomura had success with interest rate factor strategies, with some clients up more than 7% in the last year. JP Morgan developed its execution capabilities, offering an advanced long volatility intraday strategy that gives clients defensive exposure to equities. 

Pension funds continued to show interest in the space, investing in so called ‘crisis risk offset’ strategies that are built to protect against market drawdowns. This strategy was pushed by the Pension Consulting Alliance. 

But ultimately, 2019 could prove to be a key test for balanced multifactor risk premia portfolios. If these strategies continue to underperform across the industry, banks and investment funds may well face an uphill battle to keep clients. GC