Assets under management in risk factor strategies are set to top US$1trn in the next three years – double current levels – after a resilient performance through recent market turbulence answered crucial questions about an investment theory that relied heavily on back tests.
The strategies, which allocate to alternative sources of beta such as momentum, value and quality to deliver equity-like returns with low correlation and a reduced risk profile, have been embraced by some of the most sophisticated investors and are set to move further into the mainstream, dealers believe.
“The first quarter presented an ideal opportunity to test hypotheses in the risk premia space,” said Aleksandar Ivanovic, head of EMEA structured equity derivatives sales and structuring at Morgan Stanley. “The concept has now been proven to work as strategies performed in line with expectations. That has been an important process for the industry to go through.”
Risk premia strategies gained traction in 2012 when US$35bn Danish pension fund PKA applied the approach to its entire equity portfolio. Other pioneer funds followed, but many investors harboured concerns that the strategies might carry hidden stress beta that could see them correlate with traditional assets under extreme conditions.
“This is the first period of prolonged market turbulence that has put these strategies to the test and as a group they have held up extremely well,” said Sean Flanagan, head of EMEA equity structuring at Deutsche Bank. “It’s been difficult to know how a market stress would play out, but the de-correlation of diversified risk premia portfolios from equities was even greater than we expected.”
He notes that a combined portfolio of DB’s long/short, pro-cyclical, balanced and defensive equity factors delivered correlation of negative 55% to the wider market over Q4 2015 and Q1 2016. Those factors delivered performance ranging from flat for defensive strategies, to 13% up for the pro-cyclical strategy.
Fund managers that were early to the market are ramping up efforts on the back of recent performance. Gottex Fund Management, which provides alternative risk premia funds to institutional investors, believes the proven uncorrelated nature of risk premia strategies will be crucial in driving material allocation.
“After many painstaking years developing our risk premia business and promoting the de-correlated behaviour of these investments, it was extremely satisfying to see live portfolios consistently delivering positive daily performance through some of the most turbulent markets we’ve seen in a long time,” said Marc Fisher, head of marketing at Gottex Fund Management.
Performance across the segment shows some significant discrepancies, with market-neutral funds that take long and short positions retaining a better non-correlation profile and overall performance. Many listed factor products that take a long-only approach performed closer in line with the wider market. BlackRock’s iShares MSCI Factor exchange traded funds tracking quality, momentum and size traded flat over the first quarter, for example, while the value ETF lost ground.
“A lot of factor strategies are just flat year-to-date, but there are very few traditional indices that can argue that,” said Christian Raute, global head of central risk desk strategy at Citigroup.
“In a world where equity indices are down and active managers are underperforming, the performance of these products as a group looks more compelling. The risk framework embedded in factor strategies is what has allowed them to navigate this years’ turbulence with relatively greater ease.”
Rates driver
According to a recent institutional investor survey by Citigroup, more than 80% of institutional investors are currently investing in, or looking to invest in, risk premia and smart beta strategies. For insurance and pension funds, growing interest stems from a persistent low rate environment that has left them grappling for yield.
“To match their return targets, pension funds either have to take more risk or they need to look at new types of portfolio construction,” said Thomas Konig, head of Nordic and Netherlands debt sales at Deutsche Bank.
“It’s becoming the norm to think of risk allocation instead of asset allocation. Every portfolio is different, but thinking in terms of risk factors is now becoming a common approach.”
The search for yield has become increasingly difficult. Negative yielding assets now represent 23% of the global fixed income market, according to Bank of America Merrill Lynch, jumping from just 13% at the start of the year.
“Central banks have never been such a big portion of the market, and that has driven a positive correlation between bonds and equities,” said Matt Renirie, head of EMEA equity derivative sales at Morgan Stanley. “It leaves investors with very little diversification and very little yield, so they’re having to look at alternatives.”
Optimisation
While systematic harvesting of factors is viewed as a cost-efficient way to chase hedge-fund returns without the two-and-twenty fee structures, the next step in the market’s development could be a more active approach.
Strategy optimisation has already become a regular feature as algorithms are tweaked to address market events such as US rate hikes, but the next debate centres on the potential to maximise returns by timing allocations.
“Trying to determine the optimal time to buy specific risk premia can be challenging if you are just relying on a track record. To do this effectively, you need to have daily, position-level transparency and the infrastructure required is far from trivial and something we have invested heavily in,” said Gottex’s Fisher.
“We believe that the role of the fiduciary in advising on factor allocations is the next phase in the ongoing growth of this market. It has the potential to add significant benefit in terms of both transparency and performance.”
