Risk factor investments proved their diversification credentials through extreme market moves following the UK’s decision to leave the European Union. The strategies, which allocate to alternative sources of beta such momentum, value and quality to deliver equity-like returns with low correlation, defied hedge fund malaise in the aftermath of the vote, to deliver positive, uncorrelated performance that vindicates investment theory and back tests.
On Friday June 24, immediately following the surprise win for the “leave” camp, the most defensive risk factor portfolios were up 3% on the day according to analysis from Deutsche Bank. Even the worst hit portfolios comprising long/short equity risk premia lost just 10bp–15bp while traditional 60/40 equity/bond allocations lost almost 3% and the HFRX Global Hedge Fund Index was down more than 1% on the day.
“Unpredictable market events can cause systematic investment strategies to perform in ways not revealed in back tests or a simulated stress test,” said Sean Flanagan, head of EMEA equity structuring at Deutsche Bank. “Many strategies haven’t had a live out-of-sample dramatic event of this magnitude, but the strategies did what they were designed to do and provided positive returns where investors weren’t loaded too heavily on one market factor.”
Initially gaining traction in 2012 when Danish pension fund PKA applied the risk factor approach to its entire equity portfolio, pioneer funds have piled US$500bn of assets into the strategies according to some industry estimates, taking a leap of faith that the strategies would perform in line with back tests in the event of a real stress scenario.
Sceptical investors with tentative test trades were encouraged to upsize allocations following strong, diversified performance of the strategies during the first quarter when risk assets sold off on Chinese growth concerns that sent correlation soaring across traditional risk assets.
Although touted as a long-term strategy, dealers believe short-term performance through latest market shock may be instrumental in propelling the market to an estimated US$1trn in the next three years.
“We saw a period of prolonged volatility in late 2015 and early 2016, but the Brexit vote delivered a sudden sharp move across markets in response to the unexpected outcome. That type of stress test is very hard to simulate,” said Flanagan. “The theory is strong but a lot of investors had doubts about how the strategies would perform under real stress. The performance over the last two weeks has begun to answer some of those questions.”
Interest in higher-yielding, uncorrelated returns is expected to increase in response to an ever-more negative rate environment that now sees more than a third of the Citi World Government Bond Index trading at sub-zero levels.
“With rates so low, medium-term bonds in traditional portfolios aren’t doing their job in generating yield and negative correlation to equities in times of stress,” said Flanagan. “Risk premia strategies have been able to fill some of that gap. Increasingly, risk premia and risk factors are becoming a standard part of the lexicon of investment managers and asset allocators when they talk to clients about their portfolios.”