Use of Alternative Risk Premia (ARP) and factor-based investment strategies is growing among investors, however the concept is still new. We spoke to five leading experts to find out how the sector is evolving and what potential investors need to consider.
ARP is designed to give investors diversification in a cost-efficient, liquid form. A great substitute for some forms of hedge fund investing, ARP is touted as a cheaper way to get similar exposures, but with short duration performance.
Simon Robinson, Portfolio Manager at Prudential Portfolio Management Group explains: “Alternative Investments are all about getting a wider range of attractive risk-adjusted returns. ARP is a logical step in some areas, but the main challenges to the concept are replicating illiquidity premium in a liquid format and how to integrate ARP strategies into a portfolio in the first place. Strategies needs to constantly evolve, as when a factor is seen to be driving attractive returns, investors jump in and the opportunity gets arbitraged away.”
Even though this style of investing is still innovative, providers have already seen inflows from insurers looking to diversify. In particular, the asset class can be popular with investors who are hoping to move away from strategies such as diversified growth funds.
Matteo Ricciarelli, Associate Director for Asset-Liability Management and Asset Advisory at PwC says: “The concept is very welcomed by clients who want to get exposure to alternative investment areas. In the UK bulk annuity space, firms are seeking to gain exposure to alternative credit investments, in the form of illiquid asset classes (e.g. commercial real estate lending, equity release mortgages, etc). The resulting illiquidity premium represents not only good news in a prolonged low-rate environment but allows also to crystallise some Solvency II capital benefits through the matching adjustment.”
Despite this newfound popularity, one stumbling block for the asset class has been a poor performance record of late. This has been particularly troublesome for investors who are looking through a short time horizon lens.
Jeev Muthulingam, Head of Insurance Investment Solutions at NN Investment Partners explains: “There are returns/premia outside of traditional long-only investments and ARP can offer those. Risk premia strategies are expected to deliver attractive returns. In recent times, performance of the asset class as a whole has been disappointing. However, the divergence in performance is significant and there are multiple offerings that have performed as expected. In general, markets have always been unpredictable, and participants will always need to deal with a lot of uncertainties. Therefore, it is imperative to cut through the short-term noise and focus on those premia that are expected to deliver uncorrelated excess returns in the long term. Drawdowns are expected to happen as these are not risk-free arbitrage strategies. A deeper understanding of the sources of return and risk will allow for sensible construction of portfolios that deliver what is expected.”
Matthew Towsey, Principal and Head of European Liquid Alternatives at Aon adds: “The perception of factor investing will be improved if investors are prepared to take a much longer-term view, performance in one year tells us little about the long term efficacy of the strategies.
“It’s hard to pick out and out winners from within the universe of factor strategies but 2018 was a good test of how different factors and ARP managers performed and their value to a portfolio in terms of returns and diversification. The difficult performance experienced by some strategies will hopefully align investor expectations – these strategies will experience ups and downs but over the long term we would expect them to add value.”
This difficulty of tracking individual factors is another barrier to widespread adoption of the asset class. This is particularly true given the explosion in the number of possible factors than can be considered.
Marie Niemczyk, Head of Insurance Relations with Candriam says: “It is important to understand the economic reasoning behind the different factor strategies and if the case for them has been demonstrated over time.
“There has been a noticeable increase in the number of ‘new’ factors. Some studies estimate that back in the 1980’s there was an average of one factor being ‘discovered’ each year, five in the 90’s, and 20 in the 2000’s. Therefore, investors must pay close attention to the research underpinning each factor, and the ability to implement it across relevant asset classes in a cost-efficient fashion.”
As with any asset class, manager selection is critical for investors who want to explore investing in ARP. It is important to look for managers with a track record in quantitative and systematic trading styles.
Another important factor is research – not just that which has been carried out in the past but also that which is being done to create, develop and maintain factor approaches.
Muthulingam concludes: “The first question is the view of risk and how the strategy over time can work and whether it can be maintained. You should also ask how they are developing their factors considering ongoing adoption trends, to avoid crowded trade environments. ARP exist in all asset classes and assets. Actual implementation depends on whether the premia can be harvested efficiently to provide excess returns net of costs. In less liquid assets this is what holds back implementation, not the existence of them.”