A growing number of institutional investors are switching to alternative risk premia: a systematic rules-based style of investing used by hedge fund managers for the past three decades.
Under it, asset classes can be broken down into factors that explain their risk, return and correlation. Factor investing gained traction after traditional diversification became unhinged during the 2008-09 market meltdown, when it was most needed.
Since then, the rise of smart-beta strategies marks a big departure, as investors have sought to remodel their portfolios by allocating assets to risk factors such as value, size, momentum, market, low volatility, term and credit.
Smart beta is part of a new generation of strategy – alternative risk premia – that blends risk factors with techniques such as shorting and leverage.
Research shows that a high contribution to today’s market-beating returns comes from simple systematic exposure — conscious or unconscious — to these or other factors.
ARP is coming of age and causing a trifurcation in the asset industry.
First, the rise in pure passive investing, based on traditional cap-weighted indices, will slow down, as ever more investors are enticed by the prospect of earning cheap alpha returns at near-beta fees. Lately, traditional passives have disrupted traditional actives. Now the disrupters face the prospect of being disrupted themselves.
Second, ARP will not dumb down the craft of investing. Portfolio managers will still need to make judgment calls on which factors to select and which data to apply. After all, factors can become overvalued as they attract new money and hit the capacity ceiling above a certain level of assets.
Third, the term alpha will be refined into two distinct versions: the commoditised one will refer to market-beating returns that are increasingly targeted by ARP; and the informational version will seek to beat its commoditised rival by solely relying on managerial skills and proprietary research.
In a typical portfolio, these two versions will compete alongside traditional cap-weighted indices. At a time when fees are under pressure, price competition will intensify.
Active managers who fail to deliver more than commoditised alpha will be hit by the brutal Darwinian forces sweeping away the distinctions between passives and actives.
More information can be found in my article in today’s FTfm (4th November 2019), if you are a subscriber.