These systematic risk factors, collectively named ‘risk premia’, represent an alternative source of return, distinct, liquid and most importantly uncorrelated with traditional risk factors. The ‘style’ risk premia, for instance, while traditionally associated with the equity asset class, are also found across others. They represent returns that accrue to investors that systematically exploit market behavioural effects such as valuation biases (value and low volatility), herding tendencies (momentum), or survivorship bias (quality). Long-only equity funds have long since tilted portfolios towards these factors, but many hedge funds – such as ‘equity quant’, global tactical asset allocation (GTAA) and commodities trading (CTA) funds – also isolate and exploit the same factors but in market neutral format.
Likewise, with the advent of liquid derivative markets came ‘structural’ risk premia. Where a liquid options market exists, the volatility risk factor has been observed, with investors effectively being paid an excessive premium for insurance against sudden market moves. Likewise, asset classes that exhibit term structures have seen strategies develop that systematically exploit the shape of their curves and, similarly, where there is a yield differential, there is a carry trade to be made.
All of these risk factors represent a widely expanded toolkit for the cross-asset investor. While exposure to risk factors individually may deliver good Sharpe ratios as stand-alone investments, the true power of risk factor investing comes at the portfolio level, where low correlation between alternative risk factors can significantly reduce portfolio volatility and catastrophic downside risk from rare events (tail risk). When compared to traditional risky assets, correlations between alternative risk factors have remained low and stable, especially over the 2008 crisis.
In a world where volatility targeting is now ‘de rigueur’, the addition of alternative risk factors to a traditional portfolio brings more stability to covariance estimates and therefore represents the simplest and most reliable methodology to forecast and control volatility.
Risk factor investing is not without its pitfalls. The model of strategic asset allocation with tactical overlays is settled as the standard framework for traditional multi-asset portfolios. Yet this approach struggles to cope with the vastly expanded opportunity set of alternative risk factors. Also, risk factors are expected to generate a positive premium and therefore must have a sound economic rationale for their existence. As exposure to many risk factors is gained by ‘design’ of systematic trading rules, the very existence of the risk factor can be questioned when back testing and data-mining are the only proffered evidence. Similarly, model risk aside, risk factors can also be cyclical and dependent on market regimes of volatility growth and inflation as well as also being capacity-constrained. All of these issues make design, selection and forecasting a non-trivial issue when including systematic factors in the portfolio, so significant research and resources is still required when allocating to these factors. In this brave new world, this at least, is one constant and similarity with more traditional asset allocation that has not been washed away.
