Exposure to risk premia has historically meant limited transparency and liquidity and high costs. Overcoming these challenges will open up the potential benefits of risk premia investment to more investors, according to Jean-Philippe Royer, CEO of Nomura Alternative Investment Management (NAIM).
While markets have been buoyant in recent months, there is considerable uncertainty about the future. Geopolitical instability is high and increasing, which could affect markets. It is unclear when, and at what pace, interest rates will rise. But given their current all-time lows they are unlikely to continue the steady decline of the past three decades. Bond investors could experience a significant impact on their portfolio performance.
Perhaps the most important side effect of developments in recent years has been to change the way financial instruments and asset classes perform. Massive bond purchases by central banks aiming to provide further liquidity in the system and invigorate an anaemic global economy have driven interest rates into negative territory. They have also pushed the prices of all financial assets higher. With bonds and equities highly correlated and valuations at record-highs, traditional asset allocation is not providing investors’ portfolios with the diversification it offered in the past, nor an efficient risk-management toolkit. It is also more difficult to generate alpha in the current environment.
The good news is that financial assets return continues to be driven by strong fundamental factors, and that academic research and product development have made considerable progress in identifying these factors. It is now possible to harvest risk premia in new, more targeted and systematic investment strategies. Many of these risk premia, such as momentum, size, value or carry are already familiar to investors. The identification of stocks that are undervalued (value investing) has been a mainstay of investing for decades, for example. Similarly, carry strategies – buying a high-yielding currency while selling a low-yielding currency – are familiar to forex investors.
As a result of these developments, risk premia investing has become an increasingly important trend in recent years. Growing numbers of institutional investors recognise the appeal of this style of investing in the post-financial crisis era, and are switching from asset allocation to risk premia allocation. Moreover, the asset classes targeted using such strategies have broadened beyond equities, fixed income and currencies, to include commodities, credit and even volatility.
Identifying the right factors
If academic research provides ample evidence for investors wanting to select among a profusion of factors and build a portfolio of risk premia meeting their objectives, the reality of implementation can be more difficult. Building strategies to capture specific risk premia efficiently requires extensive quantitative skills and research. An even greater challenge is to execute them efficiently across asset classes, with liquidity and at low cost.
Historically, investors have invested with hedge funds or commodity trading advisors (CTAs) to get exposure to such alternative strategies. But performance has often been disappointing or more correlated to bonds and equities than expected. Fees charged can be up to 2% of total asset value and 20% of performance. Risks and hedge funds’ behaviours are not always consistent or in line with the risk premia targeted by investors. Moreover, liquidity can be as limited as weekly or monthly, when – for many financial products – daily liquidity has become the standard. Finally, many funds offer limited transparency, creating problems for investors wanting to look through and aggregate their risks across investments or comply with regulatory constraints, such as Solvency II for insurers.
Providing easy access
Thankfully, there are solutions. Rather than building complex and expensive infrastructure, investors can now outsource to a new breed of providers.
Some banks with the right quantitative expertise and trading infrastructure have developed risk premia strategies available through performance swaps. Completely systematic, these investment strategies are formulated like indices. They target a specific risk premia on one or more assets comprehensively, with committed execution prices and transaction costs, guaranteeing the consistency sought by investors. These strategies usually offer daily liquidity, as the bank takes its own risks to deliver the index value on the secondary market for flexible sizes. These strategies constitute ideal and comprehensive building blocks for the construction of an alternative risk premia portfolio.
But while swaps work well for large sophisticated investors, they are less suitable for other investors with operational or regulatory constraints. Private banks may need to invest in securities investments, preferably regulated as UCITS funds, because they have to allocate their investment across thousands of client accounts. Other investors like pension funds require a fiduciary manager to oversee a risk premia portfolio on their behalf.
For such investors, which represent a sizeable part of the market, outsourcing investment in risk premia to an external manager is the only alternative. The client can allocate a portion of their portfolio, along with its investment objectives (for instance to provide a hedge to their investment portfolio in specific market situations, or to gradually accrue performance in others), allowing the manager to select the most effective risk premia to achieve these objectives.
NAIM typically builds such risk premia portfolios in a fund. After thorough analysis and due-diligence, swaps are used to deliver risk premia strategies developed by Nomura Quantitative Investment Solutions (QIS) or other providers where appropriate. Portfolios are managed with multiple performance swaps, monitoring the adherence to the specific risk premia or investment objectives targeted, and amending allocations as needed. This allows the discipline, transparency and cost-efficiency of the risk premia strategies to be blended with a flexible and fiduciary approach.
To date, NAIM has developed two risk premia funds.
Nomura’s Equity Volatility Risk Premium (VRP) fund was introduced in June 2015. It exploits the tendency for implied volatility to be higher than realised volatility in major equity indices such as the S&P500. By selling implied volatility and buying realised volatility, this arbitrage can be crystallised. As with all products, it carries risk. For example, in the event of significant market movements realised volatility may be higher than implied volatility. However, investors are rewarded for this risk: from January 2016 to January 2017 the fund returned 18% with only 6% volatility.
A second product, the Nomura Cross-Asset Momentum (CAM) fund, uses a trend-following strategy across multiple asset classes including equities, fixed income, FX, commodities and equity volatility. Trend following tends to perform well during pronounced downward or upward movements in markets. Therefore by combining this product with the VRP product, it is possible for clients to build an all-weather portfolio that will perform better and with lower risks than a traditional long-only portfolio. Moreover, both funds are UCITS compliant and offer daily liquidity at a competitive price.
Compared to the typical 2%/20% model commonly charged by hedge funds, VRP and CAM usually have costs of 50-100 basis points depending on the size of the allocation.
NAIM is working on introducing new UCITS solutions referencing niche risk premia strategies in the future.
Investors focused on meeting their strategic goals in a challenging market environment and facing ever more complex regulatory requirements should consider the potential benefits of both a discretionary and a fund-based approach to systematic alternative risk premia investment. These solutions can remove much of the complexity associated with risk premia investing while delivering potentially attractive returns with low running costs. Furthermore, this approach provides investors with a granular and quantitative solution that targets specific risks and portfolio objectives, while having the potential to generate returns in a variety of market conditions.
NAIM's Equity VRP Fund won "Emerging Volatility Fund of 2016" at Allocator's Investors Choice Awards 2017, and the CAM Fund won Risk Magazine's Institutional Investment Product of the Year. To discuss any of the issues raised in this article in more depth, please contact Jean-Philippe Royer directly or visit the NAIM website.
This article has been prepared by Nomura Alternative Investment Management (Europe) Limited ("We"), authorized and regulated in the UK by the Financial Conduct Authority with the reference number 537366, for information purposes only and we are not soliciting any action based upon it. This press article is intended only for investors who are "eligible counterparties" or "professional clients" for the purposes of applicable regulatory rules in the European Economic Area.
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