Systematic Risk Premia Across Asset Classes

Journal of Indexes

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Written by Anthony Lazanas and Arne Staal

February 24, 2012

Index-based building blocks for portfolio management

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Systematic Risk Premia Across Asset Classes

As participation in the capital markets has increased, and enhanced information flow has intensified the interdependence of various asset classes and geographies, investors have been seeking new sources of uncorrelated returns. Non-traditional asset classes or fund structures—in particular, emerging markets, commodities, real estate, private equity and hedge funds—are now regularly included in the asset allocation mix. Increasingly, investors consider systematic strategies and factor indices across asset classes as additional elements of the investment universe, capable of providing a unique source of diversification and returns. While benchmark indexing has guided investments in equities, bonds and largely in emerging markets and commodities, systematic strategies across asset classes are often approached on a stand-alone and ad hoc basis.

After the credit crisis of 2008, when hedge fund investments experienced steep losses in line with broad asset classes, portfolio allocations came under increased scrutiny. With renewed focus, researchers and market participants sought to analyse active returns and understand the sources of "alpha". The results solidified the understanding that a large part of active returns can be explained by a set of well-established, systematic trading strategies. These strategies can often be understood as risk premia strategies; they capture excess returns by providing insurance against an identified and priced market risk or by providing liquidity in response to a structural market demand. In the same manner that long-only investments in risky assets capture the market risk premium (or "beta"), these strategies capture alternative sources of risk premia available in the markets. To the extent that they are fully non-discretionary and can be described in the form of a set of transparent systematic rules, and thus can be wrapped into an index, they can be thought of as providing access to a form of "alternative beta" rather than "alpha."

The awareness that active investment performance across asset classes can be explained to a very high degree by exposures to common investment styles and markets has led investors to view their investment opportunity set increasingly as risk factors and systematic sources of excess return, rather than as asset classes and individual instruments. Not surprisingly, there has been a continued drive from market participants towards transparency and an understanding of the 'building blocks' of returns, resulting in the ongoing commoditisation of investment strategies.

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This commoditisation of systematic sources of return has a relatively long history in equity investing. Since the publication of the seminal paper on common factors in equity returns by Fama and French in 1993, equity investors have been aware of factor-based approaches that reflect either systematic exposures to themes such as valuation (as measured, for example, by book-to-market ratios), quality (as measured, for example, by the stability of earnings and dividend policies), size (as measured by market capitalisation), momentum (as measured by relative past price performance), or risk anomalies (as measured by the outperformance of low-risk portfolios, compared to high-risk portfolios). See, for example, Melas, D., and Kang, X., 2010, for a discussion of the application of systematic equity indices in the investment process.