Index-based building blocks for portfolio management

While equity factor indices have been discussed at length in previous studies, a more general view of risk premia strategies across asset classes has been lacking. In what follows, we focus on risk premia beyond traditional market betas and equity markets. Strategies that seek to capture these "alternative betas" typically employ techniques unavailable to long-only passive investors. These include non-standard and/or dynamic weightings of index constituents, the use of short positions, leverage, and liquid derivatives. The techniques and instruments used vary widely by asset class.

In the next section, we give a high-level overview of risk premia strategies across asset classes.

SYSTEMATIC RISK PREMIA STRATEGIES ACROSS ASSET CLASSES

Systematic risk premia strategies exist in all asset classes and across a number of investment styles. These strategies have historically been the domain of hedge funds and other active investors; many classic hedge fund strategies are based, directly or indirectly, on risk premia strategies. Well-known examples include currency funds exploiting FX "carry" (long high-yielding currencies, short low-yielding currencies), equity funds involved in stock merger arbitrage (long target stocks, short acquirer stocks), commodity funds exploiting roll congestion strategies (long deferred contracts, short the front contracts), and volatility funds harvesting the short volatility premium (by selling delta-hedged options). Long-only active bond managers may decide to extend the duration of their portfolios (accessing the term premium in fixed income), credit managers may add high-yield overlays (accessing the credit carry risk premium), and equity managers may increase the weight of value stocks in their portfolios (earning the equity value premium). In Figure 2, we categorise systematic risk systematic premia strategies both by asset class and investment theme.



Even complex hedge fund strategies, such as diversified systematic or 'global tactical asset allocation', can also often be broken down into dynamic allocations to a large array of risk premia. Growing awareness of this means that direct (hedge fund) investment is not the only way to acquire exposure to these risk premia. Investable indices that track rules-based strategies can provide investors with transparent access to alternative beta strategies that can offer additional structural sources of excess return.

Two obvious questions arise at this stage:

i) How do we know whether a particular strategy is really a risk premium strategy?
ii) How can we be sure to span all the available risk premia?

Neither of these questions has straightforward answers. To answer the first we employ both qualitative and quantitative analysis. Risk premia strategies exhibit these characteristics:

• They are simple, transparent and based on well-established principles.
• They provide excess returns that can be rationalised by economic intuition.
• The magnitude of the risk premium can vary over time, but since it is compensation for a risk factor, it would require a structural change in the market for it to be "arbitraged away".
• They typically require long and short positions and often the use of derivatives.
• They may involve leverage and dynamic timing.
• They exhibit comparatively stable characteristics, such as volatilities and correlations.
• They have positive excess returns over long periods of time but can be subject to significant draw-downs when the risk (generating the risk premium) materialises. In other words, there may be a negative skew to the returns.

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