February 24, 2012
Index-based building blocks for portfolio management
The second question is harder as there is no scientific approach to finding a 'spanning set' of risk premia. We instead rely on a combination of academic research and a survey of investment strategies used by market participants. After reviewing an extensive universe of strategies we have identified eight generic risk premia categories (also see Rennison, Staal, Ghia, and Lazanas, 2011). The generic characterisation is designed to be applicable across different asset classes.
- Carry strategies seek additional compensation by going long high-yielding and short low-yielding assets from a pool of similar assets/instruments. The carry premium is the return for accepting the higher risk associated with the higher-yielding assets.
Classic carry strategy: a carry strategy in FX invests in high yielding currencies, financing them in low-yielding currencies. The FX carry strategy takes on the risk of currency crashes in the investment currencies.
- "Curve" or "term premium" strategies seek additional compensation for taking on the greater uncertainty associated with investing at longer maturities.
Classic curve strategy: the interest rate curve or "term premium" strategy seeks a premium by investing in the longer end of the yield curve and borrowing at the front end, thereby taking on duration risk.
- Value strategies aim to provide excess returns by selecting relatively undervalued assets and shorting relatively overvalued assets in a convergence trade. Given a relevant valuation model, a premium may be available for accepting the long horizon uncertainty associated with the expected value convergence.
Classic value strategy: the equity value strategy is well accepted in the academic world and investment management industry. The basic form is to overweight value stocks (those with high book value-to-market price ratios) and underweight growth (low book-to-market) stocks. This strategy is typically understood to be a long-term strategy that risks missing out on growth-led bull markets. The value strategy is effectively short the "call option" payoff profile of growth stocks, and seeks to earn the associated premium.
- Momentum and trend strategies take positions in instruments based on past price patterns. Momentum strategies go long past winners and short past losers from a pool of assets, taking on the risk of sharp reversals. Trend strategies take long or short directional positions on individual assets, based on recent price movements. In a sense, a momentum strategy is itself a basket of trend strategies. Both strategies can also be understood to rotate across market betas over time.
Classic momentum strategy: the momentum strategy has also been most frequently associated with stock selection, buying recent outperforming stocks and selling recent underperformers. The basic principle can be applied across asset classes.
Classic trend strategy: the trend strategy is most often associated with so called CTA funds. These strategies tend to take positions in portfolios of individually timed instruments across all asset classes. Risk control and portfolio construction is a crucial part of enhanced trend strategy construction.
- Event risk strategies take positions in assets that are affected by specific events which imply some prospect for future price convergence. These strategies attempt to earn any available spread prior to such convergence. They take on various forms of risk, including uncertainty over the timing and completion of convergence, model risk, financing and liquidity risk.
Classic event risk strategy: the merger arbitrage strategy seeks to earn the premium between the target's and the acquirer's stock prices following a merger announcement. The premium is in compensation for the risk of the deal collapsing, among other things.
- Liquidity premium strategies capture the additional compensation available on illiquid instruments.
Classic liquidity strategy: trading off-the-run Treasury bonds versus on-the-runs. Recently issued on-the-run bonds typically have higher demand due to their liquidity and, consequently, may have a lower yield than equivalent off-the-run bonds.
- Volatility premium strategies seek to earn the premium available between implied volatility and realised volatility in options markets, by taking on the risk of spikes in realised volatility.
Classic volatility strategy: systematically selling delta-hedged straddle options is a standard approach to capture the volatility premium that applies across asset classes. Where available, the short selling of variance swaps provides a clean method of targeting this premium.
- Emerging Markets premia may be available for those investing in certain emerging market instruments, reflecting the increased political and economic uncertainty associated with these markets.
Classic Emerging Markets Strategy: money market rates are typically higher in emerging market currencies, so a strategy which goes long emerging market deposits may earn a premium over developed market deposit rates, albeit with potentially higher currency risk.