Risk Premia Investing: Unlocking Profits Through Strategic Allocation

Risk premia investing is an investment strategy that aims to generate returns by exploiting specific risk factors in the market. It involves taking on additional risk, beyond that of traditional asset classes, in order to achieve higher returns. Risk premia refer to the excess returns that an investor expects to earn by taking on the risk of investing in a particular asset or strategy. These returns compensate investors for the potential loss of capital and are often found in alternative investments such as hedge funds, or in factors such as the size of a company, or its value. Risk premia investing has become more popular since the financial crisis as investors seek to diversify their portfolios and protect against losses associated with traditional equity and fixed-income strategies.

Characteristics of Risk Premia Investing

Risk premia investing strategies

Long-only risk premia strategies

Long-only risk premia strategies, also known as smart beta, aim to beat the market returns by using alternative weighting schemes such as volatility weighting or factor tilts in the index construction process. These strategies are simpler to implement compared to long-short alternatives but their benefits are diluted due to market exposure. A common example is a low volatility smart beta index that uses the same constituents as a benchmark index like the S&P 500 but assigns different weightings to reduce volatility.

Long-short risk premia strategies

Long-short risk premia strategies generate returns by buying a factor-based portfolio and short-selling another. These strategies target absolute returns that are not measured against benchmarks and can generate profits regardless of market conditions. They also provide greater exposure to the targeted risk premia factor. An example of a long-short trade is buying a low volatility alternative index while short-selling the benchmark index, with the expectation that the alternative index will outperform the standard size-weighted index.

Risk control mechanisms

Risk premia strategies can include built-in risk control mechanisms to manage potential losses. One approach is to include volatility caps or targets to maintain volatility at a desired level. Another method is to use stop-loss features, which limit losses to a certain level, although this may incur an annual cost for investors.

Risk-free assets

The return on a risk-free asset is often used as a benchmark to calculate the risk premium of an investment. The risk premium is the additional return that an investor expects to receive for taking on the risk of a particular investment. It is calculated by subtracting the risk-free rate of return from the expected return of the risky investment.

For example, if an investor expects a stock to deliver an annual return of 8%, including dividends, and the risk-free rate of return is 3%, then the risk premium for this stock is 5%. This means that the investor is being compensated with an additional 5% return for taking on the risk of investing in the stock.

While US government securities are considered the most common risk-free asset, other assets can also be considered risk-free depending on the context and the investor's perspective. For example, highly-rated government bonds from stable and developed countries can also be considered risk-free as they have an extremely low default risk. Additionally, certain blue-chip stocks or investment-grade corporate bonds from well-established companies with strong credit ratings can be perceived as having minimal default risk in specific contexts. However, it is important to note that these assets still carry some level of risk and may not be entirely risk-free.

Equity risk premium

Risk premia refer to the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset. Equity market exposure is one of the best-known risk premia, rewarding investors for taking exposure to long-only equity investments.

The equity risk premium is driven not just by the overall economy but also by market momentum and sentiments. Mood shifts can alter equity risk premiums, which can become too low if investors are overly optimistic about the future, and too high if investors are overly pessimistic.

The equity risk premium is calculated as the difference between the expected market return and the risk-free rate.

> For example, if government bonds are giving an investor 6% returns, any rational investor would choose the stock of any company only if it gave more than 6% returns, say 14%. Here, 14% – 6% = 8% is the equity risk premium.

The risk-free rate of return can be benchmarked to longer-term government bonds, assuming zero default risk by the government.

The Capital Asset Pricing Model (CAPM) is a model for calculating the expected returns of a security based on their systematic risk calculated by the Beta coefficient. According to the CAPM, there are two components of returns to an investor. The first component is the time value of money that is given by the risk-free rate of return, and the second is the compensation for the risk investors take, represented by the risk premium.

The CAPM can be described using the following equations:

Ra = Rf + βa (Rm – Rf)

Ra = Expected return on security ‘a’

Rf = Risk-free rate of return

Rm = Expected return on the market

Βa = Beta of ‘a’, and,

Βa = Covariance of Market Return with Stock Return / Variance of Market Return

Here, βa is the risk coefficient of stock ‘a’ which is unique to that particular stock. It measures the stock’s volatility using measures of dispersion.

The equity risk premium can be calculated using the following formula:

If we are simply talking about the stock market (a = m), then Ra = Rm. The beta coefficient is a measure of a stock's volatility or risk versus that of the market.

Alternative risk premia

Risk premia refer to the amount by which the return on a risky asset is expected to outperform the known return on a risk-free asset. Equity market exposure is the most well-known example of a risk premium, rewarding investors for taking on long-only equity investments.

The term "alternative risk premia" covers two types of systematic risk factors: skewness risk premia and market anomalies. Carry and momentum are the most frequent alternative risk premia, representing a skewness risk premium and a market anomaly, respectively. The returns of alternative risk premia exhibit diverse patterns in terms of statistical properties, option profiles, and drawdowns, making asset allocation more complex than with traditional risk premia.

Understanding the different concepts and their interconnections is crucial for improving multi-asset allocation. Alternative risk premia strategies offer investors a way to diversify their portfolios, manage risk, and potentially enhance returns by focusing on non-traditional risk factors.

Risk management

Risk premia investing is a strategy that aims to generate above-market returns by exploiting specific risk factors, such as the size factor, where small-cap stocks tend to outperform large-cap stocks, or the value factor, where cheap stocks tend to outperform expensive stocks. This strategy involves taking on additional risk compared to risk-free assets, and investors are compensated for this extra risk through higher returns, known as the risk premium.

When it comes to risk management in risk premia investing, there are several key considerations:

Diversification

Diversification is a critical aspect of risk management in risk premia investing. Traditional asset class diversification, such as investing in stocks and bonds, may not be sufficient to protect investors during periods of market turbulence. Therefore, investors should consider adopting a differentiated approach by exploring alternative risk premia, such as currency-related risk premia or other diversifying factors like value, quality, and momentum. By diversifying across multiple uncorrelated return drivers and asset classes, investors can aim to balance risk while still profiting from market trends and inefficiencies.

A robust risk management framework should be in place before allocating investments. This includes conducting thorough fundamental and forward-looking analysis to assess the attractiveness of different risk premia in terms of their risk/return profile and correlation benefits within the overall portfolio. By selecting uncorrelated risk premia, investors can better manage risk and reduce the impact of market downturns.

Liquidity

A strong focus on liquidity is crucial in risk premia investing. Markets can be volatile, and having sufficient liquidity enables investors to navigate bouts of heightened turbulence. It provides the flexibility to enter and exit positions, especially during stressful market situations, such as the sharp drawdowns experienced during the European sovereign wealth crisis or the initial stages of the Covid-19 pandemic.

Alternative Risk Premia

Alternative risk premia can play a vital role in diversifying investors' portfolios without sacrificing returns. Traditional investment spaces may not offer enough protection during turbulent market conditions. By exploring alternative options, investors can seek return drivers that are less correlated to risks in the equity and bond market cycles, thus providing a hedge against downside moves.

Stability and Quality

In volatile markets, stability and quality become essential. Investing in stable, high-quality, and attractively valued companies can provide a better chance of navigating challenging economic conditions. Additionally, seeking companies with pricing power, which can pass on inflation-related price increases, can be a valuable characteristic for portfolios in an inflationary environment.

Risk Assessment

Investors should carefully assess the level of risk they are comfortable with before demanding a risk premium. Borrowing at high-interest rates to pay a higher risk premium can increase the financial burden on borrowers and potentially jeopardize their chances of success, leading to a higher risk of default. Therefore, investors should consider the financial health and prospects of the borrower to make informed decisions.

Frequently asked questions