True Diversification

To mark the appearance of our latest Asset Allocation Committee Quarterly Outlook, we invited Global Head of Quantitative Investments and committee member Wai Lee to write as guest columnist for this week’s CIO Weekly Perspectives.

When Neuberger Berman’s Asset Allocation Committee calibrated its views on the 12-month return outlook last month, it settled on an underweight view for U.S. equities for the first time since the aftermath of the financial crisis.

In past cycles, such a view would not have raised many difficulties. If equity valuations are high, that implies that investors favor equities over bonds. That in turn implies relatively low bond prices, leaving decent yields for those who want to use them as an effective portfolio diversifier to dial down risk. But this time bonds are even more expensive than equities. Where can investors go to balance their exposures?

Excess Returns from Non-Traditional Risks

One place worth looking is alternative risk premia or “factor investing.” Against today’s low-growth, low-inflation, high-valuation, low return outlook background, more and more are asking us about these alternatives to the traditional ways of investing.

Investment theory tells us that excess returns come from bearing risk. If you consider the return from U.S. Treasury bills to be “risk free,” the excess return you can get from investing in equities is the traditional “equity risk premium.” From a corporate bond you can get the traditional “credit risk premium.”

Alternative risk premia are simply the excess returns you can get from bearing non-traditional risks. If you invest in undervalued companies, for example, evidence suggests you can get an excess return for bearing the risk that they are undervalued for a reason. Invest in securities that have been going up in price and you can get an excess return for assuming the risk that anything that gets stretched eventually snaps back.

These are known as the “value” and “momentum” risk premia. Ideally, they would be implemented using long/short strategies: shorting overvalued companies and going long undervalued companies, for example. Dozens more have been identified—the most convincing have long histories of excess returns and a clear basis in some exchange of economic risk.

Weak Correlation—With Markets and One Another

Investors are discovering that these risk premia have been weakly correlated with traditional assets: given the long/short implementation, “pure” risk premia strategies are intuitively market-neutral.

The Brexit vote showed this in action when equity markets fell sharply but recovered between three days and two weeks later. The equity value factor also fell sharply, but is still crawling back to parity after three months. That suggests that the equity premium and the equity value premium are rewards for non-synchronized risks: one interpretation is that value is closely tied to uncertainty about long-term economic and earnings growth and can take longer to adjust to potential growth shocks.

Another risk premium, “carry” in fixed income markets (which is long bonds from steeper yield curves and short bonds from flatter yield curves), actually performed very strongly in response to Brexit. The carry factor in currencies came through the event pretty flat. In short, alternative risk premia are not only weakly correlated with the traditional market risk premia, but also with one another—even when they reward similar risks in different asset classes.

Today’s Environment Puts Diversification in Focus

These things clearly have the potential to be powerful portfolio diversifiers, a valuable characteristic when valuations in, and correlations between, traditional markets are so high.

Ironically, when it comes to integrating them into portfolios, one problem is that alternative risk premia can be too efficient and too diversifying. A standard portfolio construction approach that aims for an optimal reward-to-risk ratio would end up allocating the majority of capital to these strategies. That’s not practical for most investors.

If you think of yourself as an investor in the market, with a budget for taking risk against the market benchmark, your allocation can be determined by the size of your risk budget. Given the average investor's risk budget, it’s likely to come out at around 10-20%.

For those with a traditional 60/40-plus-alternatives portfolio, it can be pragmatic to think of these long/short strategies as part of a hedge-fund allocation. We would not describe alternative risk premia strategies as a substitute for hedge funds because the latter can deliver idiosyncratic risks and returns, but it’s also true that hedge funds, like all active strategies, are likely to have exposures to alternative risk premia in less “pure” forms. With that in mind, it can make sense (in terms of both risk-return and costs) to fund alternative risk premia out of existing active allocations.

However they choose to implement them, investors are increasingly aware of the potency of alternative risk premia as the levels of traditional market risk premia become ever more compressed—a topic explored in many of the CIO Weekly Perspectives posts over the summer. Diversification has always been understood as the only “free lunch” in finance. Today’s environment forces investors to think much more deeply about what diversification really means.