Over the past few years, many investors seeking to diversify their holdings and lower their risk thought they’d found a new superhero: alternative risk premia, or ARP. These strategies seek low correlation to investors’ more traditional holdings—which some may have taken to mean that whenever, say, the equity markets declined, ARP strategies would swoop in and save the day, delivering positive returns.
As it happened, 2018 turned out to be more like kryptonite for ARP strategies, for reasons we’ll get into shortly. But the real issue may not be whether ARP strategies outperformed or underperformed in any given quarter or even any given year. Rather it’s that some investors’ expectations may not have matched up well with what ARP actually promises.
Wait, what are alternative risk premia again?
In a nutshell, ARP strategies take investments with nontraditional risk-return characteristics (along the lines of what hedge funds typically offer) and make them more accessible, more transparent, and less expensive. They’ve been called liquid alternatives, and sometimes they come under the guise of what are known as absolute return funds, but what they tend to have in common is an emphasis on looking beyond just equities and fixed income to include currencies and commodities, then optimizing those assets across a variety of factors such as carry, value, and momentum to help investors achieve superior risk-adjusted returns.
ARP strategies are still relatively young. There’s about a decade’s worth of historical data on them at this point—not an especially long track record, especially compared with other asset classes. As a result, recent performance tends to get magnified—because, well, recent performance is the only performance there is. That brings us back to 2018.
Alternative risk premia performance in 2018
Let’s not be mealy mouthed about it: ARP strategies in general performed poorly last year. The chart below shows 2018 performance data from the Hedge Fund Research Bank Systematic Risk Premia Multi-Asset Index (HFRRMA), one of the most respected and established ARP indexes.
Source: Hedge Fund Research, 12/31/2018. It is not possible to invest directly in an index.
As you can see, not exactly heroic returns. Why did this happen?
When volatility sneezed, alternative risk premia got a cold
The decade-long bull market stumbled in 2018. And not in a subtle, hope-no-one-saw-that way. Three times during the year, in February, in October, and again in December, the S&P 500® Index seemed to fall off a cliff edge, abruptly shedding more than 13% of its value in Q4 alone. In late December the Cboe Volatility Index®, or VIX, which attempts to measure the 30-day expected volatility of the S&P 500® Index, spiked to 36.07, its highest level at closing since 2011.
So what was the key antagonist to ARP strategies’ performance—the fact that the equity markets were down at times in 2018 or that we experienced some of the sharpest volatility investors had seen in years? If we superimpose the VIX atop the ARP performance chart we showed earlier, the answer becomes a bit clearer.
Source: Hedge Fund Research, Cboe, 12/31/2018. It is not possible to invest directly in an index.
As we can see, the HFRRMA Index retreated furthest during periods when volatility was highest. Why? Recall that one of the primary factors many ARP strategies rely on is momentum—in other words, buying stocks that have performed well over the previous few quarters and selling those that have done poorly, all in the hope of generating excess returns.
So when the equity markets experience long, steady returns—either positive or negative—ARP strategies can get on the right side of their momentum trades. Volatility, however—especially of the vertiginous variety we saw in 2018—is a momentum killer. Rapid reversals in market direction can quickly and all too easily put ARP strategies on the wrong side of the momentum equation, and it can take time for those strategies to adjust. Of course, by then the damage has been done. And for investors who expect ARP strategies to provide a counterbalance to down markets, the results can be disappointing.
It's worth noting that, while momentum was a major contributor to poor performance, it’s not expected to do well in sharply reversing markets. What made 2018 special is that other factors, such as value, also performed poorly. Yet 2018, as difficult as it was for some investors, was a useful reminder of what ARP strategies do, what they don’t do, and why what may need to be adjusted isn’t so much the strategies themselves but rather investors’ expectations.
Low correlation isn’t negative correlation
ARP strategies are intended to offer low correlation to traditional asset classes. This means that when, say, the equity markets rise, ARP assets have essentially a fifty-fifty chance of moving in the same direction. Importantly, it doesn’t mean that when equity markets fall, ARP assets necessarily rise in value. That would be negative correlation, an example of which would be equity puts. So it’s important for investors to understand that, while ARP strategies offer the benefits of diversification and low correlation, they won’t always behave contrary to the equity markets.
That doesn’t mean the strategies’ long-term goals aren’t valid, but in a short time frame such as a month or even a quarter (especially one in which volatility spikes), returns may lag. Or do the opposite. As you can see below, the first quarter of 2019 looks quite different for the HFRRMA Index.
Source: Hedge Fund Research, 3/19/2019. It is not possible to invest directly in an index.
Obviously, lower volatility so far in 2019 played a role in Q1 performance, but the return drivers haven’t been limited to the momentum factor. It’s been broad based, including carry and value factors as well.
The bottom line
It’s fair to say last year wasn’t a great one for ARP strategies. If 2018 were a superhero movie, it would be the point in the film when the villain—let’s call him Vix—has the upper hand. But it’s a long movie, and it’s far from over. And ARP strategies aren’t the Bizarro to the equity markets’ Superman. They don’t always do the opposite thing. In fact, they’re most likely designed to do the opposite thing about half the time.
As long as investors understand that, they’ll realize that, in investing, the only true superheroes are well-researched, systematic strategies that, boringly, can take time to show their true strength.
Tom Lee, CFA, Managing Director, Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Offices. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to the volatility risk premium. Prior to joining Parametric in 1994*, Tom spent two years working for the Federal Reserve in Washington, D.C. He earned a B.S. in Economics and an MBA in Finance from the University of Minnesota. He is a CFA charterholder and a member of the CFA Society of Minnesota.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.