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October 11, 2017

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Risk premia can be a potent alternative

SINCE the inception of the Qualified Domestic Institutional Investor (QDII) scheme in 2006, onshore Chinese investors have many channels through which to invest offshore including via money markets, fixed income, mutual funds and structured products. They also have recourse to products linked to offshore underlyings through back-to-back swaps between onshore and offshore banks. In addition, the Shanghai and Shenzhen Stock Connect schemes allow onshore investors access to constituent stocks under the Hang Seng Composite Large, Mid and Small-Cap indices as well as the H shares of dual-listed stocks.

Within this expanded universe, onshore investors are seeking to diversify beyond traditional asset classes to alternative investments offshore. According to Capgemini’s World Wealth Report 2016, high net worth individuals in China allocated 17 percent of their wealth in alternative investments.

Don’t put all eggs in one basket

The fundamental objective of the intelligent investor is to maximize returns and minimize risk. But how can this be achieved? In his publication Portfolio Selection, Nobel Laureate Harry M. Markowitz, pioneered the modern portfolio theory under which portfolio risk is reduced by holding combinations of assets that are not perfectly positively correlated. It thus makes sense to continue adding diversified assets into the portfolio, until they attain the “Markowitz-efficient portfolio” in which no further diversification is capable of lowering risk for a given expected return.

Diversification across asset classes has become increasingly important given the increased correlation within and across asset classes. If the pairwise correlation is high, active managers may struggle to outperform.

Capturing ‘alpha’ and ‘beta’

Nobel Laurette William Sharpe’s Capital Asset Pricing Model holds that the amount of systematic risk undertaken by the investor should be matched by a required rate of return to compensate for the risk. Outperformance of the required rate is known as “alpha”.

In 1949, Alfred Winslow Jones formed the first hedge fund with the objective of capturing “alpha” by combining leverage and short-selling to capture market mispricing. It was the first long-short equity strategy fund which aimed to provide absolute positive returns through having low net exposure to the market.

In 1975, John C. Bogle created the first index mutual fund. Bogle’s index fund sought to mimic index performance over the long run, to achieve a higher return than that of actively managed funds. In aggregate, actively managed equity funds have underperformed index funds. The total return of the MSCI World Index between August 2007 and August 2017 is 64.2 percent, compared to -4.9 percent by the HFRX Global Hedge Fund Index and 12.19 percent by the HFRX Fund of Funds Global Index.

This has led to the proliferation of investments through Exchange-Traded Products (ETPs), including Exchange-Traded Funds (ETFs). According to the BlackRock Global ETP Landscape report, at July 2017, US$4.234 trillion of assets under management were made up of ETPs against US$79 billion in 2000.

Capturing the best of both worlds

Once considered as alpha by long-short strategies, alternative risk premia are now viewed as alternative beta — sources of return that can be accessed in cost-efficient, transparent, liquid, and systematic ways.

Investors can access various asset classes ranging from equities, rates, commodities to foreign exchange, through rule-based strategies to capture “Alternative Beta”.

Risk premia can improve risk-adjusted returns and increase diversification of an existing asset allocation. Scandinavian sovereign wealth and pension funds are among the first wave of investors to incorporate risk premia into asset allocation techniques. Recently, a multi-billion occupational pension fund embarked on unwinding its traditional equity mandates and allocating to drivers of return within the equities market including developed markets risk premium, emerging markets risk premium, small cap risk premium, low volatility effect, dividends risk premium, implied volatility risk premium, value, momentum and merger arbitrage. Relative to traditional investments, risk premia investment is a cost-effective way to diversify asset allocation and generate consistent returns with low volatility, through a combination of “risk-on”, “defensive”, and “neutral” strategies.

Based on back-tested performance from May 2004 to February 2017, the UBS Risk Premia Portfolio delivers an annualized excess return of 8.5 percent at an annualized volatility of 3.9 percent.

Given their cost efficiency and the attractive risk-reward profile, risk premia products are poised to become an indispensable part of portfolio diversification, with the potential to replicate the success of ETFs in recent years.


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