Using Risk Premia Strategies For Greater Portfolio Diversification

Risk premia investment strategies, along with other alternative strategies, have gained popularity recently, even though they don’t outperform stock picking. A detailed report from Societe Generale quants gives an in-depth explanation on how risk-premia tactics can help investors give their portfolios more meaningful diversification.

Growth in risk premia strategies

“The idea of harvesting risk-premia across different asset classes beyond the traditional assets of equities, bonds, credit etc. is not particularly new,” says the report. “Risk models have been decomposing returns into factor exposures and quants have been compiling factor-based stock portfolios for decades.” It’s easy to imagine that the interest in risk premia strategies has been growing because it has proven to be more effective than traditional quant stock-picking models, but that doesn’t seem to be true.

traditional quant op risk premia

Reasonable returns from traditional investments

The problem is that with historically low interest rates and overbought equities, there is no clear way to get reasonable returns from traditional investments. Also, the standard practice of diversifying portfolios across asset classes fails when correlation between assets goes up. The connection between different assets and underlying economic factors like GDP growth and interest rates can be understood in hindsight but are extremely difficult to predict in advance, so a portfolio that is nominally diverse may become highly correlated during a crisis, as happened in the recent global recession.

“The enthusiasm for [risk premia] is, in part, driven by a paucity of available investment returns on more traditional assets,” says the report. “A lack of return, a difficulty in predicting those returns and limits to diversification within the standard asset allocation framework (especially during crises), are what we believe are the driving forces behind today’s interest in risk premia-based asset allocation.”

traditioal asset allocation yield low

Alternative indices growth

But these factors could drive interest in all sorts of alternative investment strategies, not just risk premia, and that’s exactly what’s happened, as can be seen from the explosion of alternative indices. “Some excellent work from Andrew Clare and his colleagues at Cass Business School entitled ‘Monkeys beat market cap weighted indices’ found that whilst most alternative weighted indices outperformed the market-weighted benchmark, so did most randomly created portfolios,” says the report. “We have found that simply assigning 10-20% of a traditional asset allocation to a portfolio of risk premia would have improved returns, with a 10% allocation adding 100bp per annum and a 20% allocation adding around 200bp.”

classic asset allocation plus risk premia

Portfolio correlation with market conditions

The key is to use a diverse set of risk premia strategies to guarantee that a portion of your portfolio has, and will maintain, low correlation even if market conditions change dramatically. Risk-premia isn’t a substitute for traditional models (and the extra cost of portfolio management makes it a loser for smaller portfolios), but implemented correctly it can improve returns and reduce volatility in a challenging investment environment.

The Societe Generale report was written by Julien Turc, Sandrine Ungari, Andrew Lapthorne, Georgios Oikonomou, Vincent Cassot, and Aymen Boulkhari.

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