Implementation Matters: A Review of the Performance of Alternative Risk Premia Strategies in 2020
Alternative risk premia (ARP) strategies have been in the spotlight lately due to performance headwinds, causing some allocators to re-examine the space. Investors’ understanding of these strategies also appears to be rapidly evolving. Many had viewed ARP strategies as a means of alternative beta capture but now consider them a form of systematic alpha potential, and recognize that managers have disparate approaches to strategy selection, design, and implementation. Similar to other alpha-oriented strategies, like hedge funds and private equity, performance dispersion across ARP managers has been extremely high and is likely to persist.
In this article, we share our perspective on key considerations related to systematic strategies, including ARP investing. We begin with a review of systematic strategies and their key attributes. Next, we recap the performance of major ARP factors this year and discuss our views of the landscape. We conclude by reviewing PIMCO’s offerings and detailing how they differ from traditional ARP products.
A recap of systematic strategies and their role in policy portfolios
Systematic strategies can be an efficient way to gain access to long-term diversified sources of alpha within portfolios. They aim to take advantage of structural risk premia and market inefficiencies through dynamic investment strategies. These exist in various forms:
- Mainstream alternative risk premia, such as value, carry, and momentum, which have been extensively researched by academics
- Unconventional risk premia, such as agency mortgage basis, or the merger arbitrage premium
- Predictable patterns in market returns, captured through dynamic trading strategies such as statistical arbitrage or machine learning
Regardless of origin, we believe systematic strategies should be underpinned by extensive research and implemented via well-defined rules. Alpha from these strategies should be harvested in a highly disciplined manner, creating return streams that are more diversifying to traditional investment approaches, which are frequently subject to behavioral biases.
While systematic strategies have been familiar to investors for many decades – in the form of Commodity Trading Advisors (CTAs), equity funds, or multi-strategy quantitative hedge funds – the last seven years have witnessed the development and growth of a seemingly new area: alternative risk premia. ARP strategies seek to bring together a collection of scalable, liquid systematic strategies, often targeting anomalies well documented in academic research.
The degree of sophistication with which ARP products are constructed varies significantly. At their best, these portfolios can be liquid implementations of sophisticated quantitative hedge fund models, bringing decades of trading know-how, quantitative research experience, and portfolio management techniques to systematically exploit various anomalies. However, the apparent simplicity and familiarity of some now well-known quantitative strategies has suggested to some that these anomalies have in some sense become “beta.” That’s led investors to question the role of skill in these strategies, and providers to simply aim for scale over performance
At PIMCO, we strongly believe that irrespective of the nomenclature – liquid quant or ARP – these strategies can provide true, diversifying alpha. However, as wide dispersion in performance demonstrates, implementation matters (see Figure 1). While any systematic quantitative strategy should be replicable by backtest, ARP strategies cannot be betas because there is little consensus on how exactly to define the risk premia, nor a standard approach to accessing them.
The large difference in performance within the same strategy (see Figure 2) emphasizes how ARP strategies are active investment strategies and that skill and experience matter in the implementation process. For this reason, instead of simply targeting the most scalable versions of well-known strategies, PIMCO focuses on continuously researching new sources of alpha, constantly refining our models, adding new and diversifying markets, and aiming to respond appropriately to changing market conditions.
Putting year-to-date performance in context
All investment strategies experience periods of challenging performance, and 2020 clearly represents such a period for ARP strategies.
In the first quarter of this year, equity volatility surpassed levels last seen at the height of the global financial crisis. The COVID-19 crisis exacerbated structural changes in the equity market, rewarding high-growth technology companies and penalizing traditional value sectors in general. As high volatility wreaked havoc, certain strategies also experienced losses for idiosyncratic reasons, such as oil falling 24% over the weekend of March 6-9 due to escalation of the Russia-Saudi Arabia price war.
These events affected ARP strategies in a variety of ways. In the case of equity value, almost everyone exposed to the factor suffered. Other strategies – notably foreign exchange (FX) carry and volatility – which typically encapsulate a premium for bearing business cycle risk, also experienced losses. While it was not surprising that these strategies posted negative returns in the first quarter, the year-to-date performance across managers varied meaningfully due to vast differences in implementation.
Portfolio construction choices also exacerbated the drawdowns experienced by some ARP managers. Notably, managers with outsize exposure to equity style premia, particularly value, struggled as these factors experienced coincident losses (see Figure 2). The consistent losses from equity value over nearly a decade have many allocators questioning whether the equity value factor is structurally impaired, with some considering lowering allocations to managers with significant exposure to it. While one should refrain from rushing to judgment and declaring the death of equity value – this factor has suffered significant drawdowns historically, such as in 2007, only to bounce back – concentrating risk in any factor is never a good idea.
To illustrate this point, Figure 3 shows the impact to overall volatility, Sharpe ratio, and drawdown of a hypothetical portfolio consisting of 10 diversifying strategies, each with a 0.4 Sharpe ratio, when allocation to a particular strategy is progressively increased. The result of increasing allocation to a single strategy at the expense of others is loss of portfolio diversification, leading to higher volatility, a lower Sharpe ratio, greater tail losses, and drawdowns that increase even more than the volatility increase. Said differently, managers running concentrated exposure to equity value were making an outsize bet – at the expense of portfolio diversification – that it had a significantly better risk/reward profile than all other strategies in their opportunity set and hence warranted a much higher risk allocation. In order to take a strong stand on value, one would need to strongly embrace factor timing, which we believe has limited efficacy. On the other hand, as we have advocated, achieving true risk diversification should be the primary goal of ARP portfolio construction. For some, this means that a reduced allocation to value may be warranted from a risk control standpoint, though this does not mean that investors should go to the other extreme and assign value an unrealistically low ex ante Sharpe ratio. Dramatic shifts in factor weights due to recent performance can be just as risky. Our view has been, and continues to be, that equity value is one of many alternative risk premia strategies that can provide returns and diversification within a well-constructed ARP portfolio.
In terms of key positive contributors to performance in the first quarter, ARP strategies that would logically be expected to do well under these stress circumstances generally fulfilled their purpose. Value and carry premia strategies in interest rate markets captured not only the large decline in yields, but also the long-predicted convergence between U.S. and European rates. These strategies also benefited on the backend of the crisis from dislocations across sovereign yield curves (see Figure 2).
As 2020 began to look like a rerun of 2008, trend-following strategies moved toward defensive positions: short equities, long interest rate duration, short energy, and long the U.S. dollar. These exposures helped to reduce losses, at least until markets turned sharply at the end of March. Had the market not bounced back so strongly, we believe performance of trend-following would most likely have mirrored 2008’s high double-digit returns. Faster trend-followers, which are designed to be more reactive, performed strongly on the way down and managed to lock in a good proportion of the profits through the rebound – behaving exactly as anticipated (see Figure 4). Slower trend-followers which had optimized to maximize capacity, turned more slowly, likely becoming short around the market bottom in March, and staying so through much of the second-quarter rebound.
In summary, the events of the first quarter of 2020 affected ARP strategies in various ways. For strategies that sought to harvest procyclical risk premia, one may have reasonably expected losses during periods of market stress, though implementation details tend to have a huge impact on the outcome. On the other hand, countercyclical strategies can benefit from these episodes, and indeed can be constructed to do so at the cost of forgoing some performance in the good times. Other, more idiosyncratic strategies can be subject to spillover effects, and understanding the dynamically varying correlations of these strategies and making them as robust as possible to outcomes, perhaps even beyond the range of reasonable expectations, is essential to their viability going forward, in our view. Above all, diversification is key in making sure that one maintains a sensible blend of risk-on and risk-off strategies and ensuring that no single factor or strategy dominates portfolio risk. Importantly, although diversification does not preclude drawdowns, a diversified portfolio, on average, is more likely to outperform a concentrated portfolio and deliver higher risk-adjusted returns over the long run.
PIMCO’S multi-asset alternative risk premia strategies
The PIMCO Multi-Asset Alternative Risk Premia Strategy (MAARS) and its defensive variant (MAARS ROVER) explicitly seek to limit equity and other key traditional beta exposures in order to boost defensive and diversification properties. For example, the FX carry strategy incorporates value factors (thus reducing exposure to high carry but overvalued currencies) and uses an optimization technique that constrains equity correlation. The two versions of our ARP strategy recognize the trade-off between defensiveness and long-term return potential. MAARS is a combination of systematic strategies that seeks to maximize estimated Sharpe ratio with near-zero long-term equity beta, while MAARS ROVER is a combination that adjusts underlying strategies to enhance defensiveness at the cost of some long-term return potential.
We believe our ARP strategies are differentiated from our peers’ because of their level of diversification, the range of assets traded, and the types of strategies implemented. Some of our strategies may resemble those targeting traditional ARP factors, such as carry, short volatility, or equity value. But many others are akin to the dynamic alpha opportunities pursued by hedge funds, which are conceptually different from static ARP strategies that most allocators are more familiar with.
Our portfolio construction is built around the importance of diversification. We avoid taking outsize risks in any individual factor or asset class. As a result, the portfolio has benefited from having more exposure to high conviction strategies outside of equities and from less exposure to mainstream equity factors that have underperformed. Diversification means these strategies also won’t maximize participation in an upside market for a specific factor or asset class, but correspondingly they mitigate the risk to the downside.
The MAARS investment process benefits from PIMCO’s expertise in accessing and trading a much wider range of instruments, such as swaps, emerging markets, mortgages and credit. We have extensive experience in fixed income, commodity, and currency strategies relative to some of our peers who generally focus on equities or trend-following. These capabilities and resources also allow us to supplement the more common ARP strategies with other proprietary systematic sources of returns.
Finally, we believe continuous innovation and development are crucial for quantitative strategies, both in terms of implementing new systematic strategies and improving existing ones. Our ARP portfolios have evolved over time and PIMCO continues to invest heavily in quantitative resources, technology, and innovation as a strategic priority.
Systematic quantitative strategies can be an efficient way to seek long-term diversified sources of alpha within portfolios. In search of these characteristics, many investors took on allocations to alternative risk premia strategies. Performance in 2020 affected ARP strategies in many different ways, but wide performance dispersion underscores the importance of portfolio construction and continuously researching new sources of alpha, constantly refining models, adding new and diversifying markets, and responding appropriately to changing market conditions.
Past performance is not a guarantee or a reliable indicator of future results. Nothing herein should be deemed to be a prediction or projection of future performance.
The investment strategies discussed herein are speculative and involve a high degree of risk, including a loss of some or all capital. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally backed by a government, government agency or private guarantor there is no assurance that the guarantor will meet its obligations. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument. Derivatives and commodity-linked derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Diversification does not ensure against loss.
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