Institutional investors' approach to asset allocation is evolving as certain style factors are increasingly integrated into portfolio construction frameworks. Historically, institutions diversified their investment portfolios across asset classes (stocks, bonds, commodities, alternatives, etc.), but market volatility demonstrates that simple asset allocation might be suboptimal. As a result, many institutions are not only incorporating factor-based or risk-premium strategies into their portfolio benchmarking process but also are actively making allocations to diversifying or risk-mitigating strategies.
Investors have typically categorized their investment returns in two buckets — beta, benchmark-like exposure to financial assets, and alpha, the active outperformance of an investment relative to a specific benchmark. When decomposing the alpha part of a portfolio, many investors now believe a percentage of those returns can be explained by certain factors. For example, smart beta strategies that use alternative weighting schemes in long-only index construction, such as volatility weighting or sector tilts, can account for a significant portion of what was previously thought of as outperformance or manager skill. Similarly, rules-based strategies, which are premised on factors such as value and momentum that take both long and short positions, can be thought of as “alternative beta.” Accessing alternative beta through systematic risk-premium strategies, whether sourced through bank sponsored strategies or from asset managers or hedge funds can be more cost-efficient than investing in traditional actively managed hedge fund strategies. Furthermore, because of the rules-based and transparent nature of the strategies, investors have greater control over the specific exposures and risks they take.
The concept of risk premiums is based on well-understood, broad and persistent sources of risk and return that are documented in academic literature. Examples include strategies based on value, momentum and carry. When constructing risk premium portfolios, investors generally start with a particular investment objective. Examples include gaining exposure to certain asset classes or strategies or selecting strategies that play a particular role in a portfolio (e.g., defensive strategies designed to outperform when market volatility increases). Portfolios can be designed to access a diverse set of risk premiums, which tend to be uncorrelated, allowing investors to achieve more stable risk and correlation benefits. Similarly, the strategies can be used to construct an overlay or a hedge to an existing asset allocation framework. Although high-quality risk-premium strategies can be obtained from banks, asset managers and hedge fund managers, the specific focus of this article is the evaluation and due diligence of bank-sponsored strategies.