Evaluating bank-sponsored risk-premium strategies

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.

In response to growing institutional demand, many major banks have committed significant resources toward building businesses around the development of risk-premium strategies. Wilshire estimates bank-sponsored risk-premium assets under management exceeded $150 billion as of Dec. 31, encompassing hundreds of strategies. For example, banks will offer several different implementations of a single risk premium (e.g., construct commodity carry strategies utilizing different underlying instruments, leverage or volatility levels). Given there are multiple bank providers, the number of distinct strategies across banks is large. The graphic below gives an example of the types of strategies available. The strategies obtained from bank providers usually have daily liquidity and investors have full transparency into the construction and components of the strategy.

As with investing in hedge funds, due diligence and ongoing monitoring is of critical importance when investing in bank-sponsored risk-premium strategies. There are both investment and operational strategy considerations.

Strategy quality checks are important in understanding each strategy's expected performance and in order to gauge the robustness of design and aid in assessing suitability for investment.

There are three common risks associated with quantitative strategies:

1. Overfitting bias is a risk with any quantitative simulation. Often algorithms are designed to explain not only the risk premiums or factors being exploited, but also any noise or unique market events that occurred in the backtest period. An algorithm that is overly complex (lots of signals, triggers, etc.) is at risk of being overfit.

By their nature, all risk-premium strategies are based on backtested data. These backtests generally include volatile market environments such as the 2008 stock market crash. Investors should be suspect of strategies that rely on certain overlays or triggers to avoid losses in difficult market environments, especially if those triggers seem overly specific with respect to a market event. Investors can seek to avoid overfitting bias by choosing strategies that are pure implementations of the factor being exploited. For example, a pure form of a trend-following or momentum strategy would use the same entry and exit rules across asset classes and avoid specific stop losses and volatility-based overlays that are designed for a specific asset class or market environment.

2. Overtesting variations of a particular algorithm. It is important to understand the evolution of the research process. If an algorithm is developed by multiple tests and the implementation is non-intuitive, then the results should be discounted. Investors should understand the origin of the strategy. Some strategies are developed to exploit a certain investment risk factor (value, low volatility, etc.), some are based on themes developed by the bank's internal research department (i.e., macroeconomic trends), and others are developed at the request of clients. As part of the due-diligence process, it is important to understand why and how the strategy was developed. The process for developing a strategy should be straightforward. If there are multiple iterations of the research process that result in very different outcomes, the strategy might be at risk of being overfit.

The team responsible for due diligence of risk-premium strategies should have relevant experience in quantitative research and developing quantitative strategies. A quant researcher is in the best position to identify flaws or shortcuts in the development process and recognize the risks of strategies that are overfit and not likely to perform in the future.

3. The risk of rare events occurring. Future tail-risk events, although rare, might be different from the events that occurred historically. It is important to understand the types of strategies that are prone to tail risk and size them appropriately in a portfolio. Even in the case of well-constructed strategies, certain strategy types will have large drawdowns in certain market environments. For example, short volatility strategies such as options selling and carry strategies, which have performed very well recently, are likely to suffer large losses in times of volatility spikes, which might not show up in the backtest. Investors should think about the types of environments where the strategy is likely to suffer losses and the potential size of those losses, and as part of the portfolio construction process manage the risk by properly sizing the positions or by adding diversifying strategies accordingly.

As with any investment, after a strategy or a portfolio is implemented, ongoing risk and investment guideline monitoring should be employed to ensure that the strategy is performing as expected. Because most bank-sponsored strategies are transacted as a swap on a total return index, it is important to decompose the index to the underlying position data to perform meaningful risk and return attribution.

It is also important that due diligence is performed on the provider of the strategy. Information on the financial stability of the provider, resources dedicated to strategy development, size and growth of the business and the sufficiency of operational infrastructure should all be evaluated. Investment-focused due diligence for risk-premium strategies is similar to what is typically done in hedge fund due diligence. Investors should spend time with the research teams that developed the strategy to understand the specific investment thesis underlying each risk premium, understand strategy implementation and be comfortable that the investment is robust. The graphic below highlights several key operational and investment considerations in assessing risk-premium strategies and the providers.

Because bank-sponsored risk-premium strategies are technically indexes, the index rules are fully disclosed to investors. This allows investors to do deep-dive due diligence into the strategy construction and the parameters used in developing the strategy. Investors should review the rules to ensure the implementation is consistent with the risk premium the strategy seeks to exploit. With access to strategy rules, investors can isolate different scenarios and stress test the outcomes under different market environments. Investors can test for robustness and stability by changing certain strategy parameters to see if results are similar under slightly different implementations. Also, in certain cases, investors can test the strategy rules on new data sets, such as different time periods or different regions, to test the stability of the strategy in different regimes.

A major difference between bank-sponsored risk-premium strategies and hedge fund strategies is that all trading fees and expenses are fully disclosed in the bank-sponsored products. Within the rules the execution is guaranteed, and therefore there are no slippage or transaction costs in addition to what is disclosed. This allows investors to analyze these costs to assess whether they are fair and reasonable compared to what can be obtained in the market and measure the overall impact of execution costs on profitability.

Unfortunately, there is very little consistency to how banks charge fees. In some cases banks charge a swap fee (similar to a management fee) and “entry” and “exit” fees to cover trading costs. These fees generally are 10 to 100 basis points. In other cases, execution and other costs are embedded in the strategy and swap fees are minimal.

Fees depend on the complexity of the strategy, the provider and other factors, such as the liquidity of the underlying instruments and capacity. The way in which fees are charged should be a focus of investor due diligence. Because banks act as market-makers and prime brokers, they have access to certain efficiencies in execution based on the flow. In some cases, these efficiencies are passed on to investors in risk-premium strategies in the form of lower embedded costs. However, we have also seen cases where the risk premium transactions costs and bid/ask spreads were above what is available in the market.

With the proper due diligence and monitoring, risk-premium strategies, whether provided by a bank, asset manager or hedge fund can be utilized effectively to diversify and complement alternative investment portfolios. Although there will always be a place for high-quality hedge fund managers that deliver true alpha, certain “alternative beta” exposures can be obtained through risk-premium strategies in a cost effective, liquid and transparent implementation.

Monique Miller is a managing director of Wilshire Associates and head of alternatives strategy and business development at Wilshire Funds Management, Santa Monica, Calif. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.