Alternatives Risk Premia - Jigsaw falling into place - DWS
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Deutsche Q4 2016 Marketing material Asset Management Alternatives Hedge Fund Advisory Alternatives Risk Premia Jigsaw falling into place For MiFID Professional Investor Only/For Qualified Investors (Art. 10 Para. 3 of the Swiss Federal Collective Investment Schemes Act (CISA)). For business customers. Not for distribution. Institutional/accredited Investors only. Not for retail distribution. Please note certain information in this presentation constitutes forward-looking statements. Due to various risks, uncertainties and assumptions made in our analysis, actual events or results or the actual performance of the markets covered by this presentation report may differ materially from those described. The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein.
Why risk premia? Characteristics Transparent Explainable Persistence Trend towards full look through Risk premia are built upon of underlying positions. Glass Risk premia may be observed empirical observations box not black box approach over a long period of time Flexible Absolute returns Low fees Can be accessed through a number of different instruments and customised Portfolios aim to generate returns Low fee implementations with to meet an investors requirements regardless of the market direction typically no performance fee Portfolio diversification Traditional asset class portfolio construction may give a false sense of diversification due to the correlations between asset classes. By viewing the exposure through a factor lens, a more robust diversification can be targeted by constructing the portfolio using risk premia. The below example illustrates how a multi-strategy portfolio which may look diversified at an asset class level, in fact has around 50% exposure to equity premia which may imply under-diversification. Traditional portfolio view Risk factor view US Equities Europe Equities Japanese Equities EM Asia ex Japan Equities Commodity Momentum Latin America Equities Equity Emerging Markets Europe IG Credit Equity Liquidity US IG Credit Equity Momentum Europe High Yield FX Carry EM US High Yield Rates Carry US Soverigns Rates Value FI EM Convertibles Commodities Alternatives Hypothetical example, for illustrative purposes only 2 Risk Premia | Q4 2016
2016: The rise of the risk premia? Introduction Will 2016 be remembered as a turning point in time for risk premia Tim Gascoigne investing? The growth in risk premia has indeed been impressive this Global Head of Hedge Funds year and this approach to investing has increasingly been viewed Deutsche Asset Management as a differentiator to other liquid alternative investment techniques and appears to assert itself as an asset class in its own right – both in terms of investor appetite but also with regards to the number of vehicles and solutions on offer. This deepening of the investible universe has coincided with a significant increase in estimated AUM allocated to risk premia over the course of this year. For example Nicolas Laporte a survey* carried out mid-year revealed that more than 80% of Head of European respondents were currently investing in, or looking to invest in, risk Portfolio Management premia solutions. According to the same research, AUM in risk premia Deutsche Asset Management related strategies is projected to rise from around 250 billion USD in 2014 to more than 1 trillion USD by the end of 2019, which if true would make this the fastest growing investment product in asset management history*. Ben Arnold Risk premia providers have been (and still are) expanding their Portfolio Analyst investment universe to meet a growing level of investor sophistication Deutsche Asset Management and demand with customisation and unique factor exposures to make it an attractive solution for investors. As this investment universe becomes less of a niche approach, the level of transparency has increased and a full daily look through to the underlying holdings for the investor is becoming the norm. Finally another key reason for the growth in popularity of risk premia is the increased overall understanding of the asset class by investors in terms of what can be achieved and how they can be integrated into their portfolios. In the light of this our paper serves to break down and further AUM in risk premia demystify the increasingly complex and esoteric world of risk related strategies is premia so it may be better understood by all investors. We share our definitions followed by our understanding of the risk premia projected to rise from universe and how it can be best classified. Insights are then provided into how portfolios can be constructed. Finally we touch upon some around 250 billion of our work on criteria for selecting providers and give our view on the often controversial topic on whether risk premia can be timed. USD in 2014 to more than 1 trillion USD by the end of 2019. *Source: Citi Prime Finance survey, Risk Premia, the 3rd Generation of Asset Allocation Risk Premia | Q4 2016 3
What are risk premia? An intuitive but complex world The risk premia definition is intuitive but what is behind this Academic risk premia definition is complex. It is intuitive in the way that investing in risk premia is like selling insurance contracts. Like an insurance One of the main drivers of academic risk premia is the existence seller, the investor in risk premia is expected to get paid (premia) of sustained behavioural biases by market participants. As for the specific risk he/she is willing to take. These premia exist a consequence, an investor who is able to understand these due to specific market structures which in turn are driven by biases can harvest these by accessing the relevant premia. persistent investor behaviours and different types of investment For example in the case of market underreaction: the investor constraints. These anomalies can be harvested but they come is compensated for reacting faster to price changes, news, with specific risks and hence their name: risk premia. analysis and fundamentals when compared to the marginal investor. In this vein, momentum-based risk premia aim to Unlike traditional assets, these premia can be captured by capture the phenomenon of assets with higher (lower) recent combining multiple instruments, taking long and short positions past returns outperforming (underperforming) over time. as well as using specific trading rules in order to isolate the premia as precisely as possible from market noise. Allocating In the case of market overreaction, the investor is compensated to a risk premia would not generically be characterised as for assessing recent price changes, news, and fundamentals allocating to a particular asset class but rather as creating a into the future. Equity value investing illustrates an example strategy that will provide a stream of returns related to a of market overreaction as assets below (above) fair value tend specific risk borne by the investor. to outperform (underperform). From a risk perspective, the market overreaction is explained by fact that investors tend to Moreover, even for the most simple risk premia, there is no such overreact to value stocks’ embedded risks such as distress risk thing as a universal truth to define the most efficient way to (companies with undervalued stocks are more likely to be in harvest it. Each provider relies on its own research and findings, financial distress), cash-flow risk and liquidity risk. making cross-provider comparison a complex and delicate task; however research, construction and execution can give an individual provider an edge in the delivery of a particular premia. Behavioral explanations rely on investor under/over-reaction Furthermore, the range of risk premia is large and expanding with new research pushing the current boundaries of the Initial under-reaction and available strategies. This means any attempt to precisely qualify subsequent over-reaction and quantify the risk premia universe represents an ongoing exercise. Price Our analysis of the risk premia universe has led us to segregate it in two main families; each family enclosing a broad range of Trend-following works during this period risk premia which themselves can be classified by asset class and style. Event causes revision Time in fair value Fair value Market price Source: Deutsche Asset Management, Nomura as of November 16 For illustrative purposes only Note that in the case of value investing in the risk premia space, Academic Implied a key parameter to determine is the fair value of an asset - a subjective number which naturally leads to some dispersion from different providers in this space. The first family is the academic risk premia, a name referencing The other main characteristic behind academic risk premia is the number of research papers that have been written by the fact that some investors are constrained in their behaviour. academics on them for decades in some cases. Generally As a premia investor, positive yield can be generated by holding speaking they are relatively simple in nature. The other family assets or taking risks that marginal investors cannot (or do not are the implied risk premia. These tend to be more complex and want to) hold. This is called carry. While carry can be derived have been developed more recently. from all asset classes, it is with commodities that the concept is best expressed. Under normal market conditions, commodities exhibit backwardation along the futures curve, stating that commodity producers have been selling long-dated contracts at a discount in order to hedge their output, whereas consumers 4 Risk Premia | Q4 2016
have been buying short-dated contracts at a premium in order imbalance between supply and demand in the volatility to secure near-time consumption. Therefore an investor who market; a trend especially observable since 2008 as there is buys from producers and sells to consumers can capture a more demand for protection and less ability to warehouse “risk premium” in the form of a roll yield – assuming, of course, it. In the equity space, the volatility premium is captured by all else being equal during the invested period. systematically selling volatility through variance swaps where one would receive implied and pay realized volatility. A more elegant way to exploit this risk premium is to run dispersion Source of the carry premia on the commodity curve trading. Dispersion trading exploits the phenomena that the difference between implied and realized volatility is greater between index options than between individual stock options. Investors therefore could sell options on the relevant index Hedging of producers and buy individual stock options. This strategy tends to be profitable during a period when individual stocks are not Price significantly correlated and loses money during stress periods when correlations rise. Buying from consumers In the case of the merger arbitrage premium, the investor receives a spread that rewards them for the risk of a deal collapse. The larger the uncertainty on the outcome of that One-month 12-month Futures potential deal, the larger the spread is and as a consequence the larger the premium to be harvested. Source: Deutsche Asset Management, Nomura as of November 16 Finally another implied related risk premium strategy involves For illustrative purposes only trading dividend futures. Over the past few years dividends have ceased to be considered a side product of equity investments, and the assertion that they constitute an asset class in their own Implied risk premia right has become more and more common. Dividends can be traded using futures, opening a new door to possible premia to be harvested. About five quarters before expiry, dividend futures Implied premia is our second family of risk premia. This family usually undergo a profound change in their risk dynamics as the encompasses all implied parameters which can lead to arbitrage stock tends to trade at a discount to the expected dividends. As situations such as volatility, dispersion, dividends or liquidity. time passes, the discount falls. This “pull-to-realized” behaviour The existence of these premia is derived from specific market can be harvested. flows which sometimes have common ground with the academic risk premia family such as investor patterns, Once divided in two broad families, risk premia can then be hedging needs or regulatory constraints. classified per asset class and styles, creating a two dimensional matrix as shown below, where peer group analysis and more Volatility risk premia investing across asset classes relies on the in-depth analysis can be run at the bucket level. historical acknowledgement that implied volatility tends to be higher than realized volatility and is explained by a structural Risk premia matrix Carry Curve Liquidity Mom. Quality Size Value Volatility Commodities Credit Equities Fixed Income Forex Academic risk premia Implied risk premia Source: Deutsche Asset Management as of November 16 Risk Premia | Q4 2016 5
Choosing providers Portfolio construction A broad and ever expanding universe Building bridges When it comes to providers of risk premia, there is a plethora From an investor’s perspective, the risk premia story is a of choice. Most investment banks offer a range of off-the-shelf fascinating on-going development. Within a couple of years, strategies. These strategies, if one invests in a particular size, a new investment toolbox has been developed and made can be more or less customized to match a client’s needs. available at a relatively low cost for investors. This toolbox It provides an almost overwhelming choice and as each is extensive: available premia range from classic academic provider has their own views on how and what information strategies to strategies which are much more complex that for each strategy is disclosed, it makes any comparison have been used by hedge fund managers for decades. exercise a difficult process. For this reason, it is advisable to use filtering methods to reduce the size of the universe to a Assuming that an investor has defined a clear methodology more manageable size, allowing one to carry out a deep-dive to assess, filter and select a sample of candidates to allocate on the relevant risk premia remaining. capital to, the next step is to define a portfolio construction process. In the active space (excluding the case of fixed One can develop a range of quantitative methods (for example allocations), we outline two ways to tackle this challenge, principle component analysis) and measures that rank strategies both of them with their own advantages and drawbacks: across variables but also take the decision to explore each group a systematic approach and a discretionary approach. of risk premia available to investors from a bottom up view. Such an approach is preferable due to the fact that even for the The systematic approach relies on a portfolio optimisation most simple risk premia, the implementation and trading by model that rebalances the allocation on a regular basis each provider is different. This results in a broad range of data without human intervention. Typically, the optimisation aims at matrices where risk premia are sliced and diced not only from maximizing returns while minimizing a user defined risk metric. a statistical and cost perspective but also from a qualitative A classic approach is to run a variant of the risk parity model. standpoint where key construction elements are detailed across The systematic approach ensures adequate diversification and each risk premia within a style and an asset class. Further, the the absence of hidden biases in the portfolio - it is disciplined. statistical perspective is easier to grasp when combined with the The discretionary approach consists of building a portfolio based analytical work done on a qualitative basis, facilitating decision on a qualitative decision making process. In contrast, it has making when it comes to selecting which are the risk premia more tactical positioning and can implement allocations with a one wishes to consider as inputs to the portfolio construction. more forward looking perspective than systematic approaches. The main downside of the systematic approach is that the Risk Premia selection process models rely on historical data while the main downside of discretionary approach is that the allocation can build up unexpected biases in terms of sensitivities to some factors Risk premia providers and can be subject to weaknesses of human investor behaviour such as loss aversion, anchoring and herding. A B C D E F One suggested approach works on a compromise, building a bridge between the two portfolio construction methods. First, one can use a panel of quantitative approaches to define weight ranges where each weight corresponds to an optimal Risk premia universe 200+ solution from a risk/return perspective. One can employ different approaches to assess risk with a focus on correlation analysis as historically correlation has had a dominant role in the success or failure of any risk premia allocation. Portfolio candidates Around 50 The next stage is based upon one’s understanding of the behaviour of each risk premia, namely how cheap or rich one perceives them to be, as well as macro considerations and on-going tactical opportunities. From this a discretionary allocation for each risk premia is made within each of the Source: Deutsche Asset Management as of November 16 bands resulting in a final allocation. In this vein, quantitative methodologies are useful tools to define allocation boundaries, and when combined with what can be seen as a macro overlay can yield a portfolio that is more robust than either a purely discretionary approach or a purely systematic approach. 6 Risk Premia | Q4 2016
Timing risk premia Adding value through discretion One of the most intensely debated and arguably the most Current carry vs 18 month average carry for selected currencies controversial of topics in the risk premia space is whether they can be timed or not. It is a debate which has traditionally 12% Current Carry polarised investors. As transparency has improved as well as 10% the expansion of the investible universe, the discussion has 8% 18m Average continued to evolve. 6% 4% Let’s return to our previous definition of risk premia from before: systematic ways of exploiting persistent inefficiencies that arise 2% in the market generally stemming from structural imbalances. 0% While in the long run these inefficiencies allow the investor to -2% generate a positive return, looking back through history, it is -4% clear that there are periods that favour one risk premium over SD SD ZA SD XN D SD AU SD SD O D CA SD SG SD GB D SE D TW SD SD KR SD SD SD another and in extreme cases, there are periods when certain S S S S LU RU RU RU U U U FU KU U U PU KU U RU U YU ZD D D D D W U BR JP ID IN EU risk premia will underperform for a significant amount of time. H N N M Determining the drivers of this under/outperformance can be a Source: Deutsche Asset Management, Bloomberg as of November 16 difficult task and harder yet is the prediction of when the change in these drivers will occur. Certainly for some risk premia such as momentum, determining when a trend will start or break would be the Holy Grail for investing. As such timing certain risk premia can be a very difficult task and many risk premia investors will choose to accept this and instead implement a Conclusion purely passive or risk parity approach to investing. The move from a black box to a glass box However, this may not be the case for all risk premia. Premia that aim to capture an arbitrage or carry spread can be monitored on a historical basis and if one accepts that over The recent spark in interest for risk premia has led to a time, asset prices will tend to mean revert to their historical proliferation of products and solutions on offer for investors. norms then it is possible to build a framework for determining The approaches in some cases vary significantly and whether a risk premia is currently “cheap” or “expensive”. understanding their different nuances and behaviours is This is perhaps best illustrated by looking at a carry strategy – crucial for successfully investing in the asset class. Our belief if we look at the chart on the right we can see the current FX is that careful provider selection is paramount and that while carry being compared to historical averages for a number of portfolio construction can be enacted on a largely systematic currencies. In this example, it would indicate that we should basis, there is value to be added employing discretion in order allocate more to emerging market vs developed market FX carry to tactically position the portfolio and to time certain premia. premia as the former looks much cheaper through this lens. The same idea can be applied to other asset classes such as This recent growth is understandable as investors look more equities, commodities and fixed income. for a low cost alternative to investing in traditional hedge funds as they become increasingly more discerning about Another take on timing risk premia is to use them as a tool their investments with regards to transparency, costs and to implement more directional tactical investment decisions flexibility and we believe risk premia investment solutions – in a similar way to how a macro hedge fund may invest. offer a very compelling response to this problem. However, For example, if we consider more traditional risk premia in the only time will tell which approaches will be successful and equity space; an investor might go long the S&P and short which may lack substance when it comes to performance. the risk free rate if they want to take a directional view on the US stock market. The same can be applied to fixed income or commodity instruments if an investor also has a directional view on those markets and wants to take on the corresponding risk for investing in them. Certain risk premia may also lend themselves to trading on a risk on/off basis such as liquidity or emerging market bias premia (for example long the MSCI EM index/Short S&P 500) and if an investor has an opinion on the market direction or regime for these, they can implement their risk premia investments accordingly. This approach allows a risk premia investor to take on a more tactical approach to investing in the strategy using their own discretion. Risk Premia | Q4 2016 7
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