Risk premia strategies can be defined as diversifiable investment styles with fundamental value and positive historic returns. Their main types are (i) absolute value and carry, (ii) momentum, and (iii) relative value. A Societe Generale research report argues that value generation of these styles may be more reliable than that of asset classes and more suitable for combination into diversified portfolios.
“Risk-premia strategies: a way to distance yourself from the crowd”, Societe Generale Cross Asset Research September 2013
(The report is proprietary research of Societe Generale. Please contact the institution for access)
The below are excerpts from the report. Emphasis and cursive lines are added.
What are risk premia strategies?
“Risk-premia investing…[means to] identify, analyse, build and develop strategies that in some way improve risk-adjusted returns…There is no formal definition of what constitutes a risk premium beyond the concept that investors should reap a reward for bearing some kind of risk…we have decided that a risk premium has: 1. Demonstrated an attractive positive historical return profile; 2. A fundamental value that allows a judgement on future expected returns; and 3. Diversification benefits when combined into a multi-asset portfolio.”
“Most [risk premia] strategies can be classified either as income, momentum or relative value…Income strategies typically accrue payments over the long-term but may give the possibility of occasional (but very large losses during periods of market turmoil, i.e. drawdown). Many value and carry strategies also fall into this category. Momentum strategies, on the other hand, perform best during periods of economic crisis or market turmoil. Momentum strategies include quality equity, call over-writing and FX momentum. Relative value strategies, however, tend to be more distinct sources of return but may suffer from liquidity constraints.”
The case for risk premia strategies
“The theory is simple enough: investing in risk premia as an alternative (or as an add-on) to the traditional mix of bonds/equity/credit/property etc. should deliver a far better – and more predictable outcome – than traditional combinations of asset classes alone.”
“An important point here is that the investor gets paid, i.e. the understanding is that the returns generated through exposure to risk premia are in some way more useful and dependable than exposures to more traditional asset classes. We are simply saying that buying cheap and selling expensive stocks is a more dependable way to make money in the long term than say simply overweighting equities versus bonds (the value risk premium is a more reliable source of return than the traditional equity risk premium, which has proved mostly useless as a predictor of future returns from equities versus bonds).”
“The attraction of adding alternative risk premia assets to a more traditional multi-asset portfolio is that not only are historical correlations across risk premia lower than for traditional asset classes, but these correlations are more consistent and robust to regime shifts.”
Examples and characteristics of risk premia strategies
1. Equity value strategies
“Value strategies are some of the best known stock selection strategies with origins dating back the work of Ben Graham and David Dodd in their 1934 book Security Analysis. The value premium essentially consists of buying undervalued stocks and selling expensive ones, using some form of fundamental valuation metric. with the most commonly cited being low versus high price to book value, as described by Fama and French in their paper.”
“A value portfolio might invest in companies that have suffered significant price declines and are having difficulties. These difficulties can be company-specific or related to the macro situation at the time. In both cases, the success of the value strategy will be determined by the ability of these companies (and the investor) to sustain losses and eventually fix their problems…Therefore, it is not surprising that we typically see the best performance from value strategies during periods of improving sentiment and economic recovery.”
2. Equity momentum strategies
“Momentum has been one of the most commonly applied factors in stock, country, sector and style selection as well as in strategies across other asset classes. In its basic form, momentum strategies simply buy stocks with the best historical returns and short stocks with the worst returns, thus trying to capture trends in the market. Typically, they look at the last three to 12 month returns, skipping the last month to avoid short term reversal effects.”
“Possible explanations of the momentum effect…draw from behavioural biases such as overconfidence and loss aversion and link momentum profits to under- or over-reactions to company-specific news…Momentum investing came under pressure after the great momentum crash of 2009, when a traditional momentum strategy (12-month lagged by one-month) lost more than 60% in the space of a few months. Whilst this clearly provided some ammunition in favour of a risk-based explanation, momentum stock selection during that period was mainly driven by the macro environment rather than capturing any reaction to company-specific news.”
3. Fixed income carry strategy
“Long term yields…are classically the sum of short term rate expectations, the credit risk premium and the term or duration premium…The rate term premium manifests itself whenever curves are steep (namely, long term rates are higher than short term rates). The strategy here would consist of buying long end instruments (such as US 10y Treasuries or 10y Bunds) and selling short term instruments…The performances of these term premium strategies are particularly good, with very few big drawdowns.”
“The main risk in major rate markets over the coming months is the tapering of quantitative easing in the US, with an anchoring of short term rates. This will inevitably lead to a steepening of the USD interest rate curve, which will in turn hurt USD-based term premium strategies.”
4. Fixed income momentum strategy
“Our momentum strategy consists of replicating the delta of a call option. This will mechanically increase the leverage in bond bull markets and decrease the leverage in bond bear markets…Any rate momentum strategy then should be viewed within the context of a 30+ year bull market, with the historical performance of a long position in long term interest rate futures having been very good. A strategy consisting of rolling US Treasury 10y futures returned an average of 4.55% per annum, or a Sharpe ratio of 0.7. On long maturities and trading less frequently, we found it very difficult to beat the performance of this long position over the past 30 years by using momentum.”
5. Fixed income RV strategy
“The Dynamic Forward Trading strategy identifies trading opportunities within the G10 interest rate swap universe…This model is based on a factor analysis of G10 rates and a wide range of macro-economic and exogenous market factors. The execution strategy consists of identifying (at any point in time) pairs of G10 rates which are trading away from their model value and to take a position assuming mean-reversion. The rates we use are five year rates and five years forward…This strategy tends to perform well in volatile markets, where the rates markets move in an asynchronous fashion.”
6. FX carry strategy
“It turns out that higher-yielding currencies do tend to appreciate on average more versus lower yielding ones as often these higher rates were linked to growing economies with better prospects…Being in essence a leveraged speculative strategy, positions in FX carry trades are often unwound when there is a potential for losses in other strategies or asset classes. Hence, whilst the strategy offers a positive carry, it has a negative skew and is adversely affected by a rise in volatility.”
7. FX momentum strategy
“It is well-known that momentum strategies benefit from increases in volatility and persistent big price moves…We have compared the performance of a trend-following system in FX to a strategy that buys delta-hedged straddles and have shown that a momentum strategy is a much more cost effective alternative to an options strategy, whilst delivering similar risk-sensitive exposures. Given its exposure profile, the momentum strategy tends to deliver strong returns during crisis situations, helpfully complimentary to a carry, which traditionally suffers when volatility spikes.”
8. Credit carry strategy
“Carry strategies, or long credit strategies, consist in either purchasing bonds or selling CDS protection, which is a standard premium strategy. A buyer of CDS protection will receive a credit spread in compensation for the default risk of the reference entity he takes a position in. The credit spread of an instrument is, in general, significantly higher than the expected value of the potential loss and offers a risk premium reward to the investor. It can be broken down into…a default premium…a risk premium…and a liquidity premium.”
9. Credit momentum strategy
“The trend system is based on an adaptive indicator using four trend indicators from one month and three month regressions of the log spread and of the mean reverting components against time. If the slope is positive, it is a buy protection signal; if it is negative, it is a sell protection signal. momentum strategies performed best when spreads move sharply in one direction, either on the upside or on the downside and the performance is more limited when the market is range-bound.”
