Measuring ‘Alternative’ Sources of Returns
The article below is from our BRIEFINGS newsletter of 16 September 2020
In recent years, investors have broadened their search for potential returns by taking on non-traditional or “alternative” risks. Many of these alternative risk premia (ARP) have historically been implemented by hedge funds and other institutional investors that develop long-short strategies aimed at mitigating market volatility. We sat down with Goldman Sachs Asset Management’s Federico Gilly and Matthew Schwab to discuss the latest developments in this space.
First of all, can you explain ARP strategies and why they’re gaining traction among investors?
Federico Gilly: To understand ARP, it’s helpful to compare them to the now more-familiar “smart beta” strategies. With smart beta strategies, the basic aim is to outperform a traditional market-cap weighted stock index by selectively choosing and re-weighting stocks in the index according to one or more common investment themes. The academic research behind smart beta—a classification of investment strategy which have gained popularity over the last 20 years—suggests that certain traits or “factors” such as low volatility, value or momentum can outperform traditional market-cap weighted indexes.
ARP are developed from a similar vein of research by isolating common investment themes among alternative managers. However, these strategies go a step further by identifying potential returns across asset classes —such as equities, fixed income, currencies and commodities—and systematically applying the concept of factor investing to long-short portfolios, thus creating a new asset class of alternative investment capabilities. As a result, ARP strategies have attracted some $200 billion in assets over the last decade.
What are the benefits of ARP to investors?
Matthew Schwab: For many investors, the biggest risk in their portfolios is equity risk. Therefore, they are constantly looking to diversify this risk, as well as find additional potential sources of return, in order to reduce portfolio volatility. ARP strategies aim to deliver returns which are independent of the equity or bond markets to provide investors with another source of portfolio diversification. For example, an ARP strategy designed to capture the well-known low volatility premium (that less risky stocks tend to outperform riskier ones) would invest in low volatility stocks and hedge the overall market risk by taking short positions in either the overall market or in high volatility stocks. This removes the “beta” of the market itself so that investors are only exposed to the “pure” returns of low volatility stocks outperforming high volatility stocks. In addition, ARP strategies are designed to be more transparent, lower cost and more liquid than many traditional alternative investments, further enhancing their attractiveness in a diversified portfolio.
Goldman Sachs Asset Management and Bloomberg just announced the Bloomberg GSAM Risk Premia Indices, the first transparent, investible index family for ARP strategies. What was the rationale for the move?
Federico Gilly: The idea for the benchmark actually came from investors who have expressed frustration at the lack of a comprehensive benchmark to evaluate the performance of ARP products. Alternative risk premia indices in the marketplace today typically aggregate the returns of individual ARP managers or indices and, as a result, are more of a peer group than a true benchmark. These indices lack the level of transparency typically desirable in a benchmark to help investors more precisely understand the risk and return of the asset class. Unlike traditional equities, which went from indexing to smart beta, ARP jumped from idea to execution without the development of an index or benchmark. As a result, investors have struggled to properly benchmark ARP managers on their performance and analyze their strategies. Compounding matters is the fact that there is a great deal of variation in how ARP managers implement their strategies, resulting in wide dispersion of returns. We partnered with Bloomberg in an effort to design a suite of indices that could help address these challenges by providing a benchmark* based on consensus definitions against which manager performance can be measured. By being transparent and replicable, these indices can be used both to understand performance as well as to provide low-cost beta to the asset class.
*The indices are administered by Bloomberg's authorized index administrator, Bloomberg Index Services Limited (BISL). BISL is responsible for calculation, governance and licensing of these indices.