Emergence of Alternative Risk Premia / Smart Beta

Description
Traditionally, portfolio returns were believed to be made up of Alpha and market Beta. Over the past few years a new thesis has caught the imagination of a fast growing investor base. Compelling research from credible sources has established that a significant proportion of the returns classed as Alpha can be captured with a systematic factor based investment methodology called Alternative Risk Premia or Smart Beta (ARP/SB).

WHAT IS ALTERNATIVE RISK PREMIA / SMART BETA

Alternative Risk Premia (ARP) investing is centred round the premia associated with long established investment themes. For example, that systematically investing based on the concept of Momentum produces persistent positive returns over time has been observed empirically, academically verified and widely accepted by the investment community. As such, the risk associated with it is seen as commensurate to the expected return. This is equally true for factors such as Value and Carry for example. The utility of these factors is that they capture a specific investment theme and are lowly or even negatively correlated with each other. When combined, they produce broadly the average of their cumulative returns but a risk that is much lower – an attractive risk/return profile borne out of the value of diversification.Therein lays the attraction of ARP investing. Smart Beta is the combination of ARP with a specific market Beta. The “Smart” in Smart Beta is the ARP. ARP has a Total Return construction and Smart Beta is long-only.

COMMODITISED ALTERNATIVE RISK PREMIA / SMART BETA STRATEGIES

The key proponents of ARP/SB based strategies are ETF providers, Index providers and Investment Banks. Lacking fiduciary responsibility, these entities seek to promote ARP/SB strategies through indexation. As such, the strategies need to be transparent and simplistic. To counter the low fee business model, they have also been designed for high capacity. Nevertheless commoditised products based on these strategies offer the prospect of outperforming the market capitalisation indices and can be accessed cheaply. As such, they serve a useful purpose.

ENHANCED ALTERNATIVE RISK PREMIA / SMART BETA STRATEGIES

Not constrained to the same extent, Asset Managers can develop and offer products with superior risk/return profiles compared to their commoditised counterparts simply by loosening the constraints alone. Asset Managers who have fiduciary responsibility and as such entrusted to act in the best interest of the investor have the scope to do much more than that.

PROPRIETARY FACTOR INVESTMENT STRATEGIES

ARP/SB strategies can be categorised as factor investing but not all factor investing strategies can be categorised as ARP/SB. A number of factor models borne out of proprietary research using esoteric factors or factor models deigned to capture a variety of security mis-pricing fall outside the established ARP/SB categories. These strategies are likely to have lower capacity. These strategies can be designed to offer a pay-off that is different or lowly correlated to their generic counterparts. These strategies can offer investors the prospect of much needed diversification to their portfolio.
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