After years of positive equity returns, investors are preparing for a downturn. That’s good news for alternatives managers offering strategies less correlated to stocks and bonds.
For example, a recent survey by London-based consultancy firm bfinance found that 55% of institutional investors were reducing their equity exposures and moving into new asset classes in an effort to position themselves more defensively.
A key part of that has been a shift into quantitative and systematic strategies, including risk premia funds and managed futures – also known as commodity trading advisors (CTAs).
That move may be surprising given these strategies’ recent performance. The Société Générale Multi Alternative Risk Premia index is down by 3.15% year-to-date through October 3, and the Société Générale CTA index is down by 2.45% over the same period. CTA funds have been broadly down for more than three years.
So what is driving the renewed interest? Chris Stevens, director of diversified strategies at bfinance, said that investors were beginning to recognize that while the rally in equities has been persistent, it could not go on forever. ‘We’ve had a good run in equities, but I think investors are reticent to add to positions in fixed income with rates on the rise. So if you want to stay liquid, then you’re going to look at these strategies because they are less correlated to the equities market.’
Risk premia and CTA funds typically invest in very liquid parts of the market, including futures, currencies and FX forwards, moving in and out of these positions quickly and with relatively little friction. Stevens added that the diversity of asset classes and sub-strategies within the two categories of funds means that investors can construct customized portfolios benefiting from diversification and downside risk protection without the illiquidity associated with some alternative strategies.
Cost is also a factor. As investors have become more fee-focused in recent years, there has been a greater recognition that you can invest in some risk premia and CTA funds for less than the traditional ‘two and 20’ fee structure that dominates the hedge fund space.
Instead, these managers are often available for between 50 and 75 basis points – similar to what investors get with active equity funds. The result is a more complex, hedged portfolio without the high cost that has been associated with hedged portfolios in the past.
While the survey results indicate that investors are now looking at these funds from a more nuanced perspective – focusing on benefits such as diversification and risk management over outperformance – it remains to be seen whether they will be able to overcome the classic behavioral traps.
A big part of investing in uncorrelated strategies is being willing to withstand periods of underperformance if market trends change abruptly but don’t last long enough for these strategies to adjust. The market caught a glimpse of that in February when these two categories of funds failed to perform well during that month’s sharp drawdown.
‘Given the recent bullish run in equities, negative market moves have to be profound and prolonged for the models to correct themselves,’ explained David Regan, director of alternative investments consulting at Société Générale Corporate and Investment Banking.
‘That is why these funds will probably not perform well initially if it’s a drawdown that only lasts a few weeks or a month. We would need to see the trend fully reverse – perhaps something that lasts three months or more.’
Riding out the bumps
For risk premia funds, market trends also need to be consistent. If there is an abrupt spike in volatility, as in February, performance will drop off. But it will likely rebound if volatility remains high for a period of time.
Shane Shepherd, director and head of research at Research Affiliates, said investors should be prepared for some bumps along the way. ‘Risk premia funds have a hard time when you’re on the way into something – whether that’s persistently low volatility, for example, or persistently high volatility. Once you get there, these strategies come back,’ he said. ‘You also have to focus on which premia you’re invested in. Value factors have had a really hard time lately, but if we see volatility come back, there could be more opportunities for those factors.’
Chandra Seethamraju, director of quantitative strategies at Franklin Templeton Multi-Asset Solutions, agreed. ‘Understanding how the strategies are constructed is critical. You have to look at the risk premia that you’re investing in and be prepared to ride that out,’ he said.
For investors that are taking a fresh look at risk premia and CTA funds with diversification and risk management in mind, the key will be manager selection. Stevens said it was important to find managers that were transparent about how they have constructed their funds and aren’t overly reliant on back-tested data, as the risk of overfitting in model-driven strategies was high.
‘There is an opportunity when you are looking at portfolio construction to think through your objectives and find managers that are positioned strongly before a big market change happens,’ he said. ‘We try to take that message to investors so they aren’t forced into decisions and can plan ahead.’