Variety is the spice of ARP
By Hamlin Lovell, NordicInvestor
A growing number of “alternative risk premia” (ARP) “style premia” and “alternative beta” funds are being launched (at least 35 and counting), by large, medium-sized and small asset managers, including hedge fund managers, around the world. The ARP strategies generally claim to be 100% systematic. Some of the managers are purely systematic while others run both discretionary and systematic strategies. Some managers are the world’s biggest systematic, quantitative, CTA and managed futures managers while others asset management arms of insurance companies, or fund of funds and multi-manager shops.
How similar or different are ARP strategies? Superficially, they may seem much of a muchness, as they often have samey names for both the fund vehicles, and the underlying strategies.
we find that risk premia, style premia, and beta, with various prefixes, suffixes and qualifiers, are used interchangeably to describe essentially the same set of strategies.
The nomenclature of funds does not reveal clues as to their differentiators as we find that risk premia, style premia, and beta, with various prefixes, suffixes and qualifiers, are used interchangeably to describe essentially the same set of strategies. The choice of precise name is probably more about creating a brand image that resonates with investors, than anything else.
But a deeper dive under the bonnet reveals marked differences – as does a glance at the performance league tables. Correlations between the different funds can be lower than some observers might expect, and over some periods, different ARP strategies have even moved in the opposite direction.
One of the arguments for ARP is that part of the return stream from some hedge fund strategies could be obtainable if the “secret sauce” can be reverse engineered and replicated using computer code. Certainly, the “back-tests” of simulated or hypothetical historical performance do indeed suggest that some hedge fund return streams might have been produced from relatively simple rules. However, not all ARP managers can show a “real money” or “live” track records that has incurred the real-world costs of implementing a strategy. Only time will tell whether the assumptions underlying the back-tests prove to be realistic. Both the assumptions around costs and execution efficiency, and the observation period for back-tests, vary between managers.
Only time will tell whether the assumptions underlying the back-tests prove to be realistic. Both the assumptions around costs and execution efficiency, and the observation period for back-tests, vary between managers.
A further ARP argument is that fees could be lower if strategies can be implemented without large teams of researchers and traders. The first question here is whether the adaptive and evolutionary process driving systematic strategies can be copied contemporaneously – or only with the time lag that separates the in-sample back-test from the out of sample performance. The next question is whether the “half-life” of these strategies is long enough for them to be aped in this way.
But in any case, investors should not assume that any product labelled as ARP actually does have fees that are lower than hedge fund fees! The ARP universe has a huge range of fees. Some products charging as much as 1.5% management fee and 20% performance fee are in fact very close to average hedge fund fees (of 1.56% and 19%, according to a Preqin survey). Moreover, where investors have an appetite for new product launches, many hedge fund managers will offer deep discounts on “early bird” share classes for the first $50 million or $100 million raised. Some ARP strategies might struggle to match the fees on many hedge fund launches, some of which boast much longer real money performance histories than do ARP strategies.
Certain ARP products are unequivocally cheaper than the vast majority of hedge funds, and charge only flat fees, as low as 0.50% and 0.75%, with no performance fees. As such, they are presumably positioning themselves to compete with more sophisticated ETF products, and with the “clean” post-RDR, commission-free, share classes of mutual funds.
Some ARP strategies might struggle to match the fees on many hedge fund launches, some of which boast much longer real money performance histories than do ARP strategies.
ARP products also differ in the type and range of strategies offered. Some products may offer only three of four strategies, such as trend following, carry and value, while others offer ten or more sub-strategies. Within the equity space, dividend income, equity size, low beta, and low volatility are examples.
Even where the same three strategies are on the “menu”, there can be substantial variation in terms of “ingredients” and “recipes”. There are differences in which asset classes are used. Some products may only apply carry to currency markets, while others include commodities and equities. Value can also sometimes be restricted to equity markets, or it may be used across a range of assets.
Then if we drill into value equities, the simplest definition might be a price to book value ratio. At the other end of the spectrum, some managers are using as many as 20 or more proprietary indicators of value, based on extensive analysis of, and adjustments to, financial statements.
Additionally, certain managers are pursuing 10 or more risk premium strategies, which might include emerging markets carry, corporate credit, merger arbitrage, volatility risk premiums, mean reversion and so on. Some of these managers’ portfolio and return patterns may have very limited overlap with those only doing three or so relatively plain vanilla strategies.
All of the strategies aim to offer some form of risk premium return that is lowly correlated or uncorrelated with traditional asset classes (namely equities and government bonds) but they do vary even on this high-level goal. Some products with significant long-biased equity exposure have seen setbacks during the February 2018 selloff, for instance.
As the number proliferates, so too will the variety, increasing the need for investors to conduct thorough research and due diligence, in order to understand the risk exposures, and fee structures.
One manager I met recently predicted that with so many launches in the pipeline, there could be hundreds –or even thousands – of ARP products within a few years. As the number proliferates, so too will the variety, increasing the need for investors to conduct thorough research and due diligence, in order to understand the risk exposures, and fee structures.
Many ARP are in “liquid alternatives” structures such as UCITS in Europe, and ’40 Act Registered Investment Companies in the US. These will often have daily liquidity, though ARP strategies can of course be offered in a Cayman offshore fund, or an onshore Irish or Luxembourg AIF, that might have monthly or even quarterly liquidity. A few are also in ETF structures. Some larger institutional allocators would insist on their own segregated and separately managed account for ARP strategies.