In this article I would like to share with you a brief history of portfolio theory as well as the latest insights into risk premia. I hope this will help both clients and investors more generally in thoughtfully deploying capital. In the modern era of finance there is a revolving door between academics and financial practitioners, where models developed by academics are used to create better financial products and construct better portfolios. One of the major areas of academic research focuses around risk premia and tries to model the relationship between risk and return. Early pioneers in this area of research were Harry Markowitz, who developed Modern Portfolio Theory, and William Sharpe, Jack Treynor, John Lintner and Jan Mossin who developed the Capital Asset Pricing Model, the first framework to define this relationship.
Pre-1950s and the modern era, portfolio returns were thought to be purely down to investment manager skill and so all the returns were considered alpha. When academics found that a portion of this Alpha was actually attributable to the inherent return in the market, they created models to measure the difference between returns contributed by either Beta or Alpha.
How the composition of return has evolved over time
What’s Beta? and what’s Alpha?
Beta is the measure of volatility of an asset relative to its underlying market; it defines the return expected from an asset. The term Beta is most often talked about in relation to equity markets, but all asset classes have Beta including fixed income, commodities, and real estate. Whilst all assets have Beta, I believe they are all different types of Beta. Having said that, the same principles apply, and it still ultimately governs the return which is at least partly explained by Beta.
Further to this, a portfolio’s sensitivity to Beta can be used as a performance gauge. By stripping away the returns of bulk Beta, investors can understand more about what is driving the under- or outperformance of portfolios.
Alpha is an excess return not explained by Beta and is often thought to be down to investment manager skill. It is idiosyncratic in nature meaning it is uncorrelated to Beta; It is also limited, meaning only a finite amount is available.
Equities and Bonds
Another key insight that Modern Portfolio Theory made was that the characteristics of a portfolio matter more than the individual risks of a single asset. A selection of high-risk uncorrelated assets might actually be a better portfolio with overall lower portfolio volatility than a selection of low risk correlated assets.
A traditional balanced portfolio would historically consist of 60/40 equity bond split. Equities are often thought of as the risky part of the portfolio and bonds thought of as the lower risk part of the portfolio. The two asset classes have a long history of being relatively non-correlated to one another. However, in some market periods the correlation between the two asset classes has been positive. This would have most likely led to double digit losses during market drawdowns.
Bonds haven’t always offered protection against equity drawdowns, what’s the alternative?
Bonds have been a relatively good diversifier over the last 30 years; however, the argument that this relation now look fragile is growing. As nominal yields have fallen, the traditional ballast from government bonds (and by extension high quality credit) has dissipated. Arguments that policy makers have always had the ability to reduce rates is now massively diminished. With real yields negative on almost all high-quality debt, investors in the bond market presently have a conundrum. They must choose between running a more risky portfolio or purchasing traditional government bonds, which now offer worse protection than they previously did as well as the invariable erosion of their purchasing power over time.
The dissipation of the government bonds ballast combined with high equity market multiples has given rise to alternatives. Given our thinking on this is not unique, it is no surprise that alternative assets have enjoyed both interest and inflows. The below graph highlights this, particularly in relation to private equity assets.
Have alternatives helped investors?
Given the performance of the stock market and the continued compression of yields, some alternative investments haven’t maintained pace. This has caused some investors to still favour a more traditional equity and bond approach. To summarise in the words of another:
“Alternatives are a good thing but why are we doing alternatives? It’s important to understand why you are doing alternatives. By doing alternatives you gain three things but you have to be able to manage them: the ability to leverage more, the ability to go long short and the ability to take on a lot more liquidity risk explicitly as opposed to implicitly.” Mohamed El-Erian, in Conversation with Frank Fabozzi by Portfolio Management Research.
There is a broad range of different types of alternative investments with significantly different characteristics. It has become a bit of a minefield for the more general investor, particularly those who require liquidity, transparency and don’t have the necessary team to access complexity.
If we use hedge funds as an example:
Hedge funds by name indicate they have a hedge on the market and thus one expects them to hold a relatively low amount of Beta and/or be uncorrelated to markets. Initially, when I looked at the data, I found that hedges looked relatively uncorrelated to markets and looked to hold relatively low amounts of market Beta. However, adjusting for monthly pricings, I found hedge funds on average hold around 0.5 Beta and are fairly correlated in aggregate to traditional equity and bond markets. Because this Beta is commoditised and cheap, paying a premium for this doesn’t seem ideal.
This cocktail of returns isn’t ideal but I believe it is born out of necessity. In my view it is partly down to behavioural biases that investors exhibit as well as risk management. If a hedge fund strategy theoretically did not run Beta, it would require zero investment. This is because the long positions act as collateral to the short positions.
In reality, some capital will always be needed, and in my view, this capital should be viewed as margin against the strategy. Funds that run a levered strategy might offer better value to investors, but in periods when the strategy is under stress, the fund might find it hard to raise the capital required to meet margin calls. There is clearly a balancing act between offering clients strategies that deliver concentrated returns, and risk management.
We have seen in the past that investors find it difficult to look past drawdowns and are reluctant to add capital at times of distress, partly because they often coincide with periods of market dislocation. Given the opportunity cost of this margin sitting idle, adding Beta to the strategies seems obvious, but this will be expensive for the investors, losing a performance fee on this commoditised return.
With the protection being diminished from bonds and some problems with alternatives, what other forms of return are available to investors which are both systematic in nature and uncorrelated to traditional equities? To try and conceptualise this, I take a step back to the concept of Beta and Alpha and how returns are derived.
What are Alternative Risk Premia?
After academics modelled the relationship of beta, additional explanations for excess returns started to appear. The most notable and popular example of this was the Eugene Fama and Kenneth French 3 factor model, which modelled additional factors which can be used to capture returns not simply explained by beta. These were Value (being cheap beats expensive on average) and Size (being small companies on average outperform large companies). Eugene Fama and Kenneth French model was later expanded in 2014 to include Profitability and Investment and since then a number of style risk premia have been found, some of them more robust than others.
These strategies only really became investible in the early 2010s when the technology had caught up to the academia. The first movers into the use of alternative risk premia were the Nordic pension and sovereign wealth funds; today the level of interest and the investors using these strategies are more geographically and institutionally diverse.
A similar new research area is Strategy Risk Premia sometimes referred to as “hedge fund replication” or “hedge fund beta”, where returns are derived from hedge fund strategies. Strategies like Global Macro, Relative Value and Event Driven. What industry practitioners are starting to find is that some of these return streams can be extracted through “rules based” and transparent active management.
The idea that not all market returns are explained by Beta, and that there could be other systematic factors such as alternative risk premia which also explains these returns, is both interesting and important. This particular area of investing is both evolving and dynamic, with it being grounded in academia and now more feasible than ever. I believe alternative risk premia, both in terms of research and implementation could form one of the best justifications for actively managed portfolios. As long-standing active market practitioners, we believe in looking beyond limited Alpha to other sources of both diversification and returns. As academics build models and implementation becomes possible through better infrastructure, accessibility and transparency, I feel optimistic about seeing better portfolios and products to meet clients financial objectives.