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DeutscheAsset Management
For MiFID Professional Investor Only/For Qualified Investors (Art. 10 Para. 3 of the SwissFederal Collective Investment Schemes Act (CISA)).
For business customers. Not for distribution. Institutional/accredited Investors only. Not for retail distribution.
Please note certain information in this presentation constitutes forward-looking statements.Due to various risks, uncertainties and assumptions made in our analysis, actual events orresults or the actual performance of the markets covered by this presentation report maydiffer materially from those described. The information herein reflect our current views only,are subject to change, and are not intended to be promissory or relied upon by the reader.There can be no certainty that events will turn out as we have opined herein.
Q4 2016Marketing material
Alternatives Hedge Fund Advisory
Alternatives Risk PremiaJigsaw falling into place
2 Risk Premia | Q4 2016
Why risk premia?
Characteristics
Portfolio diversification
Transparent
Trend towards full look through of underlying positions. Glass box not black box approach
Explainable
Risk premia are built upon empirical observations
Persistence
Risk premia may be observed over a long period of time
Flexible
Can be accessed through a number of different instruments and customised
to meet an investors requirements
Absolute returns
Portfolios aim to generate returns regardless of the market direction
Low fees
Low fee implementations with typically no performance fee
Traditional asset class portfolio construction may give a false sense of diversification due to the correlations between asset classes. By viewing the exposure through a factor lens, a more robust diversification can be targeted by constructing the portfolio using risk premia. The below example illustrates how a multi-strategy portfolio which may look diversified at an asset class level, in fact has around 50% exposure to equity premia which may imply under-diversification.
US Equities
Europe Equities
Japanese Equities
EM Asia ex Japan Equities
Latin America Equities
Europe IG Credit
US IG Credit
Europe High Yield
US High Yield
US Soverigns
FI EM
Convertibles
Commodities
Alternatives
Commodity Momentum
Equity Emerging Markets
Equity Liquidity
Equity Momentum
FX Carry EM
Rates Carry
Rates Value
Traditional portfolio view Risk factor view
Hypothetical example, for illustrative purposes only
3Risk Premia | Q4 2016
Will 2016 be remembered as a turning point in time for risk premia investing? The growth in risk premia has indeed been impressive this year and this approach to investing has increasingly been viewed as a differentiator to other liquid alternative investment techniques and appears to assert itself as an asset class in its own right – both in terms of investor appetite but also with regards to the number of vehicles and solutions on offer. This deepening of the investible universe has coincided with a significant increase in estimated AUM allocated to risk premia over the course of this year. For example a survey* carried out mid-year revealed that more than 80% of respondents were currently investing in, or looking to invest in, risk premia solutions. According to the same research, AUM in risk premia related strategies is projected to rise from around 250 billion USD in 2014 to more than 1 trillion USD by the end of 2019, which if true would make this the fastest growing investment product in asset management history*.
Risk premia providers have been (and still are) expanding their investment universe to meet a growing level of investor sophistication and demand with customisation and unique factor exposures to make it an attractive solution for investors. As this investment universe becomes less of a niche approach, the level of transparency has increased and a full daily look through to the underlying holdings for the investor is becoming the norm. Finally another key reason for the growth in popularity of risk premia is the increased overall understanding of the asset class by investors in terms of what can be achieved and how they can be integrated into their portfolios.
In the light of this our paper serves to break down and further demystify the increasingly complex and esoteric world of risk premia so it may be better understood by all investors. We share our definitions followed by our understanding of the risk premia universe and how it can be best classified. Insights are then provided into how portfolios can be constructed. Finally we touch upon some of our work on criteria for selecting providers and give our view on the often controversial topic on whether risk premia can be timed.
2016: The rise of the risk premia?Introduction
AUM in risk premia related strategies is projected to rise from around 250 billion USD in 2014 to more than 1 trillion USD by the end of 2019.
Tim Gascoigne Global Head of Hedge Funds Deutsche Asset Management
Ben Arnold Portfolio Analyst Deutsche Asset Management
Nicolas Laporte Head of European Portfolio Management Deutsche Asset Management
*Source: Citi Prime Finance survey, Risk Premia, the 3rd Generation of Asset Allocation
4 Risk Premia | Q4 2016
What are risk premia?An intuitive but complex world
The risk premia definition is intuitive but what is behind this definition is complex. It is intuitive in the way that investing in risk premia is like selling insurance contracts. Like an insurance seller, the investor in risk premia is expected to get paid (premia) for the specific risk he/she is willing to take. These premia exist due to specific market structures which in turn are driven by persistent investor behaviours and different types of investment constraints. These anomalies can be harvested but they come with specific risks and hence their name: risk premia.
Unlike traditional assets, these premia can be captured by combining multiple instruments, taking long and short positions as well as using specific trading rules in order to isolate the premia as precisely as possible from market noise. Allocating to a risk premia would not generically be characterised as allocating to a particular asset class but rather as creating a strategy that will provide a stream of returns related to a specific risk borne by the investor.
Moreover, even for the most simple risk premia, there is no such thing as a universal truth to define the most efficient way to harvest it. Each provider relies on its own research and findings, making cross-provider comparison a complex and delicate task; however research, construction and execution can give an individual provider an edge in the delivery of a particular premia. Furthermore, the range of risk premia is large and expanding with new research pushing the current boundaries of the available strategies. This means any attempt to precisely qualify and quantify the risk premia universe represents an ongoing exercise.
Our analysis of the risk premia universe has led us to segregate it in two main families; each family enclosing a broad range of risk premia which themselves can be classified by asset class and style.
The first family is the academic risk premia, a name referencing the number of research papers that have been written by academics on them for decades in some cases. Generally speaking they are relatively simple in nature. The other family are the implied risk premia. These tend to be more complex and have been developed more recently.
Academic risk premia
One of the main drivers of academic risk premia is the existence of sustained behavioural biases by market participants. As a consequence, an investor who is able to understand these biases can harvest these by accessing the relevant premia. For example in the case of market underreaction: the investor is compensated for reacting faster to price changes, news, analysis and fundamentals when compared to the marginal investor. In this vein, momentum-based risk premia aim to capture the phenomenon of assets with higher (lower) recent past returns outperforming (underperforming) over time.
In the case of market overreaction, the investor is compensated for assessing recent price changes, news, and fundamentals into the future. Equity value investing illustrates an example of market overreaction as assets below (above) fair value tend to outperform (underperform). From a risk perspective, the market overreaction is explained by fact that investors tend to overreact to value stocks’ embedded risks such as distress risk (companies with undervalued stocks are more likely to be in financial distress), cash-flow risk and liquidity risk.
Note that in the case of value investing in the risk premia space, a key parameter to determine is the fair value of an asset - a subjective number which naturally leads to some dispersion from different providers in this space.
The other main characteristic behind academic risk premia is the fact that some investors are constrained in their behaviour. As a premia investor, positive yield can be generated by holding assets or taking risks that marginal investors cannot (or do not want to) hold. This is called carry. While carry can be derived from all asset classes, it is with commodities that the concept is best expressed. Under normal market conditions, commodities exhibit backwardation along the futures curve, stating that commodity producers have been selling long-dated contracts at a discount in order to hedge their output, whereas consumers
Academic Implied
Behavioral explanations rely on investor under/over-reaction
Source: Deutsche Asset Management, Nomura as of November 16 For illustrative purposes only
5Risk Premia | Q4 2016
have been buying short-dated contracts at a premium in order to secure near-time consumption. Therefore an investor who buys from producers and sells to consumers can capture a “risk premium” in the form of a roll yield – assuming, of course, all else being equal during the invested period.
Implied risk premia
Implied premia is our second family of risk premia. This family encompasses all implied parameters which can lead to arbitrage situations such as volatility, dispersion, dividends or liquidity. The existence of these premia is derived from specific market flows which sometimes have common ground with the academic risk premia family such as investor patterns, hedging needs or regulatory constraints.
Volatility risk premia investing across asset classes relies on the historical acknowledgement that implied volatility tends to be higher than realized volatility and is explained by a structural
imbalance between supply and demand in the volatility market; a trend especially observable since 2008 as there is more demand for protection and less ability to warehouse it. In the equity space, the volatility premium is captured by systematically selling volatility through variance swaps where one would receive implied and pay realized volatility. A more elegant way to exploit this risk premium is to run dispersion trading. Dispersion trading exploits the phenomena that the difference between implied and realized volatility is greater between index options than between individual stock options. Investors therefore could sell options on the relevant index and buy individual stock options. This strategy tends to be profitable during a period when individual stocks are not significantly correlated and loses money during stress periods when correlations rise.
In the case of the merger arbitrage premium, the investor receives a spread that rewards them for the risk of a deal collapse. The larger the uncertainty on the outcome of that potential deal, the larger the spread is and as a consequence the larger the premium to be harvested.
Finally another implied related risk premium strategy involves trading dividend futures. Over the past few years dividends have ceased to be considered a side product of equity investments, and the assertion that they constitute an asset class in their own right has become more and more common. Dividends can be traded using futures, opening a new door to possible premia to be harvested. About five quarters before expiry, dividend futures usually undergo a profound change in their risk dynamics as the stock tends to trade at a discount to the expected dividends. As time passes, the discount falls. This “pull-to-realized” behaviour can be harvested.
Once divided in two broad families, risk premia can then be classified per asset class and styles, creating a two dimensional matrix as shown below, where peer group analysis and more in-depth analysis can be run at the bucket level.
Source: Deutsche Asset Management as of November 16
Risk premia matrix
Carry Curve Liquidity Mom. Quality Size Value Volatility
Commodities
Credit
Equities
Fixed Income
Forex
Academic risk premia Implied risk premia
Source of the carry premia on the commodity curve
Pri
ce
Buying from consumers
Hedging ofproducers
12-month FuturesOne-month
Source: Deutsche Asset Management, Nomura as of November 16 For illustrative purposes only
6 Risk Premia | Q4 2016
Portfolio construction Building bridges
Choosing providers A broad and ever expanding universe
From an investor’s perspective, the risk premia story is a fascinating on-going development. Within a couple of years, a new investment toolbox has been developed and made available at a relatively low cost for investors. This toolbox is extensive: available premia range from classic academic strategies to strategies which are much more complex that have been used by hedge fund managers for decades.
Assuming that an investor has defined a clear methodology to assess, filter and select a sample of candidates to allocate capital to, the next step is to define a portfolio construction process. In the active space (excluding the case of fixed allocations), we outline two ways to tackle this challenge, both of them with their own advantages and drawbacks: a systematic approach and a discretionary approach.
The systematic approach relies on a portfolio optimisation model that rebalances the allocation on a regular basis without human intervention. Typically, the optimisation aims at maximizing returns while minimizing a user defined risk metric. A classic approach is to run a variant of the risk parity model. The systematic approach ensures adequate diversification and the absence of hidden biases in the portfolio - it is disciplined. The discretionary approach consists of building a portfolio based on a qualitative decision making process. In contrast, it has more tactical positioning and can implement allocations with a more forward looking perspective than systematic approaches.
The main downside of the systematic approach is that the models rely on historical data while the main downside of discretionary approach is that the allocation can build up unexpected biases in terms of sensitivities to some factors and can be subject to weaknesses of human investor behaviour such as loss aversion, anchoring and herding.
One suggested approach works on a compromise, building a bridge between the two portfolio construction methods. First, one can use a panel of quantitative approaches to define weight ranges where each weight corresponds to an optimal solution from a risk/return perspective. One can employ different approaches to assess risk with a focus on correlation analysis as historically correlation has had a dominant role in the success or failure of any risk premia allocation.
The next stage is based upon one’s understanding of the behaviour of each risk premia, namely how cheap or rich one perceives them to be, as well as macro considerations and on-going tactical opportunities. From this a discretionary allocation for each risk premia is made within each of the bands resulting in a final allocation. In this vein, quantitative methodologies are useful tools to define allocation boundaries, and when combined with what can be seen as a macro overlay can yield a portfolio that is more robust than either a purely discretionary approach or a purely systematic approach.
When it comes to providers of risk premia, there is a plethora of choice. Most investment banks offer a range of off-the-shelf strategies. These strategies, if one invests in a particular size, can be more or less customized to match a client’s needs. It provides an almost overwhelming choice and as each provider has their own views on how and what information for each strategy is disclosed, it makes any comparison exercise a difficult process. For this reason, it is advisable to use filtering methods to reduce the size of the universe to a more manageable size, allowing one to carry out a deep-dive on the relevant risk premia remaining.
One can develop a range of quantitative methods (for example principle component analysis) and measures that rank strategies across variables but also take the decision to explore each group of risk premia available to investors from a bottom up view. Such an approach is preferable due to the fact that even for the most simple risk premia, the implementation and trading by each provider is different. This results in a broad range of data matrices where risk premia are sliced and diced not only from a statistical and cost perspective but also from a qualitative standpoint where key construction elements are detailed across each risk premia within a style and an asset class. Further, the statistical perspective is easier to grasp when combined with the analytical work done on a qualitative basis, facilitating decision making when it comes to selecting which are the risk premia one wishes to consider as inputs to the portfolio construction.
Risk Premia selection process
Risk premia providers
A B C D E F
Risk premia universe 200+
Around 50Portfolio
candidates
Source: Deutsche Asset Management as of November 16
7Risk Premia | Q4 2016
One of the most intensely debated and arguably the most controversial of topics in the risk premia space is whether they can be timed or not. It is a debate which has traditionally polarised investors. As transparency has improved as well as the expansion of the investible universe, the discussion has continued to evolve.
Let’s return to our previous definition of risk premia from before: systematic ways of exploiting persistent inefficiencies that arise in the market generally stemming from structural imbalances. While in the long run these inefficiencies allow the investor to generate a positive return, looking back through history, it is clear that there are periods that favour one risk premium over another and in extreme cases, there are periods when certain risk premia will underperform for a significant amount of time.
Determining the drivers of this under/outperformance can be a difficult task and harder yet is the prediction of when the change in these drivers will occur. Certainly for some risk premia such as momentum, determining when a trend will start or break would be the Holy Grail for investing. As such timing certain risk premia can be a very difficult task and many risk premia investors will choose to accept this and instead implement a purely passive or risk parity approach to investing.
However, this may not be the case for all risk premia. Premia that aim to capture an arbitrage or carry spread can be monitored on a historical basis and if one accepts that over time, asset prices will tend to mean revert to their historical norms then it is possible to build a framework for determining whether a risk premia is currently “cheap” or “expensive”. This is perhaps best illustrated by looking at a carry strategy – if we look at the chart on the right we can see the current FX carry being compared to historical averages for a number of currencies. In this example, it would indicate that we should allocate more to emerging market vs developed market FX carry premia as the former looks much cheaper through this lens. The same idea can be applied to other asset classes such as equities, commodities and fixed income.
Another take on timing risk premia is to use them as a tool to implement more directional tactical investment decisions – in a similar way to how a macro hedge fund may invest. For example, if we consider more traditional risk premia in the equity space; an investor might go long the S&P and short the risk free rate if they want to take a directional view on the US stock market. The same can be applied to fixed income or commodity instruments if an investor also has a directional view on those markets and wants to take on the corresponding risk for investing in them. Certain risk premia may also lend themselves to trading on a risk on/off basis such as liquidity or emerging market bias premia (for example long the MSCI EM index/Short S&P 500) and if an investor has an opinion on the market direction or regime for these, they can implement their risk premia investments accordingly. This approach allows a risk premia investor to take on a more tactical approach to investing in the strategy using their own discretion.
The recent spark in interest for risk premia has led to a proliferation of products and solutions on offer for investors. The approaches in some cases vary significantly and understanding their different nuances and behaviours is crucial for successfully investing in the asset class. Our belief is that careful provider selection is paramount and that while portfolio construction can be enacted on a largely systematic basis, there is value to be added employing discretion in order to tactically position the portfolio and to time certain premia.
This recent growth is understandable as investors look more for a low cost alternative to investing in traditional hedge funds as they become increasingly more discerning about their investments with regards to transparency, costs and flexibility and we believe risk premia investment solutions offer a very compelling response to this problem. However, only time will tell which approaches will be successful and which may lack substance when it comes to performance.
Timing risk premia Adding value through discretion
Conclusion The move from a black box to a glass box
Current carry vs 18 month average carry for selected currencies
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Current Carry
18m Average
BRLUSD
IDRUSD
INRUSD
ZARUSD
MXNUSD
NZDUSD
AUDUSD
HUFUSD
NOKUSD
CADUSD
SGDUSD
GBPUSD
SEKUSD
TWDUSD
EURUSD
KRWUSD
JPYU
SD
Source: Deutsche Asset Management, Bloomberg as of November 16
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