A sheep in wolves’ clothing
This fall I have the pleasure of serving at the jury panel for a few IPE 2017 Awards. The IPE Awards each year recognise the bar-raising achievements of the diverse pension funds and similar pensions providers across Europe and celebrate excellence by creating a meaningful and broad set of benchmarks. It’s encouraging to see the proficiency and the high level of ambition with which pension funds take on their objectives amid ultra-low interest rates and high valuations across financial markets.
It is interesting to note that quite many pension funds, in their entries, highlight allocations to “absolute return strategies” as a remedy for poor “beta” prospects and difficulties of generating “alpha”. It is almost as if asset owners and managers believe that there is a magical third source of return beyond “beta” and “alpha”. My argument is that there are, intrinsically, only two return drivers in financial portfolios and that this is crucially important for understanding, and potentially benefit from, “absolute return strategies”.
Beta and Alfa decoded
It makes better intuitive sense to think of beta as a compensation for having an exposure to economically motivated risk premiums and alfa as a reward for exploiting inefficiencies in financial markets. The taxonomy below is helpful.
The two sources of return are almost diametrically opposite to each other. Risk premiums are systematic while inefficiencies are sporadic. The size of risk-premiums and the degree of inefficiency are of course time varying, but still. One investment approach is passive while the other is active. Somewhat related to this is the frequency of portfolio positioning and time-horizons. Harvesting risk-premiums is related to what economists label a public good i.e. the fact that one investor harvest a risk-premium doesn’t exclude other investors from doing the same. Active return, on the other hand, is a private good implying zero-sum characteristics. Exposure to most systematic risk-premiums are cheap while (pure) alpha is (and should be) expensive; all goods and services that are valuable and in short supply are pricey. Risk-diversification between different asset-classes is so-so while uncorrelated active returns are (per definition) a fabulous portfolio diversifier. As far as the Great Debate of Market Efficiency is concerned, harvesting risk-premiums is fully compliant with (or rather an essence of) the Efficient Market Hypothesis while active returns imply inefficient markets.
Risk premium diversification and unconstrained portfolios
Absolute return strategies don’t get your portfolio beyond this rationality. It should be the same Investment Beliefs that underpin absolute return strategies as that of constructing traditional portfolios. The taxonomy above is thus just as relevant for absolute return strategies.
Even if one label (and sell) investment products as absolute return, there are still, inherently, only two sources of return. Either compensation for taking on systematic (undiversifiable) financial risk or reward for a skill-based exploitation of superior market insights. Absolute returns are not just something one can pluck from the air.
Bearing that in mind, absolute return strategies can play a decisive role in portfolio construction and add returns and diversification to sophisticated institutional investing. Exposure to non-traditional risk-premiums has the potency of increase risk-adjusted portfolio returns. This is especially relevant for long-horizon investors that should be able to absorb (and profit from) short-term market volatility. There are conceivably many examples of such alternative risk-premiums that investors can harvest but the purpose of this specific blog is not to make a comprehensive list. However, a couple of alternative risk-premiums exemplifies the point; systematic returns from Insurance-linked securities and selling equity volatility. Both strategies earn a long-term premium for insuring other investors from tail risk exposure; physical (often weather-related) event risk and episodes of (sometimes very) poor financial market conditions. In mean-variance space, such strategies have historically improved the long-term risk-return characteristics of traditional portfolios. Beyond mean-variance, by selling equity volatility investors get compensated for (potentially huge) portfolio losses at times when traditional equity-centric portfolios are also under duress. Protecting insurance companies from tail risk is also a strategy with event characteristics but occasional portfolio hits doesn’t correlate with the rest of your portfolio. Returns, across a large set of Hedge-funds and over time, correlates well with the returns from passively selling equity volatility.
Financial engineering skills is not the same as superior market insights
Absolute return strategies are typically less constrained than traditional mandates. That improves the potential for higher information ratios as market insights can also be utilized on the “short” end. Unconstrained betting on “underperformers” should, of course, be just as profitable as betting on “outperformers”. Important to remember, however, is that this cuts both ways. “Leverage” boost returns when bets are going your way but also enhances losses when they don’t. At the end of the day, thus, what matters is if the manager has superior market insights or not; i.e. being able to pursue and find (pure) alpha.
Research has shown that Hedge Fund returns are a blend of traditional risk premiums, alternative risk premiums and a small (and often negative) return beyond systematic risk-premiums. The mix of return sources, of course, differs widely between different managers. Just as traditional “alpha” differs across traditional portfolio managers. The crux of the matter is to understand how specific managers generate portfolio returns and what kind of risks/skills asset owners get exposed to. It is more complicated to construct portfolios that give exposure to alternative risk premiums than traditional risk premiums. However, financial engineering skills are not in short supply to the extent that superior market insights are and should thus not warrant close to “alpha-fees”. Asset owners should, as well, be cognisant of paying high management fees for portfolio leverage as leverage is just another form of systematic risk exposure.