Alternative Investment  

Where to look for alternatives to the equity market for returns

Where to look for alternatives to the equity market for returns
Credit: Philipp Birmes via Pexels

When equities rally, sometimes beyond what fundamentals would justify, a common argument for their continued outperformance is 'fear of missing out (Fomo)' – the idea that marginal buyers will be pushed into buying stocks as they chase the rally.

More recently, Fomo has been joined by Tina (there is no alternative) in the investment lexicon.

According to this thesis, with government bond yields so low and credit spreads razor thin, only equities are attractive for deploying investment capital.

Think what you may of valuations and return prospects, but we believe there’s an alternative place to fish for returns: alternative risk premia, or ARPs. It may be less catchy as an acronym, but it may offer portfolios something different and diversifying.

ARP strategies try to capture risks in financial markets that are persistent due to structural or behavioural reasons.

As we know, taking risks in markets should, over the long run, be rewarded.

While the equity risk premium is earned by investors willing to take company risk, ARPs most commonly target four factors: value, momentum, carry and quality.

These ARPs can in theory be applied across equities, fixed income, currencies and commodities.

There are many more factors out there, with hundreds having been researched, but these four have emerged as the most common and intrinsically understandable.

It’s worth noting that some strategies systematically sell volatility, in effect earning an insurance premium to give other investors protection against market drawdowns.

While these strategies can have long periods of positive returns and have a positive expected return, we believe they are not appealing in a wider portfolio context as they typically suffer when other assets that we hold in portfolios may also be losing ground.

Systematic and repeatable

The intention with ARPs is to gain exposure to factors in a systematic and repeatable way.

What that means in practice is processing market data with models to create signals on which assets to buy and which to sell.

This used to be the preserve of expensive hedge funds and investment banks, but over the past decade many more fund managers have been able to deliver such strategies in more transparent and lower-cost vehicles.

Indeed, we’ve developed a number of models to exploit ARPs and prefer to keep the ownership of the models we follow in-house.

When selecting ARP strategies, we generally look for simplicity, liquidity, transparency and diversification relative to other return streams in a multi-asset portfolio.

Calculating signals is done at a regular interval, most often weekly or monthly, but it can even be intraday.

This in itself creates two interesting discussion points around ARP strategies.

First, the quantitative nature of the strategies means that behavioural biases are ignored.

This makes it a useful complement to our main investment process, which is based on fundamental judgment and inevitably encounters some behavioural hurdles along the way (no matter how deeply we try to overcome them).