Key Takeaways
- The failure of traditional sources of diversification in recent years has underscored the need for additional tools to diversify portfolios. We believe that liquid alternatives may serve a key role in addressing this diversification dilemma.
- Our understanding of alpha has evolved alongside the evolution of the alternative investment landscape. We believe that alternative risk premia (ARP) — market factors once lumped in with alpha — are a compelling option for use in liquid alternative funds given their liquidity, low or negative correlation with equity and fixed income, and low-cost implementation.
- We believe including a portfolio of ARP in a 60% equity / 40% bond portfolio may have improved risk-adjusted return over the past eight years.
- Portfolios of alternative risk premia can serve other portfolio purposes, such as complementing traditional multi-asset positions and addressing gaps in hedge fund strategies.
Using Systematic Liquid Alternatives for Cost-Effective Diversification
The painful failures of traditional sources of diversification in recent years have crystallized the need to incorporate truly uncorrelated, complementary sources of return into traditional portfolios, beyond the classic 60% equity / 40% bond mix. Equity and fixed income indexes ended 2023 near their highest correlation on record, as these two assets comprising the universal standard ‘balanced portfolio' moved in relative lockstep for most of the preceding 24 months. Display 1 shows that this stretch was no fluke: the two asset classes have historically gone through long stretches of significant positive correlation.
Investors have responded with increasing interest in alternative investments, to pursue greater downside mitigation and gain differentiated market exposures. Over the past several decades, the universe of alternatives experienced substantial growth, and evolved to encompass myriad asset classes, structures, and strategies.
Hedge funds, in particular, have long been a popular vehicle for accessing these differentiated exposures. Hedge fund returns are often generated with very little reliance on the overall market, meaning the alpha generated is typically diversifying to traditional stock and bond investments. As the universe of hedge funds and other alternative assets has grown and evolved, so too has our understanding of the drivers of their returns. As a result, we now have a more granular picture of alpha as a combination of three elements: skill, the liquidity premium, and alternative risk premia (ARP). We believe this insight into alpha has important positive implications for investors seeking new tools for diversification through liquid alternative funds.
Display 1
The value of bonds as diversifiers has fallen as their correlation with stocks has grown
Correlation of Global Equities and Bonds
Source: Bloomberg U.S. Aggregate and S&P 500 from July 31, 1985 - December 31, 2023.
A New Perspective on Alpha
Our beliefs around alpha sources build on the concepts that were originated in the 1960s with the Capital Asset Pricing Model (CAPM, Jack Treynor, William Sharpe and others), which was later expanded into the Three-Factor Model in the 1990s (Fama and French). These practitioners determined that, broadly speaking, a fund's total return can be decomposed into three parts: cash, beta (or exposure to market premia), and alpha (Display 2).
Display 2
Initially, all alpha was attributed to skill…
Display 3
but skill is now viewed as one of three kinds of alpha
In early iterations, when these models were applied to alternative investments such as hedge funds, all alpha generation was attributed to manager skill. But the growth of strategies and asset classes commonly employed by hedge funds has refined our understanding of their return drivers: We have found that part of the return that had been attributed to skill, may actually have been the result of exposure to two other sources — various alternative risk premia (ARP) or the liquidity premium (Display 3).
Hedge funds and other alternative investments typically offer some combination of these three alpha types — skill, ARP, and the liquidity premium. The recognition of three different alpha types opens a more transparent window for alternatives investors to know what they own.
This insight has key implications for investors when considering both the fees associated with investing in alternative assets and the structure used to access each alpha source. Skill commands the highest fees (correctly, in our view) for the value delivered in terms of investment selection and timing. Plus, managers often have investment theses which may take time to play out, or managers may seek to capture the liquidity premium in more thinly traded or less liquid securities. Thus, we believe many hedge fund strategies are not well suited for daily liquid fund structures. As a result, hedge funds are generally offered through limited partnerships offered to qualified purchasers, usually with limited liquidity. Alternative risk premia, however, are not reliant on unique skill and are implemented in a rules-based process. Thus, we believe that ARP can potentially be offered more inexpensively to investors compared with skill-based alpha, and are well suited in open-end funds with daily liquidity.
Display 4
Recognizing alpha as three components helps investors know what they own
The statements above reflect the views and opinions of the MSIM Hedge Funds Team as of the date hereof and not as of any future date, and will not be updated or supplemented.
Looking Under the ARP Hood
In financial terminology, a risk premium is the extra potential reward investors expect to receive relative to an appropriate reference. For example, the equity risk premium compensates investors for assuming systematic market risk (or beta) which is the equity market's return over the risk-free rate.1
As the name suggests, the concept underlying alternative risk premia is the potential reward to an investor for taking on risk that is ‘alternative' to traditional market risks or traditional beta. These risk premia often seek to exploit the fact that the performance of different groups of securities is linked by shared factors like size, value, growth, momentum, and carry. Alternative risk premia are structured in a long/short fashion, which enables managers to isolate the risk premium associated with each factor.
Consider this example. A manager who seeks to take advantage of the size premium, which refers to the tendency of small caps to outperform larger stocks over the long term, can simultaneously establish a long position in small-caps and a short position in large-caps. Any sentiment driving the market as a whole will affect both groups equally, but oppositely. The result is that the manager will capture the pure premium small-cap stocks may deliver over large-caps, independent of fluctuations in the broad market beta.
Size is just one of many risk premia, which span all geographies and, importantly, multiple asset classes, including equities, rates, commodities, currencies. In addition to size, Display 5 highlights commonly used ARP, which often result from recurring investor behavior patterns or structural conditions.
For example, momentum refers to the herding behavior of investors when they "chase winners and sell losers." When stocks trade at below fair value, they can be classified as value stocks, based on the expectation that their prices will increase as they revert to the mean. Growth stocks are ones with high valuations in anticipation of above-average earnings growth, and are often the counterpart to value in ARP strategies. Investor mispricing of asset yields may lead to carry opportunities where investments that offer higher yields tend to outperform.
Display 5
ARP span all geographies and asset classes, including equities, rates, commodities, and currencies
Source: Morgan Stanley Investment Management. For illustrative purposes only. Not an exhaustive list.
Potential Benefits of Investing in ARP
- Diversification: The most obvious benefit is the potential benefit an investor could receive in exchange for taking on a specific exposure. Many alternative risk premia exhibit low correlations to traditional portfolio investments potentially making them good portfolio diversifiers.
- Transparency: If access via bank swaps, the banks are required to document the universe of investments and metrics around how the index is constructed and traded. These are published and provide a good degree of transparency for those willing to conduct thorough due diligence.
- Liquidity: Alternative risk premia are often accessed in the form of bank swaps on indexes which implement the established ruleset. These indexes have daily pricing and, depending on the terms of the swap, the premia can usually be exited quickly, thus allowing them to be offered in a daily liquid fund structure.
- Efficiency: Alternative risk premia can be cost efficient and potentially capital efficient. Many risk premia funds do not have performance fees and can be cheaper than other sources of alternative exposures. When implemented through bank swaps, they require less capital commitment for leverage purposes. Thus any unencumbered cash can be invested in cash/cash equivalents, potentially generating prevailing market interest rates.
Using ARP as Building Blocks for Portfolio Diversification
While individual alternative risk premia typically access a rewarded factor, meaning a factor that has a positive expected return over the long term, on a stand-alone basis each individual factor is not necessarily expected to generate consistent, absolute returns. Factors may be in favor at different times depending on prevailing market or economic conditions, and there can be prolonged stretches of underperformance by individual risk premia, as investors with exposure to the equity value factor in the 2010s can attest. However, individual ARP have demonstrated little or no intra-strategy correlation with one another, and typically have low correlation to traditional markets, making them attractive portfolio "building blocks" (Display 6). Thus, we believe that their highest utility comes from combining multiple ARP strategies into a single diversified portfolio.
Display 6
Individual alternative risk premia may have low correlations to traditional markets
Correlation of Risk Premia
Source: MSIM Hedge Funds, Bloomberg. MSCI World Gross and Bloomberg U.S. Treasury. Correlation of weekly returns measured from January 7, 2011 - May 10, 2024
How Allocations to Liquid Alternatives Can Enhance Portfolios
- As a complement to traditional multi-asset positions: Introducing ARP to a broader portfolio of traditional asset classes may provide greater diversification and drawdown protection during periods when they all exhibit high correlations. ARP can also supplement or replace the fixed-income allocation as a diversifier to equities, without adding duration exposure.
- For hedge fund portfolio completion: By addressing gaps and concentrations in existing factors, the inclusion of an ARP allocation in a hedge fund portfolio could add diversification, balance and cost effectiveness, in a structure better able to adapt to market regime changes.
- As a substitute for hedge fund positions: We believe traditional hedge funds and commodity trading adviser (CTA) structures offer valuable alpha opportunities—specifically those derived from either skill or liquidity premium—that ARP funds are not designed to provide. But when investing in hedge funds or CTAs is structurally difficult, for liquidity, transparency, or governance reasons, ARP is a strong alternative.
- As the "liquid end" of a broadly diversified portfolio of alternative investments: Dedicated alternatives portfolios are often less liquid, especially those with high allocations to private equity or credit. As such, they hold high levels of cash to manage redemptions and meet capital commitments, which can create a cash drag. Allocation to an ARP portfolio provides opportunity for "cash-plus" returns—an improvement over idle cash.
A New Alpha Allocation for the 21st Century
Evolution in the alternative investment space has allowed us to evaluate and extrapolate different sources of alpha more effectively. We believe alternative risk premia — one of these alpha sources — can offer the diversification that traditional assets have struggled to provide, complement traditional multi-asset positions, and address gaps in hedge fund strategies all in a liquid, low-cost, and transparent format.
1 More precisely, beta is the coefficient in the CAPM expected return formula that is used to describe the volatility of a stock or portfolio relative to the broad market. By definition, the beta of the broad market — say, the S&P 500 — is 1. In the CAPM formula it would be expressed as 1 x the equity premium (the market return minus the risk-free return). Of course, the excess return implied by the equity premium — or any other risk premium — may never be realized over any given investment horizon; that is the nature of risk. But the price of equities must reflect a valuation that includes a risk premium that assumes anticipated performance is realized.
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