Tuesday, May 28, 2019

How alternative risk premia are built - The devil is in the details

What generates a return difference between similar alternative risk premia - the construction details. Alternative risk premia have to be defined and constructed to isolate a specific risk factor. Institutions can define a risk premium differently because there is no standard definition for most. Alternative risk premia can be described in generalities but the actual construction is based on a set of specific criteria and definitions. These criteria can be used as a short-hand for what you need to know to understand the performance differences between risks premia. 

For example, in the case of a commodity backwardation risk premium strategy, the criteria for making the strategy index can be useful construction checklist. 

  • First, what is the universe of testing. How many commodities are included in the analysis? There can be a limited set of very liquid markets or a broad list of all commodity futures markets. Some backwardation strategies use less than 20 markets and make specific exclusions. Others may consist of a broader basket.
  • Second, the definition of the factor also critically affects return. For example, the backwardation could be measured by the difference between the first and second nearby contract, or it could be the maximum backwardation over a longer time to maturity. It could also include some exclusion for seasonality. 
  • Third, the scoring method serves as the basis for measuring the high and low for backwardation. 
  • Fourth, the selection classification may be that the top and bottom 20 percent of the scored universe.  It could also be a set number like the top and bottom three markets.
  • Fifth, the portfolio construction selection criteria will determine how the commodities will be weighted in the portfolio. For example, the three highest backwardated commodities may have equal risk contribution or an equal dollar weight.  
  • Sixth, the long/short method determines what will be the net exposure in the portfolio. This method could be dollar neutral or beta neutral. The net exposure may still have beta exposure that is not desired. 
  • Finally, there is the leverage associated with the total portfolio. This factor can be affected by the earlier choices of risk exposure. 

We can go though the same exercise for a currency carry alternative risk premia. If these are delivered through a bank swap, all of the rules for constructing an index will have to be defined so the swap can be priced on a daily basis  

While we have provided simple framework and example, the construction and analysis will generate a deeper analysis. The key point is that two alternative risk premia may be called the same but may have differences in performance based on the method of construction.

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