Sunday, June 2, 2019

Academic (public) and hedge fund (private) alternative risk premia

There are many ways to classify alternative risk premia that are developed by hedge funds and bank swap desks. The simplest categories are style and asset class. Styles can include value, carry, or momentum, and asset classes include equity, rates, commodities, carry, and credit. However, another classification method is through where the risk premia idea originated. There are two major sources, academic research and trader idea generation or implied risk premia. These could be classified as public and private alternative risk premia.

The academic path is simple. Research on factors or risk premia from academic working papers is weaponized into an investment or trading strategy that can be implement through a variety of markets. A hedge fund or swap group will read the research, breakdown the work into components that can be replicated, and convert this work into a repeatable set of rules. The investment idea is not proprietary but the conversion process requires quant and trading skill. The implementation or practical knowledge may be considered proprietary. 

Unfortunately, some of the latest research states that after working papers are published or the research enters the public domain there is a significant and economically meaningful decline in the expected returns. Once the idea is out in the market, excess returns are arbitraged away. Crowds reduce the excess returns found in the research.

The second path for alternative risk premia comes through research done by hedge funds or banks and is not in the public domain. This is often in the form of firm-specific hedge fund strategies. This is a tradable and repeatable idea that a manager can believe is unique and requires special execution skill. There may be an economic foundation for the idea, but it may not have been explicitly tested in academic research. These ideas have often focused on volatility trading and replication of fund strategies like trend-following. If developed and marketed through a swaps desk, the investor is more directly dependent on the back-testing of the bank. 

The academic work is more public and subject to crowding from investors following the strategy as the idea is disseminated. The trader idea generation is private to the firm originating the idea but subject to the more unique risks associated with specialized construction. There is a trade-off of receiving a generalized risk premia versus one that is unique to the firm who generates and constructs the risk premia. The private (non-academic) risk premia requires more investor analysis and more trust in the bank swap desk construction and execution team. Our view is that the academic risk premia should be preferred albeit the crowding issues must be addressed. A trader risk premium requires added return to compensate for their structural uniqueness  

No comments: