The development of alternative risk premia - Isolating factors

There has been a natural progression of investment developments associated with risk premia. First, there has been the identification of risk premia. Second, there has been the development of long-only focused funds or smart beta, and finally, the pure isolation of risk premia through long/short hedge funds. These developments have not always been sequential, but they should be thought of as a progression from market beta to focused premia. This progression changes the choice set for investors.

Investors have a widening set of premia choices. They can buy beta in a pure form. They can buy bundled risk premia with funds that have a premia tilt either managed passively or actively. For example, their choice could be a value fund or a small cap fund that is benchmarked against a portfolio with this premia. They can buy specific risk premia in a passive long-only form through smart beta which is a more direct approach to accessing a risk premium. For those who want the "purest" form of risk premia, investing can be done through a long/short portfolio. These premia can be accessed through hedge funds, although hedge funds may be a bundle of a few ARPs, or the investment can be done directly through a total return swap which is has a rules-based index for the risk premia.

One of the largest changes in money management over the last decades is the widening of investor choices with a broad map of methods for accessing risk premia. Identifying and isolating risk premia is a significant advancement. Investors can build and tilt portfolios that express specific factor weights in ways not possible just ten years ago.