Are alternative risk premia (ARP) portfolios a good replacement for hedge funds? A recent ai-cio.com article "Oft-Touted Risk Premia Strategies Show Their Weak Side" commented on the lagging performance of risk premia over the last few quarters and questioned whether ARPs have lived up to expectations as a hedge fund replacement. Hedge funds have fared well in 2019, but many risk premia strategies have also shown a pick-up in performance this year. Similarly, some ARPs have correlated with poorer performance with some focused hedge fund styles.
The real comparison is not between a single ARP and a hedge fund style but a bundle of ARPs and a hedge funds. Hedge funds are usually not monolithic strategies but rather a combination of different strategies weighted by risk exposures. There will be hedge funds that specialize with a single strategy or with the majority of risk exposure in single strategy but most will be described by more than one factor.
There will be performance differences between ARP portfolios executed through bank swaps and hedge fund returns because they are fundamentally different views on how portfolios and investments should be structured and managed. These distinctions are important whether you want to use ARP as complement or as a substitute for hedge funds.
ARPs should be viewed as factor building blocks that can be bundled into portfolios with well-defined risks. Hedge funds are managed investments that have factor risk exposures that can be categorized through alternative risk premia. One is a direct expression of risk factors while the other is a manager's representation of risk factors with the potential addition of skill. In the case of hedge funds, these representations may do better or worse than a specific weighted set of factors. The relative outperformance may be skill or may be caused by a poor measure of the risk taken. ARPs, on the other had can be bundled in any combination desired; however, the underlying ARP swaps are restricted by the rules used for construction.
Our table provides some of the distinctions between an ARP swap portfolios and hedge funds and offers insights on which investment choice has an advantage. An investor can run through this list and determine their preferences.
We view that ARPs can be compared with hedge funds on a number of different dimensions: strategy, portfolio, flexibility, alpha generation, cost, transparency, and liquidity. In most cases ARP structures will have an advantage over hedge funds. The key difference is manager skill, yet in many cases, when properly measured, alpha is limited. Hedge fund managers may have a slight advantage with the dynamic adjustment of strategy exposure, yet even in this case there are systematic and inexpensive ways to adjust exposures that can give ARP an edge.
Alternative risk premia will have dynamic returns which will not always be positive, but when properly compared with hedge funds, ARP will have clearly measured advantages.
The real comparison is not between a single ARP and a hedge fund style but a bundle of ARPs and a hedge funds. Hedge funds are usually not monolithic strategies but rather a combination of different strategies weighted by risk exposures. There will be hedge funds that specialize with a single strategy or with the majority of risk exposure in single strategy but most will be described by more than one factor.
There will be performance differences between ARP portfolios executed through bank swaps and hedge fund returns because they are fundamentally different views on how portfolios and investments should be structured and managed. These distinctions are important whether you want to use ARP as complement or as a substitute for hedge funds.
ARPs should be viewed as factor building blocks that can be bundled into portfolios with well-defined risks. Hedge funds are managed investments that have factor risk exposures that can be categorized through alternative risk premia. One is a direct expression of risk factors while the other is a manager's representation of risk factors with the potential addition of skill. In the case of hedge funds, these representations may do better or worse than a specific weighted set of factors. The relative outperformance may be skill or may be caused by a poor measure of the risk taken. ARPs, on the other had can be bundled in any combination desired; however, the underlying ARP swaps are restricted by the rules used for construction.
Our table provides some of the distinctions between an ARP swap portfolios and hedge funds and offers insights on which investment choice has an advantage. An investor can run through this list and determine their preferences.
We view that ARPs can be compared with hedge funds on a number of different dimensions: strategy, portfolio, flexibility, alpha generation, cost, transparency, and liquidity. In most cases ARP structures will have an advantage over hedge funds. The key difference is manager skill, yet in many cases, when properly measured, alpha is limited. Hedge fund managers may have a slight advantage with the dynamic adjustment of strategy exposure, yet even in this case there are systematic and inexpensive ways to adjust exposures that can give ARP an edge.
Alternative risk premia will have dynamic returns which will not always be positive, but when properly compared with hedge funds, ARP will have clearly measured advantages.
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