A three state investment world for risk premia - Know the time varying nature of these premia

The investment world can be described with two states - convergent and divergent. Perhaps a better description would be three states - convergent, divergent, and status quo. A three state world may better delineate periods when alternative risk premia returns will be more profitable beyond looking at business cycle factors.

The status quo will be times when the markets are in equilibrium. It is not in a period of transition. The will represent stable or low volatility periods. Under this environment, carry strategies should do well. 

Divergent periods are when market are moving to a new equilibrium state because markets have been have shocked out of the status quo. There is new information that is changing the underlying value of a security. Trend-following should do well along with some volatility trading. However, divergences by definition should not last for long periods. 

Convergent state occur when markets have moved away from equilibrium but are now starting to move back to its old state. After an over-reaction, there will be a movement back to equilibrium. For risk premia, a period of unusually strong or weak return performance unrelated to a change in fundamentals will see mean-reversion. If there is a compensation for specific risks, there may be periods of underpayment and excess payment. Investors need to understand these periods of transition.

One of the key takeaways from all of the academic literature is that the size of risk premium modeled will change with the time period used for analysis. Simply put, alternative risk premiums are time-varying or state dependent. There will be periods when some risk premiums are very profitable while other times when they will underperform. To effectively manage a portfolio of risk premiums requires an understanding of the states and the status quo. 

One way to describe a state is through economic factors like growth or recession. The mapping of economic states to risk premia also requires understanding of the times series and return dispersion of risk premia.