Monday, October 14, 2019

Antifragile alternative risk premia portfolios - Not easy to structure

Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure , risk, and uncertainty.

The antifragile loves randomness and uncertainty, which also means— crucially—a love of errors, a certain class of errors. Antifragility has a singular property of allowing us to deal with the unknown, to do things without understanding them— and do them well.

By grasping the mechanisms of antifragility we can build a systematic and broad guide to nonpredictive decision making under uncertainty in business, politics, medicine, and life in general— anywhere the unknown preponderates, any situation in which there is randomness, unpredictability, opacity, or incomplete understanding of things.

From Antifragile: Things That Gain from Disorder by Nassim Taleb 

The value of factor investing has been well documented. A diversified portfolio of alternative risk premia can generate good returns with controlled risk that are uncorrelated to traditional assets. Investors get paid from holding risks different than market beta. Yet, the core or primal problem that investors want to solve with alternative risk premia is very simple. How do you more than diversify but also protect a portfolio against left tail events?

The idea of trying to protect against left tail events is a less colorful way of saying that investors are looking for antifragile risk premia. I cannot say that there is a such a thing as an antifragile premia. By definition, a risk premia is compensation for risk taken, but the behavior of risk premia will differ across market environments and the business cycle. Premia that do better when market risks are high are valuable. Hence, they will not receive higher stand-alone returns. 

Investors are now digging deeper into the characteristics of alternative risk premia to provide diversified portfolio that have tilts to specific risks or are structured to have more potential downside protection. Some risk premia are pro-cyclical while others have pay-offs that may be more counter-cyclical. 

Some of the simple solutions to a fragile environment are costly. A program of buying puts is one possibility, but there are clear option premium costs. Switching from stocks to Treasury bonds has been a good diversification alternative since bonds serve a as flight to quality asset. However, the costs for holding bonds has risen with the decline in yields. Now bonds that serve as the flight to quality asset have negative yields. 

Still, we classify some alternative risk premia as being antifragile friendly.

Good for when there is expected fragility: 
  • Non-predictive strategies like trend-following (times series not cross-sectional) 
  • Long volatility that will improve when volatility rises
  • Non-carry strategies 
  • Flight to safety / liquidity - Treasury bonds 
Good for when markets have reached maximum fragility: 
  • Carry 
  • Value
  • Mean-reversion 
  • Short volatility 
  • Illiquidity 
While there is not single risk premia that can be viewed as antifragile, there are combination of alternative risk premia that can be bundled into portfolios that can perform better under market stress. This is an important area for further research by examining the properties of alternative risk premia under different market conditions.

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