Risk Premia and Skew - Know your skew and embrace skew

Are you paid for skew or is skew the result of crowded high returns to risk? This is an interesting question for strategy selection and important for the risk premium narrative, yet it may be difficult to unpack. 

If a risk premium or strategy has negative skew, there is the belief that investors should be paid for taking this extra risk. Conversely, there may be strategies that generate higher return to risk that then get crowded and lead to negative skew events or crashes. Crashes create negative skew. In either case, strategies or risk factors that have more negative skew will require a larger risk premium. 

The idea of a momentum crash would be an example of negative skew generated from herd behavior. Too much capital in one direction may lead to sharp reversals especially for shorts when there is a market rally shock. The negative skew in currency carry is another example of a crash risk albeit not from crowding. Money is made on a regular basis until there is a disruptive event which causes a pricing change that exceeds the carry returns. Carry investors will receive extra return to offset the chance of this disruptive negative skew. 

It may be hard to distinguish between these two alternatives, but it is worth a discussion on causality and drivers for return. The impact of skew on return is a deeper story than the simplistic premium received for higher risk with a strategy narrative. There is also a unique skew premium that seems to be independent of classic risk factors like carry, value, and momentum that is closely tied to volatility shocks. Buying high negative skew and selling strong positive skew is independent of other risk factors. 

Knowing asset, strategy and risk premium skew and embracing these skews is important for adding return and is not hard to incorporate into a portfolio.