Alternative risk premia timing - Success through nowcasting

Alternative risk premia (ARP) have been shown to have unique return profiles from the market risk premium. Building diversified portfolios of style factors can provide an alternative return stream from traditional assets. The ARP are time varying and seem to have performance that is correlated to the business cycle. For example, the equity value premium will do especially well during an economic upturn or recovery. It is natural to then attempt to exploit these time varying returns to add value relative to a simple unconditional diversified portfolio.

The problem is not whether the conditional ARP returns change with the market environment, but whether investors can determine the regime being faced. If we can predict or forecast the market regime, we should be able to adjust the portfolio for improved efficiency. A simple solution is to employ forecasting advances such as nowcasting to help with regime identification. 

Using a straightforward application in nowcasting, the Cross Asset Solutions Group at Unigestion generate dynamic out-of-sample portfolios that improve over an equal risk portfolio of ARP strategies.  Nowcasting of growth, inflation, and market stress are used to predict the market environment. Taking a large number of current economic variables, the team create z-score averages and diffusion indices to provide timely measures of market and economic environment. The work also includes a simple valuation metric for ARP allocations.  Their analysis covers a wide set of ARP across major asset classes including equities, bonds, commodities and currencies. The styles analyzed include value, carry, trend/momentum and volatility. See "Factor Timing Revisited: Alternative Risk Premia Allocation Based on Nowcasting  and Valuation Signals".     

The nowcasting approach is atheoretical. It uses current data to generate a forecast of the growth, inflation and stress regime. The growth nowcast tells us whether we are in a recovery, expansion, slowdown, or recession. The inflation nowcast looks at the combination of a 2x2 between low/high and rising/falling inflation. The market stress nowcast using a similar 2X2 framework of level and change. These nowcasts are not traditional point forecasts but regime representations.

Using the regime frameworks, it is clear that ARP performance will change based on the growth regime. Conditional excess Sharpe ratios show the added value from the full sample. There is enough return variation for nowcasting to add value.

The authors look at five out of sample portfolios: a benchmark equal risk contribution (ERC) portfolio, a dynamic macro nowcast, a dynamic sentiment nowcast,  a dynamic valuation portfolio based on variation from average returns, and a dynamic combination portfolio. The dynamic portfolios all add value. Clearly, using some form of regime forecasts help with area ARP allocation decisions. The behavior of cross asset ARP is time varying with macro. sentiment, and valuation and can be exploited through nowcasts.