ARP in Multi-Manager Portfolios – An Acquired Taste

Stockholm (HedgeNordic) – Most of those who run multi-manager vehicles in the Nordics are not investing in Alternative Risk Premia (ARP). For instance, Coeli Asset Management CIO, Erik Lundkvist, told HedgeNordic “We are not allocating to ARP”. Optimised Portfolio Management (OPM) Portfolio Manager, Martin Alm, is also not exposed to ARP. “We have looked at about ten ARP products, mainly in UCITS, but want to keep investing in alpha-focused products and not ARP, which is not as sophisticated. We also think that a fund of funds investing in ARP would need extremely low fees, since you can’t add as much value as the manager of the fund of funds” says Alm.

Still, OPM are open minded about accessing some hedge fund strategies at lower fees, and are invested in a trend-following product run by London-based GSA Capital, which charges fees comparable to those in many ARP. Says Alm “the GSA product is more sophisticated than buying a momentum strategy from an investment bank. It also uses the same technology as their alpha products”.

However, some other big allocators in the Nordics have developed a taste for ARP.

left: Erik Lundqvist, CIO Coeli Asset Management and Martin Alm, Portfolio Manager at OPM

“’Tier one’ allocators – meaning the largest pension funds, state pension funds, and insurance companies – have been the leaders in implementing ARP in portfolios” says Otto Francke, Portfolio Manager at SEB Solutions, who advise some of these giant investors.

SEB’s experience of analysing ARP dates back over 15 years. “We started seeding hedge funds and equity market neutral in the early 2000s. Then we viewed ARP as risk factors that we did not want to have in alpha portfolios based on skill alone” recalls Francke.

But in 2012 a reverse enquiry changed that. “An institutional client asked us to develop what was in effect ARP. That triggered a substantial research effort. We spent a couple of years looking at strategies, data and infrastructure. We found many investment bank offerings were overly simplistic, too expensive, and not buy-side quality. For instance, equity strategies used only one factor, bought the top quartile ranked on this factor for their long books, equal weighted, and shorted the benchmark against it. We asked why would you equal weight stocks with different risk characteristics, and why introduce sector and market cap biases by shorting a broad index?” says Francke. “The inputs were simple but the outputs in terms of return profile were not” he adds.

Francke also notes that “back-tests showing Sharpe ratios as high as 1.5 or 2 are a warning flag that the strategy has been over-fitted and over-optimised. It is very rare that a pure strategy would have such a high Sharpe ratio and anyway, we do not need a Sharpe of 2.  A Sharpe of 0.3 is fine for ten uncorrelated strategies that can be combined to give a fantastic overall Sharpe at the portfolio level”.

Otto Francke, Portfolio Manager, SEB Solutions

SEB has subsequently developed 18 internal ARP strategies across asset classes, and is also free to buy externally, from investment banks or hedge fund managers, where the IP and strategy warrants it. Francke identifies the four key advantages of his preferred ARP strategies as being fees, transparency, liquidity and balance sheet efficiency.

Fees

Fees for ARP should be seen in the broader industry context: fees in general are coming down right across the asset management industry. Francke finds it “impossible to generalise about fees on ARP, as it depends on the IP involved, data sources, and structuring. If a more generic strategy has very low costs then fees should not be much more than just execution and transaction costs. But where a certain level of skill is involved it is harder to create a DIY strategy. Then we need to outsource and pay appropriate fees”.

Francke welcomes the potential to access some strategies at lower fees: “certain actively managed hedge fund strategies that once charged 2 and 20 for simple equity value, quality and momentum are becoming commoditised, so that investors can gain factor exposures in an efficient, transparent and liquid way. Meanwhile, hedge funds have upped their game and the good ones offer more refined alpha”.

Transparency

“ARP can also offer better transparency than some hedge fund strategies” Francke has noticed.

Liquidity

“And for liquid strategies, it is not optimal to be in a hedge fund with monthly liquidity, when ARP can offer daily liquidity” he adds.

Balance Sheet efficiency

SEB typically uses swaps, which can be linked to managed accounts or indices. Where ARP can be accessed through swaps, notes or certificates that may be unfunded – or at least not fully funded – the structure can free up space on balance sheets, which can be redeployed into other investments. Swaps can also allow ARP to be used as an overlay. “Costs depend on size, and relationships with providers” says Francke.

Strategies appropriate for ARP

Francke does not think every hedge fund strategy can be accessed through ARP: “For instance, distressed debt requires proper, deep, forensic research, and strategies such as high frequency trading are capacity constrained”.

Some strategies may be amenable to both ARP and traditional hedge fund structures. “Trend following lends itself very well to an ARP framework, but hedge fund managers can add additional value on top of the beta component” he says.

Francke is alert to the risk that some ARP strategies could become over-crowded. For instance, he remembers the “quant meltdown” month of August 2007, when managers pursuing similar quantitative equity strategies on a leveraged basis were all forced to rush for the exit together. Still, Francke argues that “not all factors are created equal. Some, such as Value, seem to be fairly generic but depending on factor design, it is possible to come up with fairly different portfolios”.

ESG

Francke finds that some forms of ESG can be easily implemented in ARP. For instance, metrics scoring carbon intensity can be used, and SEB’s negative screening of certain companies has been used from the start.

However, difficulties arise in two areas: impact investing, and strategies using derivatives.

Francke argues that “it is very difficult to gain access to impact investing in a systematic way, because the whole idea is to invest in companies subject to structural change”.  This is probably an inherent problem that is not easily solved.

The challenges of implementing ESG through index derivatives may be overcome quite soon however. Historically, with little or no ESG equity index futures available, and customised baskets of equities being less liquid than the standardised futures, it was difficult to pursue a global macro or managed futures strategy on an ESG basis. Going forward however, investors should watch this space as  EUREX are about to launch ESG index futures sometime during 2019.

Insurer Swiss Re has already said that they are now using the equity MSCI ESG Index family and the fixed income Bloomberg Barclays MSCI Corporate Sustainability Index family.

Says OPM’s Alm “we are still waiting to see more systematic managers incorporating ESG. Our approach to ESG tries to be more proactive, and does not only exclude certain industries or companies”.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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