Stockholm (HedgeNordic) – What fund managers may have considered “alpha” in the past may well be codified as today’s or tomorrow’s alternative risk premia. With the emergence of new – alternative – betas, the unexplained portion of returns – alpha – is shrinking, and, thereby, getting reclassified as alternative beta. Rather than focusing on finding alpha, more alternative risk premia strategies seek out alternative return sources that offer positive expected returns and diversification.
The Quant and Overlay team at Danske Bank Asset Management headed by Jasper Riis has launched a hedge fund seeking to capture alternative risk premia across equities, fixed income, credit, and currencies. More importantly, the newly-launched fund overseen by Chief Portfolio Manager Markku Vartiainen (pictured) combines the carry strategies harvesting excess risk premia with defensive strategies that protect the portfolio against significant drawdowns.
True Alternative Risk Premia
“What we are capturing is true risk premia as compensation of risk, rather than alternative risk premia derived from behavioural risk factors such as value or size, or other risk premia that persist because of human behavior,” explains Vartiainen. “You can find risk premia in the market all over the place, but we are mostly looking for risk premia that market participants are aversive to. We recognize that the carry feature, in one way or another, is often associated with such risk premia,” he elaborates. Think of volatility risk premium, which is based on the premise that implied volatility is persistently priced above realized volatility as market participants are willing to pay a premium for insurance.
“You can find risk premia in the market all over the place, but we are mostly looking for risk premia that market participants are aversive to.”
Using long and short positions in derivatives, Danske Bank’s Global Alternative Opportunities fund employs rules-based carry strategies that play the role of return generators. The carry strategies are designed to capture alternative risk premia, “a compensation for the transfer of specific risk by risk-averse market participants in relation with carry, volatility, trend and structural styles.” As seen in practice, however, some risk premia exhibit tail beta – or hide some residual beta – and can fall along with equities. “Such strategies are, in aggregate, expected to show a positive beta exposure to global equities,” according to Vartiainen.
“The carry strategies are the workforce of the fund. Carry or risk premia is a compensation for the risk that you are taking, hence, carry strategies follow a risk-on, risk-off dynamic.”
“The carry strategies are the workforce of the fund,” explains the Chief Portfolio Manager. “In a normal or semi-normal market, carry strategies should provide consistent yield,” he elaborates. However, carry strategies exhibit risk-on, risk-off dynamics, according to Vartiainen. “Carry or risk premia is a compensation for the risk that you are taking, hence, carry strategies follow a risk-on, risk-off dynamic.” For that reason, Danske Bank’s recently-launched fund also employs a set of rules-based defensive strategies designed to do most of the heavy lifting in terms of downside risk mitigation.
Supporting Leg: The Defensives
“The defensive strategies are particularly designed to have a low cost of carry, implying that we are able to run these defensive strategies with a low cost in a standard market yet they provide a robust hedge at the time when markets enter a drawdown,” explains Vartiainen. “The secret sauce of the fund is actually the defensive strategies that we are able to construct in a way that they don’t ruin the performance in standard market conditions and yet provide a robust hedge in down markets.”
“The secret sauce of the fund is actually the defensive strategies that we are able to construct in a way that they don’t ruin the performance in standard market conditions and yet provide a robust hedge in down markets.”
One can purchase portfolio protection at any time, but that protection comes at a cost: sometimes very high. “It’s easy to find protection,” says Jasper Riis, who is heading the Quant and Overlay team at Danske Bank Asset Management. One can simply buy a put option as protection, but this type of protection can eat away all the fund’s returns before bringing the desired benefits in the form of downside protection. “Scanning the universe of asset classes and picking out the defensive exposure that helps the portfolio at a low cost is the real value of our very systematic – yet flexible on implementation – approach,” emphasizes Riis. “If nothing bad happens, which we hope that is the case, we don’t pay too much premium from owning this type of protection.”
Danske Invest Global Alternative Opportunities runs between 10 to 15 rules-based systematic strategies at any given time, the majority of which are carry strategies. “The strategies are systematic but the allocation across strategies is not static,” points out Vartiainen. “We are constantly monitoring the portfolio, and running a lot of computations, calculations and simulations on a daily basis to determine the optimal allocation to each strategy at any given time.”
“We are not stuck into a certain type of risk premia and the strategies are evolving all the time.”
The hedge fund has a fairly broad mandate, allowing the portfolio management team to set up new strategies to capture newly-identified risk premia. “We are not stuck into a certain type of risk premia and the strategies are evolving all the time,” says Riis. “We can implement both linear strategies in credit, for instance, or non-linear strategies that can be both static in their nature or more dynamic,” he elaborates. “Within the guidelines, we are able to expose ourselves in a linear and non-linear format, across asset classes and even across different underlyings within an asset class.”
The Objective: Steady Level of Risk
The fund’s objective is to deliver attractive and consistent risk-adjusted returns, eying a long-term return of 6-7 percent over risk-free rates. To meet this objective, Vartiainen and his team run a fairly steady level of overall risk in the portfolio, according to Jasper Riis. “However, the composition of the carry basket of strategies can change in this cross-asset lens, where we look to identify the risk premia that are most attractive to capture,” he elaborates. The composition of the overall portfolio also depends on how cost-efficient the defensive strategies are to implement. “The composition depends on how attractive it is to get defensive strategies on board or not. In situations where we don’t see much cheap protection out there, we can go on to run a less aggressive carry portfolio to maintain the level of portfolio risk,” says Riis.
Alternative risk premia strategies have sought to fill the role of bonds in a diversified portfolio in recent years, notices Riis. “There is a lot of focus everywhere on being less dependent on that diversification coming from bonds,” he points out. “Interest is quite broad-based because the search for diversification and desire to reduce the dependency on bonds is still there. In that context, we have increased the focus and allocation to alternatives across our solutions for several years,” he continues. One limitation of some alternatives such as hedge funds, however, is the inability of non-professional or non-institutional investors to invest in the often inaccessible – for the broad public – hedge funds. “Some of our customers have not been able to invest in the typical hedge fund structure, hence the reason for this fund launching in a UCITS format.”