Stockholm (HedgeNordic) – The concept of alternative risk premia is often seen as an extension of factor-based investing, which compensates investors for the exposure to certain risk factors. Both the investment industry and academia have identified many historically rewarded factors over the years, creating a wild ‘factor zoo’. After years of research and development, Danske Bank Asset Management launched a hedge fund in last year’s turbulent environment to capture ‘true’ alternative risk premia as compensation for actual risk rather than behavioral-based or data-mined premia. Developed in a multi-team effort and spearheaded by the seasoned Chief Portfolio Manager Markku Vartiainen, the fund is DBAM’s strategic wager on the alternative asset classes.
The new fund, Danske Invest Global Alternative Opportunities (GAO), successfully passed the initial proof of concept test in the difficult market conditions of 2022. Launched in August 2022, just ahead of the worst September for equity markets since 2002, the fund has generated a cumulative return of 5.4 percent coupled with a seven-month streak of positive performance, with very low volatility and a Sharpe Ratio above 2.0 (based on weekly observations). “One of the early successes is that the strategy has worked exactly as intended,” says Søren Funch Adamsen, Chief Portfolio Manager and Head of Portfolio Construction at Danske Bank Asset Management. “That has hopefully answered the million-dollar question.”
‘True’ Alternative Risk Premia
The still-nascent track record may serve as an indication that GAO has indeed found true alternative risk premia. But what is a true alternative risk premium and where does this premium reside in the vision of Danske Bank’s Quant & Overlay team? “In recent years, investors and researchers have been building all sorts of models showing behavioral patterns and biases among market participants,” explains Chief Portfolio Manager Markku Vartiainen. Some of these behavioral risk premia, such as value, quality or momentum, can be considered by some as alternative risk premia.
“There is an excess risk premium in certain asset classes, segments of those asset classes or instruments that reflect true risk.”
“There is another type of alternative risk premia that we think of as true, or structural, risk premia,” emphasizes Vartiainen. “There is an excess risk premium in certain asset classes, segments of those asset classes or instruments that reflect true risk,” he elaborates. “That excess risk premium is how much market participants are willing to pay for not carrying a specific risk.” A case in point is the 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. “Volatility, which manifests itself in different ways in different underlying across different horizons, obviously exhibits true risk premia.”
Evolving Attractiveness of Risk Premia
Danske Bank’s GAO seeks to capture these true alternative risk premia across several asset classes such as equities, fixed income, credit, and currencies. Alternative risk premia across most of these asset classes became more attractive to harvest in 2022 amid plunging equity prices, rising interest rates, and increasing volatility. “When the market goes into a scenario similar to that one of last year, then these alternative risk premia tend to widen quite a bit,” explains Vartiainen. “Alternative risk premia broadened across the board last year after Russia’s war in Ukraine started and inflation started getting out of hand.”
“It becomes a numerical exercise to find out the size of these risk premia and figure out a way to harvest the premia.”
“It becomes a numerical exercise to find out the size of these risk premia and figure out a way to harvest the premia,” continues Vartiainen. “Many investors who did the math, identified the size of excess risk premia, and went on to harvest those premia enjoyed a successful year,” he elaborates. And yet, one could still observe significant performance divergence among various players in the alternative risk premia universe. “Whether risk premia investing was successful for you or not in 2022, for instance, mainly depends on what types of risk premia you actually aimed to harvest,” explains Vartiainen. “If you were looking at behavioral risk premia, 2022 might have not been so successful, while investors targeting real risk premia had a more successful year.”
The excess risk premia have normalized towards the end of the year and going into 2023. “If you take volatility as a proxy for excess risk premia, there is still some room for the volatility to come down and there is still premia to be harvested,” according to Vartiainen. “Given that there are no new inflationary shocks or any other massive micro shocks and the world moves on smoothly, investors are still able to capture excess risk premia,” explains Vartiainen. “Mind, you do become a bit more vulnerable if something suddenly happens and risk premia widen again,” he warns. “One has to be extremely conscious of that fact. Ignoring it is the surest way of having an absolute meltdown in performance.”
Risk-On, Risk-Off Dynamics
Carry strategies harvesting alternative risk premia exhibit risk-on, risk-off dynamics, according to Vartiainen. “Carry or risk premia is a compensation for the risk investors are taking, hence, carry strategies follow a risk-on, risk-off dynamic.” For that reason, GAO also employs a set of defensive strategies designed to do most of the heavy lifting in terms of downside risk mitigation. “One has to be very conscious about building protective strategies as well, beefing them up to get insurance for times when you need that insurance most.”
“Carry or risk premia is a compensation for the risk investors are taking, hence, carry strategies follow a risk-on, risk-off dynamic.”
“The defensive strategies are particularly designed to have a low cost of carry, implying that they don’t ruin the performance in standard market conditions and yet provide a robust hedge in down markets when it is most needed,” explains Vartiainen. GAO currently employs 13 independent strategies, a handful of which are defensive. “The fund has so far delivered well in both up and down environments including the most recent risk-off, and the dynamics of our offensive carry strategies and defensive protective strategies have played the way they had been designed to,” highlights Søren Funch Adamsen. “This gives confidence that the optimization and analysis that was hypothetical before launching the fund has actually been working as intended.”
Alternative Risk Premia Going Forward
2022 was a good year for alternative – especially true alternative – risk premia, which is expected to represent an alternative to alpha going forward. “The magnitude and attractiveness of certain risk premia are going to change all the time, they are going to change in shape and form as have been for the last years,” argues Vartiainen. While the attractiveness of existing risk premia might change depending on the market environment, Vartiainen also expects to see new opportunities in the risk premia space as markets are evolving into areas we have not been to before.
“There are more new risk dimensions that come into the market that are being traded.”
“The market is moving towards the direction that market participants are identifying risks that they want to trade in the market,” Vartiainen explains. Market participants have been and will continue to use various instruments to trade and transfer risks. “There are more new risk dimensions that come into the market that are being traded. We just need to be able to understand how to price these risk dimensions and find a way to harvest them,” says Vartiainen. “This opens up possibilities not just because of our edge in accurately calculating risk premia in asset classes, but because we are able to look at new types of risk classes that enable diversification of positions.”
While equities and bonds often represent reliable sources of long-term returns, many investors are perhaps overly-dependent on them as observed during the market turmoil of 2022. As such, investors can benefit by diversifying their portfolios with other sources of return such as alternative risk premia. “Since the beginning of last year, we have seen that the diversification characteristics of a bond and equity portfolio are much poorer than they had been in the past,” highlights Søren Funch Adamsen. “The changed stock-bond correlation makes the role of a product like GAO more important and more attractive within a broader portfolio. This fund can extract yields and provide diversification in an environment where diversification is becoming scarcer.”
This article features in HedgeNordic’s Nordic Hedge Fund Industry Report.
