The Case for Alternative Risk Premia: Part 1
February 2016
This paper examines the characteristics of diversifying, systematic factor strategies, the kind that hold long and short positions and aim to earn returns with little or no exposure to the broad market. It groups such strategies into stock selection, trend following, systematic macro, and event-driven families, and studies how they behave on their own and together. The analysis focuses on four properties that make a factor useful in a portfolio: low correlation with traditional market exposures and with one another, positive returns during periods of market stress, attractive risk-adjusted returns, and a measurable improvement in portfolio outcomes when added to a traditional mix. Understanding these properties is central to the firm’s factor research, both in deciding which exposures may be worth harvesting and which are better avoided. The paper is written for institutional allocators and consultants, and it frames its conclusions as analytical perspective.
What This Paper Examines
- What distinguishes a diversifying systematic factor from a traditional market exposure.
- How such factors correlate with one another and with stocks and bonds.
- How diversifying factors have behaved during periods of market stress.
- How adding these factors can affect the risk and return of a traditional portfolio.
- Why capacity, liquidity, and transparency matter for using them.
Key Findings
- Diversifying factors are defined by the absence of market exposure. They hold offsetting long and short positions and require active trading, which sets them apart from long-only market exposures.
- These factors have shown low and fairly stable correlations. Historically they correlated little with one another and with traditional stock and bond exposures, which is what makes them useful for diversification.
- They tend to hold up in stressed markets. During quarters when traditional exposures fell, diversifying factors on average performed better, precisely when diversification matters most.
- Blending factors can improve portfolio outcomes. Adding a diversified set of factors to a traditional mix has historically tended to raise return and lower risk relative to the traditional mix alone.
- Understanding factors guides what to avoid, not only what to own. The same research that identifies rewarded factors clarifies which exposures to exclude, which informs the firm’s hedge fund programs today.
The Authors
Deepak Gurnani, Founder and Chief Investment Officer
Deepak Gurnani is the Founder and Chief Investment Officer of Versor Investments. Deepak has three decades of experience in applying quantitative methods to uncover alpha across global equity markets. Over the past decade, he has focused on pioneering the use of AI and alternative data in equity investing.
Ludger Hentschel, Founding Partner, Investment Advisor
Ludger Hentschel joined Versor Investments as a Founding Partner and is based in New York. Ludger has over 20 years of experience in quantitative research and investing.
Disclaimer: Past performance is not necessarily indicative of future results. Not an offer to sell or a solicitation of any type with respect to any securities or financial products.
Methodology: The analysis builds illustrative, risk-weighted composites of diversifying factors, stock selection, trend following, systematic macro, and event-driven, and compares them with a traditional, risk-weighted mix of global equities, bonds, credit, and commodities. It measures rolling correlations, performance in quarters with negative traditional or equity returns, risk-adjusted returns, and the effect of adding factors to the traditional mix. Factor returns are simulated systematic rules, net of estimated costs, with the usual back-test limitations. Index data comes from Bloomberg, MSCI, and Barclays, over a sample from 2003 to 2015.
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