A Primer on Alternative Risk Premia
123 Pages Posted: 4 May 2016 Last revised: 26 Jun 2016
Date Written: April 1, 2016
The concept of alternative risk premia can be viewed as an extension of the factor investing approach. Factor investing is a term that is generally dedicated to long-only equity risk factors. A typical example is the value equity strategy. Alternative risk premia designate non-traditional risk premia other than long exposure to equities and bonds. They may concern equities, rates, credit, currencies or commodities and correspond to long/short portfolios. For instance, the value strategy can be extended to credit, currencies and commodities. This paper provides an overview of the different alternative risk premia to be found in the academic and professional spheres. Using a database of commercial indices, we estimate the generic cumulative returns of 59 alternative risk premia in order to analyze their risk, diversification power and payoff function. From this, it is clear that the term "alternative risk premia" encompasses two different types of risk factor: skewness risk premia and market anomalies. We then reconsider portfolio allocation in light of this framework. Indeed, we show that skewness aggregation is considerably more complex than volatility aggregation, and we illustrate that the volatility risk measure is less appropriate and pertinent when managing a portfolio with these risk premia. The development of alternative risk premia shall also affect the risk/return analysis of non-linear strategies, e.g. hedge fund strategies. In particular, using alternative risk factors instead of traditional risk factors leads to an extension of the alternative beta framework. Therefore, we apply the previously estimated risk premia to a universe of hedge fund indices. To that end, we develop a model selection based on the lasso regression to identify the most pertinent risk premia for each hedge fund strategy. It appears that many traditional risk factors, with the exception of long equity and credit exposure on developed markets, vanish when we include alternative risk premia.
Keywords: Alternative Risk Premium, Factor Investing, Skewness Risk Premium, Market Anomaly, Risk Factor, Carry, Event, Growth, Liquidity, Low Beta, Low Volatility, Momentum, Quality, Reversal, Value, Short Volatility, Size, Skewness, Drawdown, Option Profile, Alternative Beta, Hedge Funds
JEL Classification: C50, C60, G11
Suggested Citation: Suggested Citation