A Framework for Risk Premia Investing: Anywhere to Hide?

Abstract

Alternative risk premia (ARP) strategies are traditionally assumed to diversify well both equity and bond market risk. We investigate alternative risk premia composites based on investment bank indices to describe the nature and risk characteristics of commonly known investable ARP strategies. While most of the strategies have low full sample betas to both equity and commodity markets, there are several strategies with statistically significant positive betas to bond markets. Additionally, risk characteristics of most of the ARP strategies change in the tails of equity and bond market return distributions, which makes it questionable to use whole sample volatilities and correlations in portfolio construction. Instead, we propose an updated framework for risk premia investing to construct diversified ARP portfolios by using a hierarchical risk allocation process.

Keywords: Factor Investing, Alternative Beta, Smart Beta, Risk Premia, Style Investing, Quantitative Investment Strategies, Portfolio Construction, Asset Allocation, Momentum, Trend, Value, Carry, Volatility, Quality, Low Beta

JEL Classification: G11, G12, G15