Deutsche backs risk premia as a hedge fund alternative

As investors look for more uncorrelated sources of return, alternative risk premia strategies are growing in popularity. BBVA Asset Management recently completed what was claimed to be the largest risk premia trade of its kind, advised by Deutsche Bank.

Spyros Mesomeris, Deutsche Bank’s global head of quantitative strategy and quantitative investment solutions (QIS) research, says the idea of alternative risk premia or alternative beta, using long/short techniques, has been around for many years, but came into sharper focus after the crash of 2008.

“Investors had added alternative asset classes like private equity, hedge funds and property to their portfolios, believing this would give them more diversity than a straight equity/bond mix,” says Mr Mesomeris. “But when liquidity was removed from the system, suddenly there was a jump in correlations – they were all moving together.” That event brought a lot more attention to alternative risk premia, otherwise known as 'factor' investing. “Sources of risk become prevalent when there’s something bad in the system,” adds Mr Mesomeris.

Attention-grabbing factors

Factors, in this context, are liquid sources of risk and return, and the most important include value, carry, momentum and volatility. Hedge funds, with their ability to bet long/short, had already been exploiting these factors to enjoy significant returns. “Ten years ago, these strategies were sold as alpha, at alpha fees. Now they are being sold at lower cost, and some hedge funds have separate alpha and alternative risk premia products,” says Mr Mesomeris.

The strategies can generate market-neutral returns because they use a combination of long and short positions with swaps and options to place generic bets via indices. The bets could be on large companies versus small companies, for example, growth stocks versus value stocks, or merger targets versus acquirers. But these techniques can also be applied to other asset classes, including commodities and foreign exchange.

Smart beta, as opposed to alternative beta, has the same investment objective of capturing factor premia, but as a long-only strategy it relies on going overweight or underweight securities relative to their benchmark indices. A risk premia portfolio can be designed in such a way that component factors perform differently under different stresses – an interest rate cut, perhaps, or a rising oil price – and so provide more dependable diversification. However, the strategy should not need a crisis in order to shine. Ultimately, risk premia are supposed to deliver better performance with lower volatility.

This is why in 2012 Danish pension fund PKA became the first institution to embrace them wholeheartedly, restructuring its entire equities portfolio to invest in risk premia strategies. To help it design and implement the changes, PKA enlisted the services of an investment bank (Deutsche Bank), a hedge fund (AQR) and an asset manager (JPMorgan Asset Management). “Since then, factor investing has become much more widely used, and in the past three or four years our risk premia franchise has seen double-digit growth, year on year,” says Mr Mesomeris.

Risk premia advantages

Sean Flanagan is Deutsche Bank’s global head of QIS and equity structuring, and, as such, responsible for implementing and executing the strategies devised by Mr Mesomeris’s team. “Risk premia is a substantially lower cost model than active management,” he says. “Many investors are now using it as a hedge fund substitute, or else adding it to their bucket without adding cost or decreasing liquidity of their portfolio.”

One of the attractions of risk premia is transparency. According to Akilesh Eswaran, global head of QIS trading at Deutsche Bank, it lies somewhere between passive and active investment styles. “There’s the black-box approach of hedge funds, where the investor gets reports but doesn’t know what's under the hood, and there’s buy-and-hold investing, which brings a lot of market beta to returns. Risk premia is somewhere in the middle,” he says.

Risk premia strategies are systematic and meant to be very transparent, Mr Eswaran adds. “And there is now a clear demand for transparent and systematic strategies.” The bank has had a dedicated QIS trading team since 2015. IT and infrastructure enhancements have improved trading efficiencies and allowed the team to deliver more complex strategies, particularly in terms of the number of underlying assets.

A pioneering approach

Deutsche Bank was one of the early pioneers in this new asset class, executing its first transaction in 2011, according to Mr Flanagan. “Since then we have done more than 60 customised transactions,” he says. “We are the preferred partner for very sophisticated investors. Our strategies are complex, but can be presented in a transparent way.” The bank’s clients include hedge fund managers, alternative managers, sovereign wealth funds and bank treasurers. as well as pension funds and traditional asset managers.

One of those clients is Spain’s BBVA Asset Management, which claims to have funds of more than $112bn under management. BBVA global head of asset allocation Jaime Martinez Gomez began looking seriously at risk premia in early 2016 for two reasons: one was the low returns available from traditional asset classes, the other was dissatisfaction with hedge fund offerings.

“There is a lot of space for absolute return-oriented strategies, but we were not happy with the hedge funds,” he says. “We wanted systematic liquidity and transparency, but in a cheap way compared with hedge funds.”

In theory, BBVA could have done this itself but realised risk premia demands a lot of quantitative research capability as well as a sophisticated trading desk. “At that time, the relevant expertise was more concentrated in investment banks than in asset managers, so we looked for an investment bank to provide a cheap passive approach,” says Mr Gomez.

A happy partner

After a beauty parade, Deutsche Bank won the mandate. “The others were good, but we appreciated Deutsche Bank’s research capability and the way it presented its portfolio,” he says. “We feel we are talking to partners, not being treated as a client.” The strategy was designed to have zero long-term correlation with equities and bonds. “The short-term correlation is not zero, but it is not high,” adds Mr Gomez.

BBVA has “hundreds” of investment vehicles, all of which will have some exposure, to varying degrees. So the bank wanted an undertakings for collective investment in transferable securities (or Ucits) wrapper, to make it easier for them all to participate, and this was set up in Luxembourg, with FundRock as its management company. Germany’s Assenagon is the fund manager and Bank of New York Mellon its custodian. “We are just investors,” says Mr Gomez, “but we are the sole investors. We made the first investment this summer.”

BBVA wanted to include as many different risk premia as possible and the initial portfolio includes 13. They cover all the major asset classes – equities, commodities, foreign exchange, credit and rates – and include strategies such as foreign exchange value, commodity curve, equity quality, and rates carry and value. “This was the largest single transaction in terms of index exposure that a bank has ever done,” says Deutsche’s Mr Flanagan, though he refuses to put a figure on it.

Fast growth

Other clients have other needs. Deutsche Bank worked with a sovereign wealth fund that wanted to develop long/short equity strategies but rather than relying on swaps, wanted to trade the stocks in the market itself. The Deutsche team helped it to program its systems with co-designed code, and to get access to the right feeds. “Helping clients to be more independent means that they trust us more,” says Mr Flanagan.

While there are no official figures, he believes total funds deployed in risk premia – which he defines as market-neutral long/short strategies – are between $150bn and $200bn. Some put this as high as $400bn, but Mr Flanagan believes that such numbers are inflated and probably include smart beta. He agrees, nonetheless, that the industry has been growing “very fast”, from about $30bn only four years ago. By contrast, more than $3000bn is invested in hedge funds, he adds.

Though there are no independent statistics to support this, Deutsche Bank believes itself to be the market leader in risk premia. It is now managing more than $20bn in market-neutral risk premia strategies, representing a doubling of such assets over the past year.