Frustrated by poor returns from traditional long-only portfolios, investors are increasingly examining the possibility of venturing into cross-asset derivatives strategies. And dealers are keen to offer such products, with Risk Premia indices proving particularly popular. 

As pension funds, asset managers and insurers struggle to generate returns on traditional diversified long-only portfolios of stocks, bonds and commodities, investment banks are having more success persuading them to put on exposures linked to cross-asset derivatives strategies.

One of the current favourites is Risk Premia, which seeks to move away from directional bets, instead generating single sources of return in each sub-category of a multi-asset portfolio. 

In many ways the Risk Premia indices created by the banks are similar to sophisticated hedge fund strategies, using options to isolate returns in areas such as correlation, volatility, small cap versus large cap, and momentum.

Rival products

But the hedge funds have themselves been delivering modest returns in recent years, while their ‘two plus twenty’ fee model eats into these gains, as do additional layers of fees where investors use a fund of funds structure. The investment banks are seizing their opportunity, and offering a range of rival products.

“With bond markets bid too high, even what were formerly viewed as risk-free assets have become a risky directional bet, while low-interest-rate and quantitative easing policies have been pushing up equity market valuations, making directional bets difficult,” says Daniel Fields, head of global markets at Société Générale. “One theme we are underlining is Risk Premia, where we are aiming to industrialise systemic strategies, making them transparent and cost effective.”  

Pension funds and asset managers that might have formerly made allocations to hedge funds are now looking closely at Risk Premia indices. What was regarded by many as an academic discussion two years ago has gained traction, as fixed-income investments such as bunds have become low-yielding and volatile assets.

Analysts say that in many ways Risk Premia is a new buzzword for an old concept, which is allocating to a variety of investment styles, such as quality, value, dividend income, momentum or low volatility. It is a back-to-basics approach, where the investment bank can meet with asset managers and discuss how and why they hope to extract value from the market. The new element of the strategy is that it has been extended from equities into a cross-asset approach. 

“Investors want to increase allocations to their alternatives buckets, but they need liquidity,” says Guillaume Picot, London-based head of the commodity investor group at BNP Paribas, who is responsible for Risk Premia. “Some academic papers have estimated that 85% of hedge fund returns can be achieved via a basket of Risk Premia strategies, but with daily liquidity and greater transparency.

 “The concept is to break down sources of return and risk, and switch from asset class allocation to allocation by type of risk. It is not so much taking advantage of
market inefficiencies or dislocations, but rather capturing structural opportunities in the markets.

“If we take commodities as an example, corporate producers and consumers have hedging needs, and their hedging activities mechanically impact implied volatility, which gives investors an opportunity to capture the spread between implied volatility and realised volatility. In effect, the investors are taking that risk from the corporate counterparties – but demanding a premium.” 

A pure package

At Vontobel Asset Management, alternative investment strategies for private and institutional investors are managed by Harcourt, a boutique investment manager. It offers a set of strategy specific ‘pure’ Risk Premia, with each of the so-called pure strategies aiming to capture the essence of the specific investment concept (such as value or momentum) while simultaneously hedging against systematic market or beta risk.

“Alternative strategies should make a multi-asset portfolio not only more profitable, but also more robust,” says Jan Viebig, head of alternative investments at Vontobel.

The Vontobel approach is to increase the appeal to a broader investor base by packaging products such as its Pure Premium Strategy as highly regulated Undertakings for Collective Investment in Transferable Securities funds, though institutional and high-net-worth investors can also come in via the more lightly regulated Alternative Investment Fund Managers Directive.

“The concept is one of style rotation, and using derivatives to isolate and leverage up returns,” says Julien Turc, head of cross-asset quantitative research at Société Générale. “Hedge funds have been doing this for some time, but there is a shift by asset managers and pension funds towards standardised indices, which clarifies the process and enables the asset manager to focus on the strategies that they select rather than the details of managing the trades.

“In an environment where asset managers are struggling with long-only multi-asset portfolios, our discussions on Risk Premia are being well received by investors. Some pension funds might be re-allocating from hedge fund exposure in their alternatives buckets, while others are adding Risk Premia strategies to their existing portfolios.”

Marc Pantic, senior index structurer at Société Générale, says: “The advantages are cost, transparency, liquidity, and the predictability of systematic indices. Our approach is modular, offering building blocks that deliver specific factors, and then blending them together to complement the client’s existing portfolio. 

“It is a bespoke approach, though investment managers are all facing common issues in the current environment. A diversified approach works best, but each [module] is available by itself. For example, a portfolio might already have exposure to an equity momentum strategy, and may want to add a swap trade on US dollar-versus-euro foreign exchange momentum.”

Thematic indices

Outside of the Risk Premia space, investment banks are also seeing a lot of take-up for thematic indices connected to quantitative easing (QE), the low-interest-rate environment, and exchange rate shifts, which are often themselves linked to QE.

During the QE phase in the US, excessive liquidity pushed up valuations on domestic stock markets. In addition, cash-rich companies found it increasingly difficult to generate adequate returns on cash balances, and engaged in either aggressive stock buyback programmes or returning cash to investors via high dividends.

When QE from the European Central Bank (ECB) was being discussed late in 2014, prior to its actual announcement on January 22, hedge funds and investment banks were already looking at strategies to take advantage of the same behaviour by European corporates.

In addition, regardless of central banks using QE with the stated goal of creating liquidity and stimulating economic growth, QE is widely viewed as a mechanism to lower currency values and promote exports.

Just as the US dollar fell during QE in the US, it has soared against the euro since the ECB’s QE appeared on the horizon. This has had the side-effect of encouraging US companies to look for takeover targets in Europe, and banks have created indices with exposure to European corporates that might be ripe for acquisition.

“We regularly get requests from institutions to create indices on themes that they come up with, and we recently had a request from an asset manager for a basket of potential takeover targets,” says one banker based in Germany. But so far themes such as mergers and acquisitions have gained little traction in the retail space, and such indices are being created for a single institution rather than being packed into certificates for broad distribution.

Japan’s buybacks

With regard to the stock buyback theme, it is currently highly relevant in Japan, and both hedge funds and bank indices providers have been quite nimble moving between Eurostoxx derivatives underlyings and Nikkei or Topix underlyings, as market conditions dictate.

In addition, the implied versus realised dividend theme has been to the fore in Japan this year, and bankers report sizeable request for calls on Japanese dividend futures, which is a new type of trade for many investors.

Investors are also arbitraging between equity and credit valuations for banks, given the emergence of the sizeable contingent convertibles market, paying high coupons but which can be cancelled like equity in the event of a bank default.

These are all areas where the major derivatives banks have been working closely with their hedge fund clients, unlike in Risk Premia, where the two are often in competition. “How to play Abenomics or European QE have been key themes for hedge funds, who often come to us with a specific idea, but need our help on execution,” says Stephane Mattatia, head of global flow sales at Société Générale.

“The hedge funds are looking to make leveraged bets by cheapening the options that they buy, and we are structuring a lot of hybrid option trades that are contingent on some other condition, such as a call on the Nikkei plus euro versus yen. We also do correlation trades between, for example, the Nikkei and Eurostoxx. Players such as hedge funds need an investment bank to take the correlation risk, because we have large cross-asset books and can unwind exposures with other investors globally.”

Hedge fund speed

The hedge funds tend to move faster than other market participants, even if it is only a matter of a few months, and will often put on a set of sizeable trades on the same theme, but split into different maturities. Notional sizes can be very large, running anywhere between Ä50m and Ä250m for single tickets for trades that are put on very quickly once the hedge fund develops the trading idea.

But the market is very fast to pick up on new trading strategies, which will often be requested by asset managers or pension funds, but soon be packaged up into indices offered by banks to a wider investor base.

The hedge funds need execution and liquidity, but may also lack the capacity to observe global flows and trends, and may look to their relationship banks to come up with ideas about market dislocations where value can be extracted.

Pension funds and asset managers are more likely to rely on their bank to bring the trading idea to them as well as provide execution. Insurance companies are much more constrained by regulatory considerations in their usage of derivatives solutions such
as Risk Premia or indices. They may
often prefer to look for value in alternatives allocations to real estate or long-term infrastructure loans, where they are willing to pick up extra yield because of the illiquidity in these asset classes.

Alternative opportunities

For the investment banks, the opportunities in developing new ways of putting on exposure to alternatives are sizeable, given the very low proportion of alternatives that are currently allocated within large institutional portfolios. 

For example, a sovereign wealth fund with Ä10bn to manage might typically still have allocations of 55% fixed income, 25% equities and 20% for everything else, including sub-asset classes private equity, property, infrastructure, commodities and hedge funds/indices.

This might mean an allocation of only 4%, or Ä400m, to their hedge fund/indices/Risk Premia bucket. But given the extreme pressure on returns with assets such as 10-year bunds trading at about 1%, these allocations could be increased.

It is even more urgent, given the extreme volatility this year during which 10-year bund yields have swung between 0.2% and 1%, in an environment where ECB president Mario Draghi has said that investors should “get used to” volatility. 

Such an environment is likely to lead to an increase in allocations into new strategies such as Risk Premia, whose volumes look set to grow in 2015 and 2016 as the QE experiment from the ECB attempts to boost economic growth – and eventually move interest rates back to historically normal levels.

Thus far the Risk Premia approach has gained most traction in markets such as the US, Canada, the UK and the Netherlands. Asset managers in the Nordic countries have also been quick to add Risk Premia to their alternatives buckets. But large institutions in markets such as Germany still have to make their move, while Asian investors still favour directional trades. There is plenty of scope for growth.


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