Alternative Investments. Black Keith H.

CREDIT RISK PREMIUM: Based on the credit risk of bonds. The strategy is to take long positions in bonds with low credit quality and short positions in bonds with high credit quality.

      

TERM PREMIUM: Based on the riskiness of long-term bonds. The strategy is to take long positions in long-term bonds and short positions in short-term bonds.

      

IMPLIED VOLATILITY PREMIUM: Based on the risk premium earned by the volatility factor. The strategy is to be short the implied volatility of options (e.g., create a market-neutral position using short positions in out-of-the-money puts and short positions in stocks).

      

LOW VOLATILITY PREMIUM: Based on the return to low volatility stocks. The strategy is to take long positions in low volatility stocks and short positions in high volatility stocks. The same strategy can be implemented using betas.

      

CARRY TRADE: Based on the return to investments in high-interest-rate currencies. The strategy is to take long positions in bonds denominated in currencies with high interest rates and short positions in bonds denominated in currencies with low interest rates.

      

ROLL PREMIUM: Based on the return earned on commodities that are in backwardation. The strategy is to take long positions in commodities that are in backwardation and short positions in commodities that are in contango.

      2.5.3 Risk Premiums Vary across Risk Factors

      Do all risk factors offer the same risk premium? The answer to this question has already been provided by the two factors that were presented in Exhibit 2.10. Those two factors offered different risk-return profiles. Different risk factors offer different risk premiums, and the sizes of the risk premiums are not constant through time. Therefore, while a passive allocation to several risk factors could produce attractive results, a more sophisticated approach would consider the size of the premium attached to each risk factor and create an asset allocation that would take advantage of changes in risk premiums. In other words, it might be beneficial to apply tactical asset allocation to risk factors by assigning higher weights to risk factors that are believed to be offering more attractive risk premiums. In addition, academic research has shown that those risk factors that provide poor returns during bad times are the ones that provide attractive returns during normal times. Risk premiums associated with legitimate risk factors are there because these factors perform poorly during bad times. Investors should be willing to hold them only if they provide attractive returns during normal times. Actually, the first step in determining whether an observed source of return is a legitimate risk factor is to compare its return during good and bad times. If the factor provides an attractive return during good and bad times, then it is not a risk factor – it is an arbitrage opportunity.

      2.5.4 Risk Factor Returns Vary across Market Conditions

How do these risk premiums behave through various stages of a business cycle? Exhibit 2.11 displays the rolling 24-month average returns on the two factors discussed in Exhibit 2.10.

      Clearly, these two factors display significant time variations. As previously mentioned, we must expect factor premiums to display some volatility and to perform differently during various stages of the business cycle. If there were no risks, then there would be no premiums. For instance, the book-to-market factor (i.e., value factor) tends to produce attractive risk-adjusted returns during normal market conditions but have poor risk-adjusted returns during economic downturns.19 The momentum factor tends to produce positive returns most of the time but has a tendency to display large negative returns over a short period of time when a market correction takes place. Momentum is notorious for performing poorly during momentum crashes. A momentum crash occurs when those assets with recent overperformance (i.e., those assets with momentum) experience extremely poor performance relative to other assets (Asness et al. 2010). In the same way that investors have learned to hold diversified portfolios in terms of asset classes, they should hold diversified portfolios in terms of risk factors.

EXHIBIT 2.11 Rolling 24-Month Average Returns to Factors

      Source: K. French Data Library.

      2.5.5 Risk Factors and Investability

      Are all risk factors investable? While 20 years ago it might have been difficult and costly to create investment strategies that represented various risk factors, financial innovations of the past two decades have substantially reduced the cost of such strategies. For example, in recent years, exchange-traded funds (ETFs) have become available that track value, volatility, momentum, size, and roll factors. These strategies are often described as using smart beta. Another term for describing the investability of a risk factor is that it is tradable.

      While many factors are tradable, they may not be fully implementable. For example, the value factor has been shown to be strongest for the very small-cap firms. However, there is limited capacity for investing in these firms, and the bid-ask spreads for their stocks are quite wide. Since creating the value factor would require frequent rebalancing of the portfolio, it may not be possible to fully implement factor investing in value stocks. Therefore, traded investment products designed to replicate the value factor tend to concentrate their allocations to large-cap stocks, which have shown to be poor representatives of the value factor.

      Even when pure risk factors may not be fully traded, their return properties are useful in measuring risk exposures of investment products (e.g., hedge funds) and in determining if they offer any alpha. If one were to regress the excess return of an investment product against the returns of several traded factors, the intercept would represent the alpha of the investment product.

      2.5.6 Risk Allocation Based on Risk Factors

      How does one perform risk allocation based on risk factors? Factor or risk allocation is no different from asset allocation. After all, one has to use assets to isolate risk factors. Two issues related to factor investing should be considered. First, it is not possible to create a benchmark for a passive factor investing strategy. This is because factors involve long/short strategies, and therefore it is unclear what the passive weights of a diversified portfolio of factors should be. Should the factors be equally weighted, or should they be volatility weighted? There is no clear answer to this question.

      Second, direct factor investing requires the investor to actively manage portfolios that are supposed to represent risk factors. Therefore, there is no such thing as passively managed factor portfolios. It should be pointed out that if there are enough investment products (e.g., funds and ETFs) replicating each risk factor, then the investor could follow a buy-and-hold strategy involving these investment products. However, unless one is willing to allow the weights of some factor to become very high or low, the investor will have to rebalance the portfolio on a regular basis. In addition, direct investments may not be a viable strategy for some institutional investors, as most factor strategies would require long and short positions in certain asset classes, and many institutional investors may not be prepared to take short positions.

      Several hedge fund strategies earn their returns by exploiting these risk factors. For instance, the merger arbitrage strategy earns a premium by exploiting a risk factor related to the uncertainty surrounding the completion of mergers. The convertible arbitrage strategy exploits a form of the implied volatility factor, and many equity long/short and equity market-neutral strategies have been shown to have significant exposures to risk factors of the equity markets (Zhang and Kazemi 2015). Finally, global macro strategies often rely heavily on the carry trade factor to generate returns.

      2.5.7 Performance with Allocations Based on Risk