A long-term perspective on ARP

The below is an extract from our Q3 Asset Allocation outlook.

We’re now within touching distance of a decade of integrating ARP strategies into some of our multi-asset portfolios. So, it feels like a good time to reflect on what we’ve learnt about the role of these strategies, how we’ve implemented them and – of course – how they’ve performed in a variety of market environments.

As the name suggests, ARPs are an alternative way of seeking returns over the ‘risk-free’ rate in exchange for taking on various risks. They aim to capture risks that are persistent due to structural or behavioural reasons, and to do so in a systematic and repeatable way. While equity risk premium is earned by taking company-specific risks, ARPs typically target factors. There are hundreds of them out there, but the four shown below are the most common and understandable:

• Value: Assets or currencies that are ‘cheap’. i.e. that trade at discount to fair value
• Flow: Providing liquidity amid a structural imbalance between supply and demand
• Carry: Higher-yielding assets or currencies that earn an insurance premium
• Momentum: Rule-based approach to avoid behavioural biases causing the persistency in returns

Our overarching philosophy on using ARPs in a multi-asset context is simple: you’re only harvesting a reward for taking a certain risk, so make sure you understand the risk, target risks that are different from what you already own, and harvest them without undue costs.

This means we look for simplicity, liquidity, transparency and diversification relative to other return streams in a multi-asset portfolio.

1. Simplicity: We try to capture 80% of the risk premium and leave the last hard-to-get 20% to others – this allows us to use cheaper-to-trade derivatives
2. Liquidity: Turnover tends to be higher than for most traditional long-only strategies, so trading in liquid derivatives and keeping trading costs low are important, in our view
3. Transparency: We want to know which risk we are insuring against, which structural flow are we hedging, or which behavioural bias is causing the inefficiency
4. Diversification: We’re wary of ARP strategies that may look different, but basically provide more of what we already own

How have they done?

When considering the performance of ARP strategies, it’s important to remember their quantitative nature. Not only does this mean the models can be easily back-tested, but they can be created specifically to produce a favourable back-test. ‘Data mining’ can lead to models with apparently remarkable risk and return characteristics, but academic research finds this advantage can all too easily slip away in the real world. As such we apply a 75-100% haircut to any historical Sharpe ratio to arrive at a more realistic expectation.

Even with significantly lowered expectations, the industry-wide performance of ARP has struggled for much of the period in question. However, our sophisticated statistical testing of the realised track records of ARP suggests the returns we have experienced are within the normal range of expectations, albeit at the low end.

One of the ways we’ve evolved our use of ARP is to be mindful of structural breaks in markets that may limit the effectiveness of particular strategies.

For example, we stopped following currency momentum signals during the period of historically low interest rates and increased central bank intervention in FX markets – this was vindicated as those strategies went on to deliver negative returns. Similarly, during the pandemic we moved away from slow-moving momentum strategies as we were wary of their ability to keep pace with the rapidly shifting market of that time.

Diversify and thrive

While headline performance of ARP strategies has struggled, their diversification benefits[1] have led to improved client outcomes, in our view. Over the near-decade in question they’ve showed close to zero average correlation to other return streams in multi-asset portfolios – namely, market risk and tactical asset allocation.

As ardent believers in diversification we note that ARP strategies aren't just different from traditional market risk premia; because they are systematic, they are fundamentally different from the people-led discretionary macro investment process we use elsewhere. This is demonstrated by their low correlation of -0.2 with our tactical trades.

The diversification properties have been especially important in periods of market downturns, when our ARPs have generally been positive or at least remained flat. This return profile is arguably the key reason for us to keep using them.

Overall, we believe ARPs justify their place in a multi-asset portfolio, but with the caveat that they need to be considered holistically. In our view, this is best done by integrating ARP research into a team with the experience to read the macroeconomic environment and spot structural breaks that could cause certain risk premia to underperform.

The above is an extract from our Q3 Asset Allocation outlook.

 

[1] It should be noted that diversification is no guarantee against a loss in a declining market.