Mercer | Risk Premia Investing

Alternative Investments

Risk Premia Investing – From the Traditional to Alternatives

Alternative risk premia have become a popular area of focus in the investment world. Academic literature has been supplemented with product launches from the asset management community and new solutions from investment banks (some marketed as “smart beta” strategies). Recent surveys of large institutional investors illustrate an attraction to this type of framework, with indications that large endowments and pension plan investors are increasingly focusing on factor analysis and specifically risk premia when constructing their broader investment portfolios.

Alternative risk premia are not new. Many investors already have exposure to them via their actively managed equity and hedge fund portfolios. Their greater recognition has, however, brought to light the explicit roles that they can play in investor portfolios:

  • As specific return drivers to exploit or target in an equity portfolio.
  • As premia to understand and track in other asset classes (such as active currency management or in portfolios of hedge funds).
  • As possible standalone components of a liquid growth portfolio. 
     

Alternative risk premia are not new, but their greater recognition has highlighted the explicit roles that they can play in investor portfolios.

In this paper we provide an overview of the risk premia concept and focus on a set of liquid “alternative” (or non-traditional) risk premia in particular. We cover the following topics:

  • Identifying traditional risk premia (how risk premia can be defined and the common exposures for investors).
  • The emergence of alternative risk premia (such as value, carry, and momentum) as recognized and exploitable sources of returns.
  • Identifying alternative risk premia (the types of alternative risk premia that are regularly and consistently identified as sources of returns for institutional investors).
  • The possible roles of alternative risk premia (why investors might want to gain exposure).
  • Thoughts on using new alternative risk premia products as standalone components of a growth portfolio. 

Overall, we believe that investors can benefit from a bias to alternative risk premia in their equity portfolios — capturing additional drivers of return above and beyond simple equity market beta. In essence, their role in this context is as a tilt to the underlying equity market exposure.

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