Faced with historically low bond yields amid equity market volatility, institutional investors are increasingly combining alternative risk premia strategies with other diversification strategies, like managed futures and tail risk hedging, to create “risk-mitigation portfolios.” Below, PIMCO portfolio manager Matt Dorsten and asset allocation strategist Brad Guynn explain how multi-asset alternative risk premia strategies can be customized to complement other risk-mitigation strategies in these portfolios while retaining attractive return potential.

Q: What are alternative risk premia strategies?

Dorsten: Alternative risk premia strategies, which include value, carry, and momentum, generally invest across liquid asset classes and aim to generate returns outside of market beta, often through the prudent use of derivatives and long/short portfolio construction.

Over the last decade, investment products dedicated to various alternative risk premia have evolved, and their popularity has grown significantly in the past few years. Today more than 40 asset managers offer these solutions, with total assets of $150 billion−$250 billion globally.¹ PIMCO launched the Multi-Asset Alternative Risk Premia Strategy (MAARS) in March 2017, and since inception, our approach has resulted in strong performance.

Although strategies dedicated to alternative risk premia are relatively recent, PIMCO has deployed the concepts behind them since the 1980s in many actively managed portfolios and hedge fund strategies, and in our view, these have been a key driver of our ability to add value in client portfolios.² Historically, we referred to these strategies as “structural alpha”³ when we used them as part of our broader alpha toolkit because they generally seek to benefit from persistent behavioral anomalies or market inefficiencies that compensate investors for taking exposure to risks that others are unable or unwilling to underwrite.

Q: How can alternative risk premia strategies mitigate portfolio risk?

Guynn: Recognizing that equity risk drives portfolio volatility in most institutional portfolios, investors concerned about diversifying away from equity risk have traditionally turned to cash, core fixed income, and real assets as “ballast” to try to offset the impact of equity market downturns. However, these asset classes offer meager yields today and returns far below the levels many institutional investors require to meet their liabilities.

As a result, some investors are beginning to create “risk-mitigation portfolios” by combining long maturity bonds, managed futures, tail risk hedging, and alternative risk premia. These portfolios are designed to target attractive returns, while maintaining robust equity risk mitigation.

Within these risk-mitigation portfolios, alternative risk premia strategies typically play the role of return generators. Because they seek returns with little or no correlation to equities or fixed income, their inclusion isn’t expected to erode the equity risk mitigation properties of the other components (i.e., long bonds, managed futures, and tail risk hedges), which are designed to do most of the heavy lifting in terms of downside risk mitigation.

Alternative risk premia strategies are in general relatively liquid. So, much like the other components of the risk-mitigation portfolio, they can be tapped for liquidity opportunistically if an investor decides to rebalance the investment portfolio.

Q: What should investors consider when choosing an alternative risk premia strategy for risk-mitigation portfolios?

Dorsten: As alternative risk premia strategies have increased over the past decade, we have seen significant performance dispersion, which shows that strategy construction varies significantly across managers, even if the strategies appear similar on the surface. For example, in the fourth quarter of 2018, U.S. equity markets, measured by the S&P 500 index, fell more than 14%. (The peak-to-trough drop was nearly 20% between 24 September and 24 December.) Over the quarter, the best-performing alternative risk premia strategies posted gains in the single digits, while the worst-performing experienced double-digit losses, according to Société Générale.

Some alternative risk premia strategies are designed to be hedge fund substitutes and focus on maximizing their overall Sharpe ratios, or risk-adjusted returns. Others focus on providing diversification even if that means a modestly lower long-term Sharpe ratio. The latter fared better overall during Q4 2018 as these strategies systematically had taken steps to reduce or eliminate equity market risk altogether.

Recognizing that some investors want this heightened focus on diversification/risk mitigation, we designed PIMCO Multi-Asset Alternative Risk Premia Strategy Risk-Off Version, or MAARS ROVER.

We make adjustments to the underlying strategy design and portfolio construction in MAARS ROVER in an effort to further reduce or even eliminate equity market correlation. For example, some alternative risk premia strategies can exhibit directional bias over shorter horizons or in turbulent markets, despite their market neutrality on average over time. In MAARS ROVER, we seek to reduce or eliminate these, even if the procyclical bias would surface only in tail scenarios, because we don’t want beta to creep into the portfolio if equity risk mitigation is a key investor objective. Conversely, we emphasize strategies that have a more countercyclical bias, given their potential to generate positive returns in risk-off environments. We also make adjustments when we can to “tilt” an alternative risk premia strategy toward a modestly negative equity correlation or away from long equity market beta.

As a result of these adjustments, we estimate MAARS ROVER is likely to exhibit a lower equity market correlation than MAARS, potentially making it more suitable for inclusion in risk-mitigation portfolios. This potential benefit isn’t free: We also estimate the adjustments in the MAARS ROVER portfolio can reduce its long-term returns modestly versus more common alternative risk premia strategies. In exchange, however, MAARS ROVER aims to outperform during equity market drawdowns. For example, in the equity drawdown during the fourth quarter of 2018, the S&P 500 returned −13.52% while the Société Générale Multi-Alternative Risk Premia Index, a broad benchmark for ARP strategies, returned −1.55%. MAARS ROVER is designed to outperform both during such periods.

Q: How does PIMCO’s approach to alternative risk premia strategies differ from others?

Guynn: We manage more than $3.2 billion in client assets in the MAARS and MAARS ROVER strategies as of 30 September 2019. We believe our approach of offering multiple solutions designed to more closely align with investors’ objectives is innovative: MAARS seeks to maximize its Sharpe ratio, while targeting a near-zero correlation with equities over a full business cycle; MAARS ROVER is a modified portfolio designed to reduce the average correlation to equities by about 20%, although we expect this to come at a modest cost to long-term returns.

PIMCO’s approach to alternative risk premia is differentiated from others’ in several ways. These include:

1. A balanced allocation to non-equity-based alternative risk premia strategies. Many others may concentrate more than half of their risk allocation in equity-based strategies, but MAARS and MAARS ROVER allocate roughly equal shares of risk across fixed income, equities, commodities, and currencies. We believe the diversity of models and ideas we implement in non-equity sectors is unrivaled among peers.
2. The breadth and depth of expertise of PIMCO’s platform. In strategy design and execution, our quantitative portfolio managers and researchers benefit from the insights of and collaboration with PIMCO’s macro and sector specialists.
3. The advantages of scale. Alternative risk premia strategies typically trade frequently and make prudent use of short positions, derivatives, and leverage. We believe MAARS and MAARS ROVER benefit significantly from PIMCO’s capabilities in execution, risk management, collateral management, and counterparty risk management. We can also access markets that may be challenging for others, and can potentially realize many operational benefits from being part of an asset manager with $1.88 trillion under management.

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