The increasing popularity of smart beta strategies and subsequent product proliferation has increased the risk of crowded trades, according to asset consultant Willis Towers Watson.
Although most fund managers active in this space are well aware of the potential pitfalls of their individual strategies, the vast range of products available today will inevitably contain strategies that are less thoughtful in their risk management approach.
“Given the rapid growth in this emerging space, there is some risk of crowding, and investors who don’t fully understand the risks of investing here should work with an advisor or outsource,” the consultant said in its report The Global Alternatives Survey, which was published last night.
“This is especially important among the quantitative and factor-based strategies, many of which carry left-tail risks and are managed using an antiquated or less differentiated approach,” the report said.
Sydney-based Senior Consultant Aongus O’Gorman told i3 Insights that although it was still early days investors would do well to monitor the situation.
“We are seeing an awful lot of product being created and of course the really good managers understand their stuff and are aware of the tail risks, so I wouldn’t generalise it,” he said.
“But because there is so much product coming on line, there is a risk that not every manager is on top of these things,” he said.
If everyone takes the same position at a similar point in time, then rather than getting a trend you’d get this sharp movement to a new price level.
Part of the problem is that crowding in certain trades could see a departure of a strategy’s behaviour from what is modelled.
“You might start off saying: ‘Okay, I understand this strategy; it is a momentum strategy and it might make money when equity markets fall because you get strong trends’.
“The risk with a strategy like that is that everybody puts it in their portfolio at the same time and has the same expectations for its behaviour.
“If everyone takes the same position at a similar point in time, then rather than getting a trend you’d get this sharp movement to a new price level.
“If you think about these systems, which are often set up for slower moving trends, the speed with which they capture this trend takes longer and if you are confronted with this sharp movement it is unlikely that these systems would capture it. That is how it would play out.
“But it hasn’t played out like that at the moment – it hasn’t been this crowded – but these are the concerns we have, because not everyone is going to understand that or be familiar with those risks,” he said.
In the survey, Willis Towers Watson said that despite the recent performance headwinds and investors’ continued focus on lower fees, hedge funds and liquid alternatives continued to fulfil an important role in mitigating risks and providing diversification away from equities.
“Overall, we continue to see value to be had if done correctly, and we are advising our clients to increase their allocations generally,” the report said.
“Industry wide, we anticipate continued growth in alternative beta strategies and assets, perhaps offsetting any redemptions from alpha seeking managers who have struggled to perform,” the report said.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.