In October last year, Michael Flycht, Deputy Chief Investment Officer at Danish pension fund PKA, raised an important question: How do we know we have the right expression of a factor?
Flycht, speaking at the [i3] Global Investment Strategy Forum 2018 in Singapore, gave an example where the fund was trying to capture a risk premium associated with taking short volatility positions on the Euro Stoxx 50 Index.
He showed two implementations that were nearly identical, but whose performance differed dramatically. Which one was the right one?
David Elms, Head of Diversified Alternatives, is responsible for enhanced index, risk premia and hedge fund portfolios at Janus Henderson Investors.
Elms admits the search for the true expression of a factor is inherently complex.
“There is no easy answer and different professionals will disagree [on the right implementation],” he says in an interview with [i3] Insights.
“The important thing about factors is that they behave the way you want them to behave. You can talk a lot about the construction – and there are interesting academic and practitioner arguments that can be made – but when we look at factors, we tend to look at whether they are fit for purpose in our proposition to clients.
“It should provide something that the traditional asset classes don’t provide.”
The important thing about factors is that they behave the way you want them to behave... It should provide something that the traditional asset classes don’t provide
But he admits stripping out the equity or bond premia completely is a daunting task.
“You gave the example of the volatility risk premium and we have done some work in that area in the last couple of years. It is very difficult to take a volatility risk premium that is not polluted by equity returns,” he says.
“This means that if you have a large exposure to the volatility risk premium, you tend to produce negative performance when equities sell off and that means that you have failed to deliver the diversification that the strategy is designed to produce in that sort of environment.
“For us, this means that in our ARP (alternative risk premia) strategies, we don’t run the short volatility risk premium because it is inconsistent with our promise to investors of diversification.
“It is more about the outcome in the way that the factor behaves, then the input in terms of the way that you manufacture it. It is about what the investor gets at the end of the day.”
But he also points out the market for volatility trades has changed significantly over the years and what might have worked in the past doesn’t necessarily work today.
What’s happened over the last few years is that systematic volatility sellers have provided a price-insensitive component to the sell side of the implied volatility risk premium
“The rise of systematic volatility sellers has changed the supply and demand balance in the market for equity volatility,” he says.
“I think you can argue that you had buyers of protection that were relatively price-insensitive; they just had to protect their portfolios. The other side of that trade were banks and hedge funds that would sell at a price that suited them and typically made money out of the premium that they were able to access.
“What’s happened over the last few years is that systematic volatility sellers have provided a price-insensitive component to the sell side of the implied volatility risk premium.
“This is likely to result in worse returns for being short volatility and potentially opens the door to buying volatility and enjoying the protection that that brings at levels that are better than have been achieved historically.”
Ultimately, it is hard to play single factors, he argues, since most of them have relatively low Sharpe ratios and work best if combined in a multi-factor portfolio.
“By putting them together you can create a portfolio that has strong performance,” he says.
“In doing that, I think it is important to understand the rationale of an underlying strategy. If you believe a strategy has a strong economic rationale, then that is a criterion that is independent of performance and whether it is up or down in a given year.”