When an investor begins the journey to allocate to alternative risk premia they face challenges to be able to effectively diversify their portfolio. They need to determine where alternative risk premia belongs in an asset allocation scheme, whether they should explore only alternative risk premia supported by academia or venture in to premia where only practitioner research is available. There are also challenges as to how investors can assess crowdedness, determine a benchmark and source a transparent alternative risk premia solution.
“When you think about J.P. Morgan, when it comes to alternative risk premia, the strength in research, analytics, as well as their ability to develop flexible and customized solutions, continues to set them apart,” said one U.S. asset manager looking to increase its exposure to alternative risk premia over the next 12 months. “If you take research as one example, one of the key differentiators for the firm is its cross-asset risk premia strategies ‘Views & Analytics’, particularly given that it provides analysis with qualitative and quantitative perspectives.”
When investors enter a swap with a bank to receive premia, they also receive a rules book detailing the mathematical formulae and legal minutiae that will determine their returns. This transparency is in fact a major draw for many allocators, who are increasingly turning to bank risk premia because it is more of an open book. For the banks, however, the transparency can make it harder to differentiate their offering. The Street’s back tests are uniformly positive and pricing is increasingly competitive. So what’s a bank to do to set itself apart from rivals?
J.P. Morgan’s successful strategy has been two-pronged. Firstly, to provide standout client services at all phases, from pre-trade to post-trade. And secondly, to ensure that execution and product design correlate to the requirements of the end-investor when seeking out an alternative risk premia solution.
Most importantly, setting appropriate expectations with investors is key when communicating the advantages of alternative risk premia, when in the context of stretched valuations for risky assets and the current yield compression across the board. “I think it’s important you set expectations in the right place,” said Arnaud Jobert, global head of investable indices structuring at J.P. Morgan in London. “There should be no disconnection between what clients expect to receive and what they actually get.” The difficulty is that, since all banks are able to produce attractive Sharpe ratios from a back-testing standpoint, the temptation is there to deliver a strategy that looks great on paper but is less likely to perform in conditions like those the markets experienced in early February. J.P. Morgan’s approach is to work with customers to make sure they fully understand what they are buying into – and that perhaps, you should not be expecting to deliver a Sharpe ratio of 2.5 or 3 where you have a combination of risky assets and compression of fees across the board, Jobert said. “We tend to have a very straight-forward discussion with clients in terms of looking at all of (the) risk premia, looking at which ones are likely to perform across different environments over the long term,” he said. The bank prefers to set more realistic expectations, for instance, a Sharpe ratio of 1 given the low volatility over the last two years.
There should be no disconnection between what clients expect to receive and what they actually get.
Global Head of Investable Indices Structuring, J.P.Morgan
As well as working pre-trade to set the right expectations, the bank also works during execution and post trade to make sure the customer is comfortable with the risk-return profile of the investment. J.P. Morgan provides analytical tools to understand how its premia behave in different market scenarios, the officials said. The idea is to help the client understand exactly what is in their portfolio, said Rui Fernandes, head of EMEA equities structuring and fund linked products. “Crucially (this then) helps their organizations understand what they have in their portfolios – that’s really important,” he added.
In connection with preparing customers’ expectations before entering an ARP solution, J.P. Morgan works on testing its risk premia through a rigorous scenario analysis. It’s important for clients to understand how a strategy will perform in multiple scenarios, said Fernandes. “What’s really important…as we launch new strategies is not just to create a typical historical back test but rather do that plus a lot of work on stress testing and scenario analysis of that strategy not just pre-launch but post-launch,” he said. This kind of scenario analysis is also helpful to define more accurately what an allocator is putting their money into – i.e., they might be investing in a momentum strategy, but how will that strategy perform in a down-market, up-volatility scenario? Will it be defensive or not? Jobert noted that the ARP industry at large needs to think and talk about strategies with more specificity. “We need to categorize with more granularity,” he added.
Ensuring that product design helps set J.P. Morgan apart is another important part of the bank’s strategy. A recent innovation has been an intraday momentum strategy to deliver returns within a defensive bucket. While many ARP investors have watched as some of their defensive premia allocations have underperformed expectations in recent months, given their inherent short-vol bias, J.P. Morgan’s intraday momentum strategy had one week with a performance around 20% in February.
J.P. MORGAN’S INTRADAY
PERFORMANCE IN FEBRUARY
The strategy allows investors to go long the Cboe Volatility Index at any point during any trading session when VIX passes a barrier on the upside, then the bank closes up the position to lock in a profit on the hedge. The main driver for coming up with this product was designing something for a shorter-term trend that would be able to be more reactive, Jobert said. “We typically think of different kinds of horizons,” he said, adding, “Trend following is considered the long term time horizon, i.e. you would need a prolonged sell off of trend following to develop protection.” That would not work in an environment like early February’s. “What had happened was a quick reset so we need to think more reactive,” he explained. The VIX intraday product is also an example of J.P. Morgan’s emphasis on execution. It is not just about intellectual property, he said.
For Jobert and Fernandes, it is by investing in the execution framework that will drive further growth in alternative risk premia solutions from institutional investors. “When we hold our roundtable of Nordic investors, one typical feedback they have for banks is in a large extent around investing in the execution framework. So if you look at the VIX intraday solution as an example, in our case it’s not about the IP – going long the VIX is a simple IP – but what is critical is the execution framework,” said Jobert. “So in the VIX market where you could have sparse pockets of liquidity you need to make sure you deliver execution in the VIX market that mitigates the market impact. Execution has been a big area of focus for J.P. Morgan across all product areas i.e. deliver beta access to fundamental premia and behavioral premia.”
…it is by investing in the execution framework that will drive further growth in alternative risk premia solutions from institutional investors.
Alongside this, Jobert added that it is in structural premia where the bank wants to see some further extension of alternative risk premia allocations, which have broader applications within traditional and strategic asset allocations. “In our view there is more room for some of the traditional asset owners implementing traditional factor mandates to look for more opportunities in the structural premia space which would be more dependent on more market supply/demand imbalances and provide a more interesting carry addition or risk off profile,” he noted.
Kari Vatanen, head of cross-assets and allocation at Varma in Helsinki, who participated at the recent EQDerivatives Europe EQD conference in Barcelona alongside Jobert on the risk premia investor panel, added that another benefit of structural premia is that it can increase the diversification of your portfolio. Vatanen recently co-authored a paper with Antti Suhonen at Aalto University School of Business setting out a new framework for alternative risk premia investing to facilitate the construction of balanced portfolios of commonly known strategies across asset classes.
“In a core portfolio that is made up of fundamental and behavioral premia, I think there are limited ways in adding different things. Carry premia is what it is, momentum premia is what it is, and if you want to go beyond these two premia types and add diversification you have to do something else – this is where opportunities in structural premia come in,” said Vatanen. “There are a lot more possibilities in structural premia as it reflects opportunities in changing markets and feature strategies that tend to work at some point of time but not all the time. So, if you add these kinds of strategies as a satellite to your fundamental and behavioral risk premia portfolio you can increase your diversification since structural premia is typically less correlated with traditional assets or premia, and there are extra returns available given the positive expected premia embedded in many of those strategies.”
Looking forward, J.P. Morgan is working on expanding the breadth of applications for alternative risk premia. “One of the areas we’re spending a lot of time on is how to think of the breadth of ARP in terms of possibilities,” Fernandes said. The bank is working with clients to move beyond thinking of ARP as a replacement for hedge funds that is cheaper, more transparent and with a better risk-adjusted return. That might be the original rationale for allocating to ARP, said Fernandes, but he said he wants to progress with clients to look at using ARP as an outright replacement for an equity allocation. “The moment investors start thinking along those lines, the possibilities are that much greater,” he said. “I think that is one very promising area of growth.”