A study by Aquila Capital's quant team demonstrates how a ‘Factor Premia’ approach to investment can deliver additional sources of return and improve portfolio diversification when added to a balanced risk parity portfolio.
According to Aquila Capital, the addition of a ‘Factor Premia’ approach could help a risk parity portfolio to better withstand times of market stress, as seen in May and June 2013.
Aquila’s ‘Factor Premia’ approach moves away from the traditional view of asset classes and instead looks at the underlying forces – the factors – that actually drive asset prices. Its new ‘Factor Premia’ study provides a roadmap for factor selection and analyses the returns of a portfolio comprising factor exposures as well as its correlation with traditional asset classes. Such a portfolio would indeed have acted just like an asset class of its own, hence the term ‘New Asset Class’ – originally just a code-name for the research project – stuck.
Since September 2009, this ‘New Asset Class’ would have yielded an annualised premium of 4.7 per cent with a volatility of 4.6 per cent.
Aquila has selected a combination of three factor exposures for its ‘Factor Premia’ implementation, with these exposures being derived from equities, fixed income and commodities. In the equities space, it has identified Momentum as the key factor, in the fixed income space it is Carry and for commodities it is Backwardation.
Aquila’s ‘Factor Premia’ respond to the increasing difficulty of building diversified portfolios as asset classes become ever more correlated due to globalisation and freer markets. Aquila believes that greater central bank and government intervention in financial markets and specifically the act of depressing interest rates since the start of the financial crisis in 2007/2008 is also making asset classes move in lockstep and is causing the correlations of supposedly unrelated markets to increase.
As a result, Aquila believes that traditional asset class diversification has become increasingly difficult, as demonstrated by the market events in May and June 2013, when a substantial and rapid price decline and spike in asset class correlation led to significant losses across all asset classes, consequently also impacting the performance of risk parity managers.
Torsten von Bartenwerffer, director of portfolio management in Aquila Capital's Quant Team, says: “Combining a number of judiciously chosen factor exposures provides an uncorrelated, liquid source of returns as well as additional diversification. As a result, a ‘Factor Premia’ approach has all the right characteristics to make a valuable contribution to a well-balanced risk parity portfolio, while still adhering to the building blocks of risk parity: building on long-term positive risk premia and low correlation, rather than forecasting or discretionary trading approaches.”
Risk parity has increasingly gained the attention of investors seeking an alternative to the unbalanced risk profile of a traditional capital-weighted portfolio. It aims to achieve true diversification by constructing a portfolio in such a way that individual asset classes contribute equally to the portfolio’s overall risk.
