Sources of Return Dispersion in Alternative Risk Premia

Abstract

The author qualitatively identifies eight sources of potential return dispersion across portfolios of risk premia strategies, including strategy inclusion, amount of systematic risk, instrument choices, parameter choices, instrument weighting mechanisms, data choices, execution timing/execution processes, and level of crowding in the strategies employed. The author then performs simulation analysis that shows that returns of simulated portfolios can be quite different from one another as a result of altering just a few of the sources of risk premia return dispersion. While others have noted the return dispersion of risk premia providers, the author’s contribution is to provide an initial taxonomy of the drivers of this dispersion as well as an analysis that helps to make these ideas more concrete.

TOPICS: Analysis of individual factors/risk premia, portfolio theory, portfolio construction

Key Findings

• • Alternative risk premia (ARP) portfolios and indexes tend to perform very differently from one another, with low correlations and substantial return differentials, despite being similar in name and broad investment approach. This renders ARP funds difficult to compare, analyze, and benchmark.

• • The sources of return dispersion generally fall into eight categories. Analysis of ARP managers along these dimensions may be useful in determining how and why return streams of particular managers differ. This taxonomy may also be helpful in determining which ARP managers are most suitable for a given investor.

• • Alternative risk premia strategy implementation matters, and there is no substitute for a more nuanced understanding of the potential offerings in the space.