This is a summary of “Hedge Funds vs. Alternative Risk Premia,” by Philippe Jorion, published in the Fourth Quarter 2021 issue of the Financial Analysts Journal.
Listen to an audio version of this summary.
Alternative risk premia in the form of bank-provided total return swaps provide effective, cheaper, and easier-to-access hedge fund returns.
What’s the Investment Issue?
Alternative risk premia (ARP) provide access to the long–short risk premia that drive hedge fund performance. ARP are growing in popularity because they offer investors exposure without having to pay the high fees usually attached to hedge funds.
ARP can be accessed in two ways: through private funds or through total return swaps (TRS) created by banks. Because little research exists on the TRS market, this article focuses on the performance of TRS. The key question the article answers is whether ARP allocations made via TRS can replicate hedge fund returns.
How Do the Authors Tackle the Issue?
The authors turn to an entirely new data source, consisting of bank risk premia indices constructed by Hedge Fund Research (HFR). These innovative indices, based on 1,125 products offered by 12 major banks, aim to replicate the performance of bank risk premia products across many asset classes and investment styles.
In order to compare returns on these products, the HFR metrics have common features such as being net of fees, calculated in US dollars, and measured in excess of the risk-free rate.
Using these metrics, this article evaluates the performance of ARP products and compares their returns with those of hedge funds from 2010 to 2020.
What Are the Findings?
Many ARP provided strong returns.
For a 10% target volatility, the average excess return for equity value TRS products was 6.9%, which is significant. Notably, many TRS had some directional exposure to equities, which enjoyed a post–financial crisis surge during the decade analyzed.
Excess return for rates products was 3% to 6%, and for credit products, around 4%. On the other hand, currency products did not perform well, and commodity products displayed mixed performance.
ARP explain a large proportion of hedge fund performance, especially for quantitative strategies and traditional market factors, such as equities, rates, and credit. After accounting for market factors and a selection of bank risk premia, hedge fund indices have very little excess return left over. Currency and commodity funds, for instance, are heavily weighted toward currency and commodity risk premia. Meanwhile, macro systematic funds are weighted on momentum factors, and merger arbitrage funds load predominantly on the rates volatility factor.
The article also shows that some hedge fund strategies are not well replicated by risk premia. These include most equity strategies (other than quantitative) as well as security-specific strategies, such as activist and distressed debt funds.
What Are the Implications for Investors and Investment Managers?
The approach outlined may help investors toward an improved replication of hedge fund index returns. The findings are especially relevant for investors in and managers of quantitative hedge funds, who are more likely to follow systematic trading rules. They are less relevant for investors in security-focused hedge funds.
Consequently, investors in certain hedge fund strategies could consider outsourcing the execution and design of their investments to banks that operate TRS. Unlike academic risk premia, the proposed approach is fully investable because it accounts for all transaction costs.
In particular, using TRS products within the framework described can help guide the manager search process by distinguishing between what is an ARP exposure (and can be replicated cheaply) and what is alpha generated by genuine manager skill.