I'm reading about this three concepts but still can't see the difference between the three of them, can someone please explain the main difference between three of them ? Thanks
$\begingroup$
$\endgroup$
4
-
2$\begingroup$ Here is my completely useless opinion: Not much difference. Expected value still zero, except progressively more noise terms to justify management fees. $\endgroup$– user34971Commented May 8, 2020 at 14:44
-
1$\begingroup$ According to T. Roncalli "Alternative risk premia designate[s] non-traditional risk premia other than long exposure to equities and bonds. (Emphasis added). So the risk premium on equities (ERP) and the term premium on govt bonds are "traditional", everything else is "alternative". These are marketing terms, so some skepticism/cynicism is justified (though I don't think it is all noise). $\endgroup$– nbbo2Commented May 8, 2020 at 15:12
-
1$\begingroup$ Possibly the Credit Premium on Corporate Bonds is also traditional, although some would argue it is mostly a combination of the other two. You can see how ambiguous it all is. $\endgroup$– nbbo2Commented May 8, 2020 at 15:44
-
1$\begingroup$ @noob2 's comment is of course the more thoughtful / balanced one, and therefore the better one for the OP. (Marketing, and hypes in general, just make me cranky..) Skepticism is always good, and more often than not heavily publicized/advertised strategies have been traded away long time ago (i.e. no systematic premium left). $\endgroup$– user34971Commented May 8, 2020 at 15:47
Add a comment
|
1 Answer
$\begingroup$
$\endgroup$
OK, I'll share a lot of the scepticism voiced in the comments to the OP above. There is an important marekting>reality dimension here. The problem is that if an investor wants a core traditional risk premium like Treasuries or the S&P, there's an ETF costing single-digit basis points. Institutions can do liquid futures (or swaps on interest rates) at the same or less. A lot of the new terminology "adds value" in much the same way that Nestle takes cheap coffee and turns it into a pricier "Nespresso". Some healthy scepticism is warranted here.
But in fairness, "much the same" is not the same as identical. The basic concept with ARPs and Factors is that there are families of risk premia embedded within the traditional asset classes and their "risk premia", that are not fully correlated with the latter. This lack of correlation generates (fingers crossed) diversification benefits, "the only free lunch in finance", that can improve the risk-reward compared to the vanilla asset class. Which is the basis (if it works) for those higher associated charges.
So the classic "factors" within equities are small-cap, value, momentum, and "quality" (whatever that means, however that is measured). Conceptually if the theory is right, one could construct a portfolio long of these factors that is zero-beta of the broader stockmarket; and thus represents an independent source of returns.
ARPs are much of the same, but traditionally found more in other asset classes, rather than equities. A classic example (if not cliche) is the FX carry trade. Higher interest rate currencies pay off for being, generally, higher-risk currencies to hold.
But perhaps a cleaner expression of concept lies in commodity markets. Commodity returns are obviously dominated in the short-term (but not WTI last month!) by spot price movements. Over the longer-term, roll dynamics can accumulate to matter more. So one ARP, analogous to the FX carry trade, is to long-short commodities in backwardation/contango respectively. This is a risk premium within commodities, that does not depend on commodity prices higher or lower. As such it is deemed/described as "alternative". Another one is to hold the front three contracts and roll 1/60th (given 21 trading days a month) every day from front to 3rd; while selling the traditional front-month roll (that killed WTI last expiry). In essence, you get paid (fingers crossed) for taking the illiquidity beyond front-month. Again, it's a commodity trade; but it's not a directional bet on commodity prices. As such, it becomes "alternative".
One could also choose to see covered-call selling of stocks in the same light, trying to harvest a volatility effect (because usually implied > realised) from stocks. Which is related to but different from buying/selling stocks.
The jury is still out on whether any of this stuff actually/reliably works; but hopefully that explains the essence of distinction in terminology?
