To view in digital magazine format, click here.
Exotic betas offer attractive long-term returns, more consistent performance than traditional asset classes, and low correlation to global equity markets. Some are already embedded in the typical institutional portfolio; more explicit and purposeful management of these exposures can lead to better balance and diversification.
Institutional investors have undertaken significant efforts to better manage and balance risk. While progress has been made, much work still lies ahead. Most portfolios remain severely imbalanced, with the typical portfolio dominated by equity and equity-like risks. This remains true even after the broad-based reallocation of capital to other assets and alternatives. The drive toward “risk parity” strategies over the past few years has been fueled by the need to address these imbalances. The principal concept underpinning such strategies—the need to balance risk, rather than capital—is a key step toward more consistent performance.
Risk parity strategies seek to balance risk across traditional asset classes. This yields improvements, but the improvements are limited. Significant additional gains are available once long-only asset class-level constraints are relaxed and the focus is shifted to underlying risk factors. This requires deeper analysis, with a focus on the underlying risk factors driving returns, rather than just the typical distinctions between stocks versus bonds or alpha versus beta.
Eight years ago, well before the financial crisis, we began discussing exotic beta, a concept that is sometimes referred to as “alternative risk premia,” “risk-factor investing” or “smart beta.” We define exotic betas as exposures to risk factors that are both uncorrelated with global equity markets and have positive expected returns. We describe them as existing on a spectrum between alpha and the widely known equity market beta. Like alpha, they are a source of uncorrelated returns to most portfolios, but unlike alpha, they are not opportunities captured by unique active management skill. Exotic betas are compensated risk factors for which investors earn excess returns. They are transparent and relatively well-known. What differentiates them is simply the source of the return.
In this article, we describe the high-level characteristics of exotic betas and their potential role in institutional investment portfolios. Due to limitations in space, we cannot fully describe our research, testing, and live experience with exotic beta strategies. We provide a more thorough analysis of the subject in “Exotic Beta Revisited,” our comprehensive white paper on the sources, characteristics, and practical features of exotic betas and exotic beta portfolios.
Sources of Exotic Beta Returns
We believe there are four primary reasons for compensated risk factors:
Structural: Restrictions on the free flow of capital create differences in the cost of capital that are unrelated to typical measures of market risk. For example, many investors in bonds are limited either by regulations or preferences to invest in bonds of a specific term or rating. This explains the large jump in spreads between similar risk bonds that are on opposite sides of the investment-grade cutoff.
Behavioral: Biases often lead investors to make decisions that are driven by emotions rather than rational considerations. For example, many investors have deep aversion to holding assets that have fallen in value. It takes strong conviction to be a contrarian: to sell what has gone up significantly and buy assets that have disappointed. We believe this bias accounts for the persistence in value risk premia across all asset classes.
Liquidity: Investors rationally dislike markets with lower or highly variable liquidity. An example is an off-the-run government bond after the issuance of a new bond with almost the same maturity. The off-the-run bond offers a higher yield for a virtually identical security, because investors prefer the higher and more stable trading liquidity of the on-the-run bond.
Insurance: Some exotic risk premia exist because the returns on the underlying assets exhibit fat tails on the downside, and investors require compensation to accept those unlikely but extreme events. Exposure to natural catastrophe risk is an example: the left-tailed distribution of returns is undesirable to many, even if it is a source of diversification to their overall portfolio.
The following are some examples of the exotic risk premia that we have researched, stress-tested, and implemented in our own exotic beta strategy. The list is not exhaustive; we continue to research new exotic betas and continually re-evaluate the attractiveness of the individual premia currently included in our strategy.
Examples of Exotic Risk Premia
• Natural catastrophe
• Commodity hedging pressure
• Commodity seasonality
• Global credit
• Global equity index value
• Global yields relative value
• Inflation risk
• Global term structure value
• Currency carry
• Currency value
• Real asset
• Equity index crash risk
• Low volatility
Some of these risk factors are already present in institutional investment portfolios. But they are embedded only as byproducts of asset allocation and active management decisions. They are rarely explicitly managed and controlled. We believe that exotic betas present a compelling opportunity to access return streams that are durable, diversifying, and low cost. Purposefully budgeting risk to exotic betas can yield significant improvements to the risk-return profile of most portfolios.
Exotic Beta Portfolios
How would exotic betas, individually and as a portfolio, compare to the prevalent alternatives in the market? Chart 1 shows the cumulative excess returns of nine exotic beta composites (organized by asset class) since 1990. Each return stream is beta-hedged to global equities; on a daily basis, the risk factor’s beta to global equities is estimated, and a corresponding hedge is implemented to neutralize that beta. The result is a return stream that is ex-ante uncorrelated to the movements of the global equity markets. The returns are also net of estimated transactions costs, and to facilitate comparison, are adjusted to the same risk level across premia and over time. In addition, the chart shows the cumulative excess returns of global equities, represented by the MSCI ACWI, as a point of reference.
Although every exotic beta had periods of underperformance, all are positive over the entire period. This is consistent with what we would expect, as these are risks for which investors require compensation. They are also persistent, and all but one exhibit Sharpe ratios higher than global equities. As a natural consequence of the global equity market hedge, which is the principal common risk component, the exotic betas display essentially no common pattern of performance, with an average correlation of 0.03 over our sample. These relatively high Sharpe ratios and low correlations make exotic betas particularly compelling when combined into a portfolio.
Table 1 presents the performance of an equal-risk-weighted model portfolio of the nine exotic beta composites shown above. For comparison, we also show the performance of global equities, global fixed income, hedge funds, and a model risk parity portfolio.
As they each realize different risk levels, the Sharpe ratio is the most relevant performance measure in this comparison. Moving across the table from left to right, the Sharpe ratio increases consistently from equities to bonds, to risk parity, to hedge funds and finally to exotic beta. Also relevant is the level of maximum drawdown per unit of volatility, which is above 3.0 for equities, bonds, risk parity and hedge funds, but only 2.0 for exotic beta. Finally, as a benefit of the hedging process described earlier, the ex-post correlation with equities is the lowest for exotic beta.
Exotic Beta Dynamics
The passively managed portfolio of exotic betas described in Table 1 performs well. However, we find that incorporating views on the valuation of risk premia can further improve portfolio performance. Although investing in exotic beta is closer to the passive end of the return spectrum than to alpha, slow-moving reallocations are warranted because risk premia vary over time. Like anything else in the markets, they can become relatively expensive or relatively cheap.
It has been widely documented, for example, that the price of crash protection spikes significantly after an extreme event, even though the ex-ante probability of such an event occurring again hasn’t materially changed. Similarly, stocks can become significantly cheaper after periods of market panic, and leveraged fixed income exposures tend to be considerably less attractive when interest rates are at historic lows. This variation in risk premia creates timing opportunities to better control downside risk and to position for a higher probability of positive excess returns. These timing views are akin to value investing in risk premia.
Structural changes in markets offer additional opportunities for active management as dislocations due to regulatory requirements or changes in investor preference can have a material impact on risk premia. One example is the inverted long-end of the UK government bond curve, which many associate with insurance company positions mandated by UK regulators. The broad contango in many futures curves caused by the strategic shift of institutional investors into the commodities markets is another example.
Lastly, we know that shocks in one market can often ‘spill over’ into other markets. This can cause factors that are typically uncorrelated to become more correlated and to perform poorly at the same time. A well-designed, appropriately sized process that evaluates the likelihood of spill-over effects and time variation in premia can significantly improve performance and risk control.
Role in an Institutional Portfolio
An exotic beta portfolio is attractive as a standalone absolute return strategy. But its application is even more compelling in the context of the broader investment portfolio. Chart 2 below shows the performance impact of a 10% reallocation of capital from global equities to exotic beta in the typical 60/40 portfolio. The modest shift produces material improvements because of the higher Sharpe ratio of a diversified exotic beta portfolio, but also because of the structurally low correlation of exotic betas to the principal risk driving the typical portfolio: equity risk. As our analysis suggests, the result is higher return, lower risk, and reduced bias to underperform during periods of equity market turmoil.
The typical institutional portfolio remains severely imbalanced. Although elements of the risk parity approach can lead to improvements, we believe further gains can be attained by focusing on the underlying factors driving portfolio risk and returns. “Exotic betas” that are already embedded in the portfolio as byproducts of other decisions offer a source of consistent and uncorrelated returns. We believe that more explicit and purposeful management of these exposures can result in better balance and diversification.
