AlphaWeek Q&A: Brett Bina, Vice President, Business Development, Berenberg Asset Management LLC
AlphaWeek’s Greg Winterton discussed trends in institutional investor attitudes to alternative risk premia to volatility strategies with Brett Bina, Vice President, Business Development at Berenberg Asset Management LLC, a subsidiary of Hamburg, Germany based Berenberg, a private bank.
GW: Brett, thanks for taking the time today. Given the recent solid performance of alternative risk premia (ARP) strategies and the more favourable cost model vs. traditional hedge fund structures, what are you seeing with regards to appetite from institutional investors with regards to these products and why?
BB: Although the principles behind typical alternative risk premia strategies such as carry, value and momentum are not new, the practice of allocating capital to alternative beta strategies in lieu of hedge funds is a more recent development. You have these portfolios that are commoditizing many return sources previously only available to hedge funds, and are doing so in a more transparent, more liquid and cheaper way and that’s incredibly interesting to a lot of allocators.
From a North American standpoint, I think it’s safe to say that ARP strategies have become a significant part of the alternatives landscape in a fairly short amount of time. Some estimates I’ve seen indicate that between USD $200 to $300 billion are invested in ARP so there is definitely a lot of interest and capital flowing into the space. One researcher at a large consultancy on the West Coast told me a couple weeks ago that the biggest trend he’s seeing with his institutional clients with respect to alternatives is ARP. The idea is that you shouldn’t have to pay a manager 2 & 20 to access an alternative beta strategy that has essentially become open-sourced. Some of the shift has to do with how investors are restructuring their hedge fund portfolios using a core-satellite approach, with cheaper ARP at the core and more expensive, lower capacity alpha managers as the satellite. Whether or not ARP is embraced has a lot to do with an investor’s recent experience in hedge funds since the GFC of 2008-2009. Some allocators came away with that period seeing that their hedge fund portfolio took losses and didn’t provide the downside protection they had expected, with a lot of market beta lurking under the surface. Although there is already a lot of capital in the space, only a handful of large institutional investors in the US have had ARP portfolios up and running for more than a few years. But I am definitely seeing many allocators exploring the space and a number of mandates coming this year and next.
GW: Do you think this is a fundamental shift in how institutional investors construct their alternatives portfolios or do you think that allocations will revert to traditional hedge fund managers when the macroeconomic environment favours those investment styles?
BB: I think the trends of lower fees and position and process transparency align well with the value proposition of alternative risk premia managers and will provide them with a sustainable advantage. To the extent that more traditional hedge fund managers can add alpha above what is offered by ARP strategies, they will continue to have opportunities to differentiate themselves and compete for business.
The effect ARP on portfolio construction really varies by strategy. Hedge fund managers relying on volatility-selling, momentum and carry as sources of returns have faced significant disruption in the wake of ARP’s rise and will continue to be challenged for new allocations. Strategies on the credit side such as distressed and convertible arbitrage, along with some event driven and more black-boxy quantitative strategies have been less impacted and will continue to take in investor flows unless ARP managers can figure out how to systematize these sources of returns too.
GW: What are the most common misconceptions amongst investors with regards to alternative risk premia products and how do you allay them when in conversations with potential investors?
BB: Sometimes it’s not completely intuitive about what types of environments tend to help or hurt a certain strategy. The misconception we see most often is that some people expect that ARP, particularly volatility strategies, will have a high return correlation with equity and will suffer during periods of equity market volatility. One of the best examples of the last decade would be in August of 2011 when the United States lost its AAA credit rating. This resulted in an S&P 500 decline of 6.7% in a single day. The S&P then proceeded to finish the significantly volatile year nearly flat. However, due to the lack of correlation between equity and strategies like short volatility, some ARP managers, ourselves included, benefited from the effect increased volatility has on options prices and ended the year with good results.
Another one is that these types of strategies are opaque, hard to understand and benchmark. They’re not. Many managers offer holdings-level details and many are happy to explain their investment process in greater detail than a hedge fund. There are also a number of benchmarks available to institutions for many of the more widely used factors such as carry, volatility and momentum. CBOE Eurekahedge has one for volatility and Albourne is developing a multi alternative risk premia index, to name a couple.
GW: Are there any traits which separate the good volatility managers from the pack?
BB: It’s all about risk management. In a short volatility strategy, you know your maximum possible return at trade initiation because it consists of a premium and a return on collateral. What you don’t know is how the market will behave, so it is imperative to dynamically manage risks using a robust risk model, a well-thought out philosophy on correlations and risk measurement, underpinned by a high quality source of data.
Some managers in the space are not very diversified, and derive their entire return from selling volatility on one index, such as the S&P 500. Volatility managers with more arrows in the quiver, such as programs that can harvest the volatility risk premium in credit, commodities or rates may offer enhanced risk adjusted returns by using a broader opportunity set.
GW: It’s well documented that 2017 was the quietest year for stocks from a volatility perspective for quite some time. Do you think volatility will return to more normal levels in 2018, or do you think that the low-vol environment has more life in it, and why?
BB: Quiet markets such as this one are not necessarily a detriment to short volatility programs, as the spread between implied volatility and subsequent realized volatility remains pretty good. In managing the strategy, we’re agnostic on future levels of volatility. Instead of being normative on what volatility ought to be, we focus on making sure that we adapt to any new volatility regimes as they arise.
If you believe that markets are becoming more efficient, then lower volatility levels could be expected as part of that. If markets are becoming less efficient and driven more by central bank action and sentiment than fundamentals, you might expect volatility to eventually revert to a longer term mean. Technology is helping corporate managers better manage inventory and staffing to better match supply to demand, which could theoretically lower earnings volatility as businesses and revenue become more predictable. Regardless of the nominal level of volatility, the structural difference between implied and realized volatility tends to be positive and represents a compensation for a service that isn’t a pattern or an arbitrage opportunity, so the strategies should continue to perform regardless of the nominal level of volatility. Overall this is a topic that we think about quite a bit at Berenberg.
GW: Finally, Brett, what other considerations should institutional investors have when reviewing their allocations to alternative risk premia strategies?
BB: There are a number of considerations. Fees are certainly at the top of everyone’s mind and some multi-ARP managers’ fees might still be a bit high. But given my background as a risk manager, I tend to approach these types of strategies by thinking about what could go wrong. First, I think it’s important to characterize the P&L drivers in ARP portfolios. There are “true” alternative risk premia factors, some of which could be seen as insurance-like. These are premia such as volatility, merger arbitrage and carry. Then there is a second category of alternative risk premia that can be described as market anomalies. These anomalies are essentially trading strategies that worked in the past (overweighting small cap vs. large cap or using momentum), and are based on the expectation that the pattern will continue to play out in the future. Investors need to be mindful about how much of their ARP P&L is predicated on the persistence of patterns and how much of it is derived from an economically valid reason, a return for taking on a specific risk. Thierry Roncalli has written several papers on this subject which are worth reading.
Another thing to consider is that many alternative risk premia strategies exhibit very non-normally distributed returns. Strategies such as carry, volatility and merger arbitrage are taking on significant skew and tail risk. This can mean evaluating these types of strategies using measures like ex-post volatility and the Sharpe Ratio can tend to paint a fairly rosy picture of their risk adjusted returns, particularly important given the short history of many of these strategies, many of which did not exist during the global financial crisis. This is where stress testing a portfolio and looking at the third and fourth moment of the distribution can be helpful for investors to get a better sense of what kinds of drawdowns are possible.
Additionally, investors need to think carefully about is capacity and crowding. It’s important to have an ARP manager that has a differentiated portfolio management process in order to help mitigate some of the risk of crowded trades. The quant meltdown of 2007 comes to mind as an example where many managers were doing something similar, and there are some parallels to that today with ARP. Andrew Lo, a Professor of Finance at MIT Sloan Business School, has done some great research in this space that was summarized in his recent book, Adaptive Markets Financial Evolution at the Speed of Thought. Capacity in these types of strategies can be significantly lower than in a fixed income or equity strategy, and investors need to be mindful of how their managers will monitor and assess future capacity constraints for their strategy.