A new label can shed light on an old idea, as is the case with alternative risk premia (ARP). Multi asset class strategist Dr. Brian Jacobsen discusses how ARP may benefit your clients.
Wayne Badorf: In the next two episodes we’re discussing alternative risk premia—understanding what it is, and how the Wells Fargo Asset Management Multi-Asset Solutions team is putting it into practice—with the purpose of learning how the investment approach may benefit your clients. I’m Wayne Badorf.
Jon Lagerstedt: And I’m Jon Lagerstedt, and this is The Essential Practice podcast. The doctor is in the house. Dr. Brian Jacobsen, that is. He’s Senior Investment Strategist with the Wells Fargo Asset Management Multi Asset Solutions team. Brian, welcome.
Brian Jacobsen: Hey, thanks for having me.
Wayne: Brian, recently you wrote a paper that these discussions are based on that we’re going to talk about today called, “The ABCs of ARP,” and we’d encourage our audience to seek it out for a deeper dive on the topic. I believe there are some charts to help with some of the explaining. But let’s level set this conversation by asking you to explain what risk premia is.
Brian: I think that most financial advisors and investment professionals will remember that risk premia are those compensations that investors expect to get for bearing certain risks. Four very common ones that investors might be familiar with are, 1) things like inflation risk premia, 2) in the fixed-income markets—term risk premia, say, a 30-year treasury bond versus a 30-day treasury bill, 3) you can also have default risk premia, so if you’re investing in corporate bonds versus government bonds, 4) and then finally equity risk premia, with equities, you’re lower down the capital structure, those tend to be a lot more volatile than fixed-income [investments], and as a result investors want to be compensated for being, sort of, last in line to get paid and then also to having to bear all that volatility.
Jon: So could you help us understand and define what alternative risk premia is—ARP?
Brian: Yeah, so what I just described, those four, those are really your traditional risk premia. Alternative risk premia is almost defined by what it’s not. Alternative risk premia would be everything else besides those traditional risk premia.
One of the ways to think about it is traditional risk premia are going to drive the major market asset classes—kind of the broad asset classes—makes equities go up and down, bonds go up and down. But then alternative risk premia explain differentials within the asset classes. A very common one that investors might be familiar with is investing in value versus growth, or small- versus large-companies—those are actually alternative risk premia where [the category] isn’t explaining the broad equity market moves, but rather, within the equity markets, it’s what explains the differential within the [equity market].
Wayne: Brian, I have to ask, if ARP is defined by what the traditional risk premia are not, is there a subset of, or a collection of what we would consider alternative risk premia? Or is it just everything and almost a large set of alternative risks?
Brian: That’s a great question. The three most common alternative risk premia are value, carry, and momentum.
Value is just simply investing in companies that have low price-to-book ratios. You buy assets with low valuations, sell those with higher valuations.
Carry has to deal with buying higher-yielding assets and selling lower-yielding assets. As an example, that would be like looking at emerging market debt versus developed market debt. Or there can be carry if you look at 90-day treasury bills versus 30-day treasury bills. And, maybe, by persistently going long that 90-day T-bill and shorting the 30-day T-bill, you can capture that yield differential.
And then momentum, that’s about buying assets with strong recent performance and selling assets with weak recent performance—the idea that you let your winners ride, effectively, and you assume that the losers are going to continue to lose. Part of the art of managing these three alternative risk premia is trying to figure out: When is momentum going to turn? When is it that carry can unwind? When is value actually identifying value traps as opposed to value opportunities?
Wayne: In your paper you talk about certain diversification benefits that ARP strategies can offer compared to traditional strategies. And I wonder if you can talk a little bit about some approaches to asset allocation and how ARP strategies offer diversification benefits.
Brian: I think that one of the ways that ARP strategies can really benefit investors from a diversification perspective is that it’s a different perspective of looking at the markets. What are these underlying risks that should be driving returns of these traditional asset classes? And so, it’s really about trying to look for differential opportunities—opportunities to add value by perhaps biasing the portfolio more towards lower-value stocks, maybe higher-carry types of fixed-income instruments, and to, maybe, commodities that are demonstrating some momentum. So, it’s that different lens. And I think taking that different view when everybody else seems to be taking a rather traditional or conventional view—that’s how, it can bring more diversification benefits.
Wayne: And Brian, I appreciate those comments, and really excited about our next program as we’re going to learn more about how your team puts alternative risk premia approach into practice—“harvesting alternative risk premia” as you put it in your article.
But what can an advisor tell their clients to expect when this approach is really applied to investing?
Brian: This is going to be a more detailed look at what the risk exposures are in the portfolio. And, in a way, to give more transparency into what those risks are that clients are getting exposure to.
Jon: Well Wayne and Brian, let’s wrap this conversation up here and learn about harvesting alternative risk premia in our next episode. Brian, thanks for joining us!
Brian: Thanks for having me.
Wayne: You can get more from Brian on our companion podcast On the Trading Desk® and on our blog AdvantageVoice®. And, as always, contact your regional partner to help deliver on any needs you have.
Jon: And you can do that by contacting your regional or associate regional director at 888-877-9275. Until next time, I’m Jon Lagerstedt.
Wayne: I’m Wayne Badorf.
Jon: And thank you for listening to The Essential Practice podcast.
All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics.
Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses.