Alternative Risk Premia: Is the Selection Process Important?

Abstract

Alternative Risk Premia (ARP) are rule-based strategies. They should reward investors exposed to non-traditional systematic risk factors. Yet, allocation to ARP is not straightforward. First, there are many ARP indices proposed by different providers that claim to capture the same underlying risk premia. Second, a proposed index may not automatically mimic an existing risk premium whose performance is sustainable or persistent. Our findings confirm these suspicions. If some categories of indices show risk-return characteristics that are rather homogeneous, others are highly heterogeneous. Stated otherwise, performance is provider dependent making the choice of an index an important component of the allocation process. Differences between simulated past results and live data are then calculated. Results are indisputable. There is a significant overfitting bias. Once launched, the performance of ARP indices dropped significantly, thus questioning their sustainability. To summarize, this research paper shows that investors should take no short cuts. When it comes to allocating capital to ARP, an extensive due diligence process is required.

TOPICS: Analysis of individual factors/risk premia, performance measurement, simulations