For larger funds, while the direct costs (especially commissions) are not immaterial, they pale in significance when compared with the indirect costs, such as market impact costs that traders can incur as a result of slippage arising from insufficient investment capacity. Moreover, indirect costs are remarkably difficult to model. This may suggest why larger investors in alternate beta strategies tend to prefer weighting schemes that retain some kind of link to the market capitalisation of the individual stocks.
Furthermore, there is a trade-off between investment capacity and the degree of factor exposure. A weighting scheme that is designed to get as much exposure as possible to a certain factor is unlikely to have a high investment capacity. Precisely what weighting scheme investors should choose should depend on the purpose of the allocation; a tactical allocation involving a small amount of money may call for a different weighting scheme than a strategic/core allocation.
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Performance measurement and monitoring:
Ongoing performance monitoring is indispensable to conform the alternate beta strategies chosen with investor expectations and objectives. This would involve examining the portfolio’s overall factor exposure, sector biases and whether it has any secondary exposures to macroeconomic factors.
Risk Premia as Portfolio Building Blocks
There is a growing interest in investing in risk premia directly. The difference between alternate beta and risk premia strategies is market exposure. Essentially, alternate beta are long-only strategies that have both market and factor exposures. Portfolios based on these strategies are primarily dominated by market risk. In contrast, the risk premia strategies that we refer to in this paper are long-short strategies that aim to separate systematic risk factors from overall market risk. Bender et al (2010) note that correlations between many risk premia have been historically low, and a portfolio of risk premia may represent a new approach to portfolio diversification.
To demonstrate this, we constructed a portfolio consisting of 10 liquid risk premia by taking long positions on different alternate beta strategies and offsetting them against their corresponding benchmark in order to attempt to isolate the factor. A long-short portfolio constructed in this manner does not capture beta-neutral exposures, but it could be easier and cheaper to implement.
For equities, we took long positions on the small-cap, low volatility, value, momentum and quality indexes and, simultaneously, took a short position on the benchmark. Similarly, for commodities, we took long positions on three risk premia—curve, value and momentum—through long-short commodity indexes. Finally, for fixed income, we proxy the credit risk premium by going long on U.S. corporate high yield bonds and short on the U.S. Treasury bills. The term premium was isolated by taking a long position in long-duration U.S. Treasury bonds and a short position in U.S. Treasury bills. These risk premia are well understood and relatively easy to implement.