Research Affiliates: Alternative Risk Premia

September 25, 2018

Key Points

  • Most investors seek to earn a 5% annualized return above inflation to securely meet their financial needs in retirement. With today’s low expected returns across financial markets, most mainstream portfolios, including the typical advisor portfolio, are poised to fall well short of this mark.
  • An alternative risk premia strategy—one that harvests robust factor premia via long–short exposures to mature and varied asset classes, preferably in a straightforward, systematic, and transparent framework—provides attractive absolute return prospects and materially improved odds of achieving long-term return targets.
  • A systematic alternative risk premia strategy can deliver valuable benefits beyond attractive returns, such as improved portfolio diversification and reduced downside risk.

For most investors, earning less than a 5% annualized total return above inflation means they will likely fall short of meeting their financial needs in retirement. A couple of years ago, our colleagues West and Masturzo (2016) invited investors to try the “5% challenge,” posing the question: What are the odds your portfolio will earn an annualized real return of 5% over the next decade? Since launching the challenge two years ago, of the more than 53,000 portfolios created, only 14% have topped this mark. Unfortunately, from today’s starting point of low interest rates and elevated equity valuations, most mainstream portfolios are doomed to fall short. The 5% challenge proves difficult even for the relatively diversified portfolios recommended by the average financial advisor.

We see a wide gap between 1) the long-term return most investors base their planning decisions on, and 2) the annualized return their conventional portfolio is poised to realize over the coming decade. In this article, we explore one path with the potential to close a portion of this gap without materially increasing portfolio-level risk. We propose adding a liquid and transparent systematic alternative risk premia strategy as a core alternative allocation to complement investors’ mainstream-centric portfolios. This strategy appears to offer a compelling option which should raise an investor’s odds of clearing the 5% real return hurdle.

Falling Short: Expected Returns Of Traditional Portfolios
Today, we expect a traditional US 60/40 portfolio allocation1 to earn an annualized real return of 0.6% over the next decade. This translates into less than a 1% probability of achieving a 5% annualized real return. As Brightman (2012) explains, starting yields make up the largest and most predictable component of expected returns for most assets and strategies. A more-diversified portfolio, such as one recommended by the average financial advisor,2 also appears to fall far short of most investors’ desired long-term return target. Despite allocating nearly one-quarter to nonmainstream assets such as credit, commodities, real estate, hedge funds, and private equity, the typical portfolio recommended by financial advisors, which we call the Average Advisor portfolio, is priced today to eke out a real return of only 1.6% a year over the next decade. The probability of its earning an annualized real return of 5% over that period is a mere 1.5%. A 5% annualized real long-term return is an increasingly difficult hurdle to clear!


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Improving The Odds
Backed by our investment research and supported by our investing philosophy, we believe including a systematic alternative risk premia strategy can improve the odds of a portfolio’s meeting its long-term return hurdle. Such a strategy harvests robust factor premia, such as carry, value, and momentum, via long–short exposures to liquid futures contracts in a straightforward, systematic, and transparent portfolio design. For instance, we estimate a 20% allocation to such an approach3 more than triples the Average Advisor portfolio’s probability of clearing the 5% return target, improving the odds from 1.5% to over 5%, and an aggressive allocation of 40% moves this probability to over 21%. Importantly, the alternative risk premia strategy includes exposures absent from most advisor portfolios, so the increased return comes along with improved portfolio diversification, lower portfolio-level volatility, lower higher-order moments, and reduced downside risk.

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