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The use of risk premia as a means to diversify portfolios and improve returns, while not new, is a concept Asia is just starting to open up to.
In simple terms, risk premia investing means an investor takes on extra risk with the expectation of generating higher return. That contrasts to risk-free investing where the expected returns are generally very low, if not, non-existent.
In Asia, where institutional investors are generally conservative, risk premia investing has been generating interest in light of the low-yield market environment.
“Interestingly investors are now looking at the world in terms of risk factors and economic exposure,” says Fayez El Hicheri, head of restructuring, Asia Pacific Investments Group at Credit Suisse.
In a recent Taiwan Derivatives and Structured Products forum organized by The Asset, Hicheri said 30% of institutional investors in a survey led by State Street are looking at risk factors and economic exposure as part of their investment strategy.
This trend deviates from traditional investment practice where asset managers focus on their field of investment expertise – an equity investor focuses exclusively on stocks and fixed income investors on bonds.
The survey suggests interest in risk premia investing is growing rapidly. Hicheri says the strategy is expected to generate US$1 trillion in assets by 2020 and more than double in value by 2025.
“These are not niche numbers. The trend towards risk premia investing is not a fad,” Hicheri says.
The trend is particularly strong among global insurance companies, which have increased their investments in risk premia and risk factors in the past three years.
“About 62% of the participants increased their usage of risk factor or risk premia over the last three years. Over the next three years, the trend is pretty much the same. Insurers are saying that they will increase even further their focus on this kind of investment technology,” says Hicheri citing a separate survey from the EIU.
Among the benefits of risk premia investing is that it allows investors with the right risk appetite to access investment strategies similar to alternatives like hedge funds without taking on huge fees, lock-up periods, and reduced liquidity traditionally associated with alternative investing.
With risk premia, investors can diversify their portfolios by gaining access to a broad set of risks, thus gaining opportunities that may not have been available to them otherwise. For example, by using risk premia to complement existing hedge funds within their portfolio, investors can benefit from a number of operational and cost efficiencies, while allowing focus on high-alpha ideas.
“We believe the addition of risk premia strategies is most appropriate as a complement to more liquid types of alternatives such as hedge funds,” says Myron Cheung, senior structurer, APAC Investment Solutions Group, Credit Suisse.
Flexibility in risk premia
Many insurance companies in Asia are starting to look at risk premia investing as a means of generating returns amid a low interest rate environment. Although interest rates are starting to trend higher after the US Federal Reserve raised interest rates, it will take a while before that could impact portfolios of long-term investors like insurers and pension funds.
“How investors actually operate to access risk premia depends on the existing regulations in the market. In South Korea, Taiwan, Hong Kong and Singapore, different regulations apply,” Cheung says.
For insurance companies and other institutional investors, risk premia strategies are suitable for manufacturing structured products at relatively lower costs. Investment products using risk premia strategies can also be tailored to comply with the regulatory requirements of a particular jurisdiction.
With risk premia investing, investors are able to tap many risk factors that can be constructed around fairly liquid instruments which, from a bank’s standpoint, are relatively inexpensive to hold on the balance sheet. This means it is fairly cheap for structured product providers to manufacture a particular product for a client.
“The cost of the intellectual content involved in manufacturing a structured product (using risk premia investing) may vary depending on specific requirements. But in terms of manufacturing and pricing, it will be cheaper. We can easily do capital protected structured products. We can do them from an offshore standpoint in US dollars. We can also manufacture those exposures if it’s required in Taiwan dollars, basically partnering with local banks to put together structured deposits. There’s actually quite a lot of flexibility. So that’s strictly how you invest in these things,” Hicheri says.
Another interesting aspect of risk premia investing is that investors can calibrate a particular risk that they want to take at a given time. This is particularly important for institutional investors as they take a holistic approach in assessing risks in portfolios.
“A lot of the investors that we speak to on a global basis tend to be pension funds, insurance companies or institutions with a liability such as a defined benefit type pension fund, for instance. So we can actually have a holistic conversation to calibrate exactly the sort of risk that a fund wants to take,” Hicheri says.
Investors can also use risk premia investing as a substitute for alternative investments such as hedge funds. “You can look at it from an alternative investment or hedge fund bucket and consider it as a substitute product that is cheaper and more liquid in terms of manufacturing and also potentially a less expensive product from a regulatory capital standpoint,” Hicheri says.
Risk premia also offers more transparency as a strategy compared to alternative investing. “If you invest in a macro hedge fund, for example, you could be playing very esoteric exposure and you may not know the exact risk you’re taking. The differentiator here is that your exposure is very precise and easy to understand,” Hicheri says.
The full granularity investors get in terms of the return drivers of their exposure in risk premia investing is another advantage.“I think it gives you a lot of levers in terms of calibrating exactly what you’re looking to achieve. As opposed to being long equity, volatility is high. Beta can be high depending on your specific exposure,” Hich