Alternative risk premia strategies are generally assumed to diversify equity and bond market risk, but this isn’t always the case, according to a paper out of Finland.

“There hadn’t really been an effort to go through the variety of strategies which exist today, and really have a better understanding of how the individual strategies behave, especially in stressed market conditions,” says Aalto University’s Antti Suhonen, one of the paper’s authors.

The risk characteristics of most alternative risk premia strategies change in the tails of equity and bond market return distributions, the paper found.

“Basically, we’ve seen in 2018 that many alternative risk premia portfolios have suffered [from] having more dependencies to market variables than what was expected beforehand,” says Varma Mutual Pension Insurance Co.’s Kari Vatanen, the paper’s co-author.

Instead of using whole sample volatilities and correlations when constructing portfolios, the paper proposed using a hierarchical risk allocation process.

This process divides alternative risk premia strategies into two major categories depending on sensitivities to the equity and bond markets. “Strategies in the offensive category tend to have positive sensitivity to equity risk and negative sensitivity to bond market risk,” the paper said. “In contrast, the defensive category includes strategies that have mostly negative sensitivity to equity risk and positive sensitivity to bond market risk.”

After the strategies are broken out into defensive and offensive, they’re further broken down into fundamental, behavioural and structural premia categories and then to strategy sub-groups within those categories.

At a high level, this is about investors better understanding the structure of the categories they’re investing in, says Suhonen. Rather than thinking that each individual strategy is independent, they can allocate according to clusters that behave similarly, and within clusters.

Hopefully, the paper provides pension plans with food for thought, Suhonen says, and inspires them to take a closer look at the strategies they’re invested in and go deeper in analyzing risk.

The first lesson, Vatanen notes, is that there may be less diversification in alternative risk premia portfolios than investors previously thought, especially when measuring the diversification in the tail events of equity and bond market returns.

“The second message there is that you can construct your portfolio by using the information of the characteristics of the different strategy types and get more balanced portfolios when you know what the tail behaviour of different strategy types is and take that into account in your asset allocation process.”