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Risk Allocation Solutions - June 08, 2016

Research must be at the core of investment decisions and long-term allocation

In this month's interview, we talk to Thierry Roncalli, Head of Research & Development at Lyxor, about the latest study from the Lyxor “Risk Allocation Solutions” research chair, which falls under EDHEC-Risk’s “ALM and Asset Allocation Solutions” programme. We also touch upon the main challenges that remain when it comes to efficiently harvesting alternative risk premia, and the value of academic research for the hedge fund industry.

Thierry Roncalli

This June sees the release of the latest research publication from Lyxor’s “Risk Allocation Solutions”, research chair within the ALM and Asset Allocation Solutions programme at EDHEC-Risk. This study analyses what the best possible approach is for harvesting alternative long-short risk premia with a particular focus on hedge fund replication and alternative long-short risk factors. What are the most important points raised by this research in your view?

Thierry Roncalli: This research on Alternative Risk Premia is a natural extension of the research programme on factor investing done by EDHEC-Risk Institute and published last year. Indeed, alternative risk premia designate non-traditional risk premia other than long exposure to equities and bonds and they correspond to long/short systematic risk factors that help explain returns across asset classes (equities, rates, credit, currencies and commodities). In this publication, EDHEC-Risk Institute studies the links between alternative risk premia and hedge fund strategies. Contrary to the common idea, they showed that using alternative risk premia does not significantly improve hedge fund replication at the strategy level. The first main finding is then that out-of-sample replication remains poor. However, they also showed that heuristic portfolios of alternative risk premia may have risk/return characteristics that are close to those observed in hedge fund strategies. Therefore, the second main finding is that a diversified portfolio of alternative risk factors is a better way for harvesting alternative risk premia.

What are the main challenges remaining to harvest efficiently alternative risk premia?

Thierry Roncalli: There are three main challenges. The first one concerns the definition of an alternative risk premium. Since these alternative risk factors correspond to long/short strategies, their risk/return characteristics will strongly depend on the portfolio construction. We do not have this drawback with traditional risk premia. For instance, harvesting the US equity risk premium can be done using any one of the S&P 500 index, the MSCI USA index or the FTSE USA index. The choice of the investment vehicle is not very important, because these three indices are highly correlated. However, with alternative risk premia, we obtain another story. For a given alternative risk premium, we could have several products that claim to replicate the premium, but they are not highly correlated. The choice of the investment vehicle would therefore require heavy due diligence. The second challenge is the lack of investable solutions and robust benchmarks with long track records. Consequently, most of today’s findings are based on backtests and there may be discrepancies between these simulations and what investors may expect from such investments. In fact, the level of knowledge on alternative risk premia is still low compared to traditional risk premia or smart beta. The third challenge relates to the objective of a portfolio of alternative risk premia. We would face different implementation issues if the objective were to diversify a traditional equity/bond portfolio, or to mitigate the risk of an equity portfolio, or to meet long-term performance targets. In particular, the portfolio construction will be different if we use alternative risk premia as diversification or performance assets.

Are there any other conclusions from this research that you think are worth highlighting?

Thierry Roncalli: An interesting by-product of this research concerns the CTA strategy. Indeed, the research conducted by EDHEC-Risk institute showed that some hedge fund strategies are more easily explained by dynamic exposures to traditional and alternative risk factors than others are. For instance, this is the case with emerging markets and long/short equity strategies and to some degree, with event-driven and convertible arbitrage strategies. By contrast, equity market neutral strategies are extremely difficult to replicate using risk factors. We thought about the possibility of using alternative risk factors, in particular momentum risk factors, to significantly improve the replication of CTA strategies. Curiously, the research of the EDHEC-Risk institute did not confirm that, meaning that the CTA strategy cannot be reduced to a portfolio of momentum risk premia. This result is puzzling and shows the importance of the correlation premia in the CTA industry.

EDHEC-Risk Institute and Lyxor launched this three-year a research chair in 2013 to develop academic insights that can be used towards the design of high-performance multi-asset investment solutions, based on specific investor needs. Do you think that EDHEC-Risk’s research was useful for your clients?

Thierry Roncalli: The original idea of this Lyxor research chair was to be in touch with the current concerns of institutional investors in terms of asset allocation and portfolio construction. The first year, we focused on conditional risk parity portfolios, in the second year we explored the factor investing approach and finally, the last year was devoted to alternative risk premia. These research programmes have provided our clients with a better understanding of the multifaceted nature of diversification. Beyond these academic publications, specific events and seminars provided our clients the opportunities to access to high-level presentations on these topics. At Lyxor Asset management, we strongly believe that research must be at the core of investment decisions and long-term allocation. With EDHEC-Risk Institute, we found the right academic partner to share this vision and work together to address the current concerns of institutional investors.

About Thierry Roncalli

Thierry Roncalli is Head of Quantitative Research at Lyxor Asset Management. Prior to Lyxor, he was Head of Investment Products and Strategies in the Structured Asset Management Department at SGAM in 2005. He was previously the Head of Risk Analytics at the Groupe de Recherche Opérationnelle of Crédit Agricole. From 2001 to 2003, he was also a member of the Industry Technical Working Group on Operational Risk (IT-WGOR). Thierry began his professional career at Crédit Lyonnais in 1999 as a financial engineer. Before that, Thierry was a researcher at the University of Bordeaux and then a Research Fellow at the Financial Econometrics Research Centre of Cass Business School. During his five years of academic career, he also served as a consultant for different banks and asset managers. Thierry holds a PhD in Economics from the University of Bordeaux and is the author of many articles in quantitative finance. He has also published two books on Financial Risk Management and Quantitative Asset Management. His last book “Introduction to Risk Parity and Budgeting” has been published in August 2013 by Chapman & Hall. Since 2003, he has been Professor in Finance at the University of Evry. Since August 2014, he is also member of the Group of Economic Advisers (GEA) at ESMA’s Committee for Economic and Market Analysis.