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Research
Alternative risk premia: Style selection for investment objectives
Fidelity’s ARP framework emphasizes construction of more focused peer groups of styles than are available in traditional ARP benchmarks to assess the risk and return profile of premia for use in portfolio design.
Key Takeaways
- Alternative risk premia (ARP) style selection is a non-trivial exercise when designing objective-orientated portfolios due to the vast range of sub-style and implementation choices available, resulting in heterogenous risk and return profiles within and across premia.
- Determining the right mix of premia to include in portfolios for objective orientated outcomes can be informed by using available ARP benchmarks, which are helpful in representing the average behavior of ARPs across asset classes. However, using these benchmarks can pose a challenge as investors may be abstracting too far away from the effect of sub-style and implementation nuances to be able to robustly design portfolios with specific investment objectives in mind, especially due to the dispersion in risk and return profiles in the cross section of broad style benchmarks.
- We advocate for the construction of more focused peer groups of ARP styles across a multitude of implementations to assess the risk and return profile of premia more reliably for use in portfolio design. This approach also provides a benchmark for continuing performance and risk assessment of strategies deployed versus their peer groups.
- We employ a three-step process for ARP style selection that includes the curation of the universe of ARP strategies, the formation of bottom-up peer groups, and then the uses of these for objective-driven portfolio design. Such an approach allows investors to harvest the versatility of using ARP strategies to provide a source of diversifying returns in a manner that aligns with investor objectives and preferences.
- We find that ARPs can be largely classified into three clusters: carry, diversifying, and tail-hedging. Guided by estimates of distributional characteristics and hierarchical clustering, our style classification approach categorizes ARPs into these three buckets, which can then be used to target specific investment objectives. For investors with return-seeking objectives, allocating more to premia in the carry cluster can be beneficial. Conversely, for a balanced profile with some protection during equity tail events, higher allocations to diversifying and tailhedging strategies, perhaps funded with an allocation to carry-like premia, can be a viable solution.
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Alternative risk premia: Style selection for investment objectives
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Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
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