Alternative Risk Premia in Inflation Markets

By Michael Ashton

I’m going to wade into the question of ‘alternative risk premia’ today, and discuss how this applies to markets where I ply my trade.

When people talk about ‘alternative risk premia,’ they mean one of two things. They’re sort of the same thing, but the former meaning is more precise.

  1. A security’s return consists of market beta (whatever that means – it is a little more complex than it sounds) and ‘alpha’, which is the return not explained by the market beta. If rx is the security return and rm is the market return, classically alpha isThe problem is that most of that ‘alpha’ isn’t really alpha but results from model under-specification. For example, thanks to Fama and French we have known for a long time that small cap stocks tend to add “extra” return that is not explained by their betas. But that isn’t alpha – it is a beta exposure to another factor that wasn’t in the original model. Ergo, if “SMB” is how we designate the performance of small stocks minus big stocks, a better model is

    Well, obviously it doesn’t stop there. But the ‘alpha’ that you find for your strategy/investments depends critically on what model you’re using and which factors – aka “alternative risk premia” – you’re including. At some level, we don’t really know whether alpha really exists, or whether systematic alpha just means that we haven’t identified all of the factors. But these days it is de rigeur to say “let’s pay very little in fees for market beta; pay small fees for easy-to-access risk premia that we proactively decide to add to the portfolio (overweighting value stocks, for example), pay higher fees for harder-to-access risk premia that we want, and pay a lot in fees for true alpha…but we don’t really think that exists.” Of course, in other people’s mouths (mostly marketers) “alternative risk premia that you should add to your portfolio” just means…

  2. Whatever secret sauce we’re peddling, which provides returns you can’t get elsewhere.

So there’s nothing really mysterious about the search for ‘alternative risk premia’, and they’re not at all new. Yesteryear’s search for alpha is the same as today’s search for ‘alternative risk premia’, but the manager who wants to earn a high fee needs to explain why he can add actual alpha over not just the market beta, but the explainable ‘alternative risk premia’. If your long-short equity fund is basically long small cap stocks and short a beta-weighted amount of large-cap stocks, you’re probably not going to get paid much.

For many years, I’ve been using the following schematic to explain why certain sources of alpha are more or less valuable than others. The question comes down to the source of alpha, after you have stripped out the explainable ‘alternative risk premia’.

As an investor, you want to figure out where this manager’s skill is coming from: is it from theoretical errors, such as when some guys in Chicago discovered that the bond futures contract price did not incorporate the value of delivery options that accrued to the contract short, and harvested alpha for the better part of two decades before that opportunity closed? Or is it because Joe the trader is really a great trader and just has the market’s number? You want more of the former, which have high information ratios, are very persistent…but don’t come around that much. You shouldn’t be very confident in the latter, which seem to be all over the place but don’t tend to last very long and are really hard to prove. (I’ve been waiting for a long time to see the approach to fees suggested here in a 2008 Financial Analysts’ Journal article implemented.)

I care about this distinction because in the markets I traffic in, there are significant dislocations and some big honking theoretical errors that appear from time to time. I should hasten to say that in what follows, I will mention some results for strategies that we have designed at Enduring Intellectual Properties and/or manage via Enduring Investments, but this article should not be construed as an offer to sell any security or fund nor a solicitation of an offer to buy any security or fund.

  • Let’s start with something very simple. Here is a chart of the first-derivative of the CPI swaps curve – that is, the one-year inflation swap, x-years forward (so a 1y, 1y forward; a 1y, 2y forward; a 1y, 3y forward, and so on). In developed markets like LIBOR, not only is the curve itself smooth but the forwards derived from that curve are also smooth. But this is not the case with CPI swaps.[1]

  • I’ve also documented in this column from time to time the fact that inflation markets exaggerate the importance of near-term carry, so that big rallies in energy prices not only affect near-term breakevens and inflation swaps but also long-dated breakevens and inflation swaps, even though energy prices are largely mean-reverting.
  • We’ve in the past (although not in this column) identified times when the implied volatility of core inflation was actually larger than the implied volatility of nominal rates…which outcome, while possible, is pretty unlikely.
  • Back in 2009, we spoke to investors about the fact that corporate inflation bonds (which are structured very differently than TIPS and so are hard to analyze) were so cheap that for a while you could assemble a portfolio of these bonds, hedge out the credit, and still realize a CPI+5% yield at time when similar-maturity TIPS were yielding CPI+1%.
  • One of my favorite arbs available to retail investors was in 2012, when I-series savings bonds from the US Treasury sported yields nearly 2% above what was available to institutional investors in TIPS.

But aside from one-off trades, there are also systematic strategies. If a systematic strategy can be designed that produces excess returns both in- and out- of sample, it is at least worth asking whether there’s ‘alpha’ (or undiscovered/unexploited ‘alternative risk premia’) here. All three of the strategies below use only liquid markets – the first one, only commodity futures; the second one, only global sovereign inflation bonds; and the third one, only US TIPS and US nominal Treasuries. The first two are ‘long only’ strategies that systematically rebalance monthly and choose from the same securities that appear in the benchmark comparison. (Beyond that, this public post obviously needs to keep methods undisclosed!). And also, please note that past results are no indication of future returns! I am trying to make the general point that there are interesting risk factors/alphas here, and not the specific point about these strategies per se.

  • Our Enduring Dynamic Commodity Index is illustrated below. It’s more volatile, but not lots more volatile: 17.3% standard deviation compared to 16.1% for the Bloomberg Commodity Index.

That’s the most-impressive looking chart, but that’s because it represents commodity markets that have lots of volatility and, therefore, offer lots of opportunities.

  • Our Global Inflation Bond strategy is unlevered and uses only the bonds that are included in the Bloomberg-Barclays Global ILB index. It limits the allowable overweights on smaller markets so that it isn’t a “small market” effect that we are capturing here. According to the theory that drives the model, a significant part of any country’s domestic inflation is sourced globally and therefore not all of the price behavior of any given market is relevant to the cross-border decision. And that’s all I’m going to say about that.

  • Finally, here is a simple strategy that is derived from a very simple model of the relationship between real and nominal Treasuries to conclude whether TIPS are appropriately priced. The performance is not outlandish, and there’s a 20% decline in the data, but there’s also only one strategy highlighted here – and it beats the HFR Global Hedge Fund Index.

I come not to bury other strategies but to praise them. There are good strategies in various markets that deliver ‘alternative risk premia’ in the first sense enumerated above, and it is a good thing that investors are extending their understanding beyond conventional beta as they assemble portfolios. I believe that there are also strategies in various markets which deliver ‘alternative risk premia’ that are harder to access because they require rarer expertise. Finally, I believe that there are strategies – but these are very rare, and getting rarer – which deliver true alpha that derives from theoretical errors or systematic imbalances. I think that as a source of a relatively unexploited ‘alternative risk premium’ and a potential source of unique alphas, the inflation and commodity markets still contain quite a few useful nuggets.


[1] I am not necessarily claiming that this can be exploited easily right now, but the curve has had such imperfections for more than a decade – and sometimes, it’s exploitable.

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Gary

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