Portfolio of Risk Premia: A New Approach to Diversification

Abstract

The traditional asset allocation to equities and bonds is characterized by high volatility and lacks sufficient diversification, particularly during periods of distress. The meltdown of 2001-2002, in which markets around the world tumbled together, amply demonstrated this fact. As a consequence, there has been a gradual shift in strategic allocations towards alternative asset classes, such as private equity, hedge funds and commodities. Unfortunately, these new allocations only partially provide the needed diversification. Several researchers, including Asness, Krail, and Liew [2001] and Anson [2007], have shown that even alternative asset classes are exposed to traditional equities and bonds.

In an ideal world, a portfolio would be composed of a wide range of return-producing units, each of which is risky but independent of the others. Such a portfolio would result in high returns with low volatility. These return-producing units would also have capacity large enough for allocations by large funds. So, where do we find such independent, return-producing units? One simple answer is that many of these return-producing elements or risk premia already exist in traditional asset class portfolios. However, they are accompanied and dominated by broad equity or bond returns. We only need to separate them.

The objective of this paper is to explore risk premia as basic units in investment management. First, we define and classify risk premia. We then identify a number of premia across different asset classes and discuss how an investor may capture them. Next, we study their risk and return characteristics, both as standalone entities and in a portfolio context. Lastly, we illustrate the potential benefits of building a portfolio of risk premia for asset allocation.