Harvesting Risk Premia with Strategy Indices

Sep 5, 2011

Systematic risk premia such as value, size or momentum can account for a substantial part of long-term institutional portfolio performance. Over the last few years, we have seen the development of many new indices that reflect systematic risk premia, opening up the possibility to capture risk premia through indexation. Yet, the institutional asset allocation process continues to focus more heavily on the selection of active managers rather than the selection and combination of risk premia, despite growing evidence that risk premia contribute more to the long-term performance of the portfolio. We argue that the focus of institutional asset allocation may shift from diversification across managers in multiple alpha mandates towards diversification across strategy betas in multiple index mandates. Allocations to risk premia strategies could be based on the expected risk and performance characteristics of different strategies. Substituting traditional mandates with risk premia strategies has historically reduced volatility and enhanced long-term risk adjusted performance of a sample institutional portfolio. Indexation can play a crucial role in redefining institutional portfolio construction by providing low cost easily accessible building blocks for strategic asset allocation.