Deutsche Q4 2016

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Risk Premia
Jigsaw falling into place

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Please note certain information in this presentation constitutes forward-looking statements.

Due to various risks, uncertainties and assumptions made in our analysis, actual events or
results or the actual performance of the markets covered by this presentation report may
differ materially from those described. The information herein reflect our current views only,
are subject to change, and are not intended to be promissory or relied upon by the reader.
There can be no certainty that events will turn out as we have opined herein.
Why risk premia?

Characteristics

Transparent
Explainable
Trend towards full look through
Risk premia are built upon of underlying positions. Glass
empirical observations box not black box approach
Persistence
Risk premia may be observed
over a long period of time

Flexible
Absolute returns Low fees
Can be accessed through a number of
different instruments and customised Portfolios aim to generate returns Low fee implementations with
to meet an investors requirements regardless of the market direction typically no performance fee

Portfolio diversification

Traditional asset class portfolio construction may give a false sense of diversification due to the correlations between asset
classes. By viewing the exposure through a factor lens, a more robust diversification can be targeted by constructing the
portfolio using risk premia. The below example illustrates how a multi-strategy portfolio which may look diversified at an
asset class level, in fact has around 50% exposure to equity premia which may imply under-diversification.

Traditional portfolio view Risk factor view

US Equities
Europe Equities
Japanese Equities
EM Asia ex Japan Equities
Commodity Momentum
Latin America Equities
Equity Emerging Markets
Europe IG Credit
Equity Liquidity
US IG Credit
Equity Momentum
Europe High Yield
FX Carry EM
US High Yield
Rates Carry
US Soverigns
Rates Value
FI EM
Convertibles
Commodities
Alternatives

Hypothetical example, for illustrative purposes only

2 Risk Premia | Q4 2016

2016: The rise of the risk premia?
Introduction

Will 2016 be remembered as a turning point in time for risk premia Tim Gascoigne
investing? The growth in risk premia has indeed been impressive this Global Head of Hedge Funds
year and this approach to investing has increasingly been viewed Deutsche Asset Management
as a differentiator to other liquid alternative investment techniques
and appears to assert itself as an asset class in its own right both
in terms of investor appetite but also with regards to the number
of vehicles and solutions on offer. This deepening of the investible
universe has coincided with a significant increase in estimated AUM
allocated to risk premia over the course of this year. For example Nicolas Laporte
a survey* carried out mid-year revealed that more than 80% of Head of European
respondents were currently investing in, or looking to invest in, risk Portfolio Management
premia solutions. According to the same research, AUM in risk premia Deutsche Asset Management
related strategies is projected to rise from around 250 billion USD in
2014 to more than 1 trillion USD by the end of 2019, which if true
would make this the fastest growing investment product in asset
management history*.
Ben Arnold
Risk premia providers have been (and still are) expanding their Portfolio Analyst
investment universe to meet a growing level of investor sophistication Deutsche Asset Management
and demand with customisation and unique factor exposures to
make it an attractive solution for investors. As this investment universe
becomes less of a niche approach, the level of transparency has
increased and a full daily look through to the underlying holdings
for the investor is becoming the norm. Finally another key reason
for the growth in popularity of risk premia is the increased overall
understanding of the asset class by investors in terms of what can
be achieved and how they can be integrated into their portfolios.

In the light of this our paper serves to break down and further
AUM in risk premia
demystify the increasingly complex and esoteric world of risk related strategies is
premia so it may be better understood by all investors. We share
our definitions followed by our understanding of the risk premia projected to rise from
universe and how it can be best classified. Insights are then provided
into how portfolios can be constructed. Finally we touch upon some around 250 billion
of our work on criteria for selecting providers and give our view on
the often controversial topic on whether risk premia can be timed. USD in 2014 to more
than 1 trillion USD by
the end of 2019.

*Source: Citi Prime Finance survey, Risk Premia, the 3rd Generation of Asset Allocation

Risk Premia | Q4 2016 3

What are risk premia?
An intuitive but complex world

The risk premia definition is intuitive but what is behind this Academic risk premia
definition is complex. It is intuitive in the way that investing in
risk premia is like selling insurance contracts. Like an insurance
One of the main drivers of academic risk premia is the existence
seller, the investor in risk premia is expected to get paid (premia)
of sustained behavioural biases by market participants. As
for the specific risk he/she is willing to take. These premia exist
a consequence, an investor who is able to understand these
due to specific market structures which in turn are driven by
biases can harvest these by accessing the relevant premia.
persistent investor behaviours and different types of investment
For example in the case of market underreaction: the investor
constraints. These anomalies can be harvested but they come
is compensated for reacting faster to price changes, news,
with specific risks and hence their name: risk premia.
analysis and fundamentals when compared to the marginal
investor. In this vein, momentum-based risk premia aim to
Unlike traditional assets, these premia can be captured by
capture the phenomenon of assets with higher (lower) recent
combining multiple instruments, taking long and short positions
past returns outperforming (underperforming) over time.
as well as using specific trading rules in order to isolate the
premia as precisely as possible from market noise. Allocating
In the case of market overreaction, the investor is compensated
to a risk premia would not generically be characterised as
for assessing recent price changes, news, and fundamentals
allocating to a particular asset class but rather as creating a
into the future. Equity value investing illustrates an example
strategy that will provide a stream of returns related to a
of market overreaction as assets below (above) fair value tend
specific risk borne by the investor.
to outperform (underperform). From a risk perspective, the
market overreaction is explained by fact that investors tend to
Moreover, even for the most simple risk premia, there is no such
overreact to value stocks embedded risks such as distress risk
thing as a universal truth to define the most efficient way to
(companies with undervalued stocks are more likely to be in
harvest it. Each provider relies on its own research and findings,
financial distress), cash-flow risk and liquidity risk.
making cross-provider comparison a complex and delicate
task; however research, construction and execution can give an
individual provider an edge in the delivery of a particular premia. Behavioral explanations rely on investor under/over-reaction
Furthermore, the range of risk premia is large and expanding
with new research pushing the current boundaries of the
Initial under-reaction and
available strategies. This means any attempt to precisely qualify subsequent over-reaction
and quantify the risk premia universe represents an ongoing
exercise.
Price

Our analysis of the risk premia universe has led us to segregate

it in two main families; each family enclosing a broad range of Trend-following works
during this period
risk premia which themselves can be classified by asset class
and style.

Event causes revision Time

in fair value
Fair value Market price

Source: Deutsche Asset Management, Nomura as of November 16

For illustrative purposes only

Academic Implied
The first family is the academic risk premia, a name referencing
the number of research papers that have been written by
academics on them for decades in some cases. Generally
speaking they are relatively simple in nature. The other family
are the implied risk premia. These tend to be more complex and
have been developed more recently.
Note that in the case of value investing in the risk premia space,
a key parameter to determine is the fair value of an asset - a
subjective number which naturally leads to some dispersion
from different providers in this space.
The other main characteristic behind academic risk premia is
the fact that some investors are constrained in their behaviour.
As a premia investor, positive yield can be generated by holding
assets or taking risks that marginal investors cannot (or do not
want to) hold. This is called carry. While carry can be derived
from all asset classes, it is with commodities that the concept is
best expressed. Under normal market conditions, commodities
exhibit backwardation along the futures curve, stating that
commodity producers have been selling long-dated contracts at
a discount in order to hedge their output, whereas consumers

4 Risk Premia | Q4 2016

have been buying short-dated contracts at a premium in order
to secure near-time consumption. Therefore an investor who
buys from producers and sells to consumers can capture a
risk premium in the form of a roll yield assuming, of course,
all else being equal during the invested period.
Source of the carry premia on the commodity curve
Hedging of
producers
Price
imbalance between supply and demand in the volatility
market; a trend especially observable since 2008 as there is
more demand for protection and less ability to warehouse
it. In the equity space, the volatility premium is captured by
systematically selling volatility through variance swaps where
one would receive implied and pay realized volatility. A more
elegant way to exploit this risk premium is to run dispersion
trading. Dispersion trading exploits the phenomena that the
difference between implied and realized volatility is greater
between index options than between individual stock options.
Investors therefore could sell options on the relevant index
and buy individual stock options. This strategy tends to be
profitable during a period when individual stocks are not

significantly correlated and loses money during stress periods

when correlations rise.

Buying from consumers

In the case of the merger arbitrage premium, the investor
receives a spread that rewards them for the risk of a deal
collapse. The larger the uncertainty on the outcome of that
One-month 12-month Futures potential deal, the larger the spread is and as a consequence
the larger the premium to be harvested.

Source: Deutsche Asset Management, Nomura as of November 16

For illustrative purposes only
Implied risk premia
Implied premia is our second family of risk premia. This family
encompasses all implied parameters which can lead to arbitrage
situations such as volatility, dispersion, dividends or liquidity.
The existence of these premia is derived from specific market
flows which sometimes have common ground with the
academic risk premia family such as investor patterns,
hedging needs or regulatory constraints.
Volatility risk premia investing across asset classes relies on the
historical acknowledgement that implied volatility tends to be
higher than realized volatility and is explained by a structural
Finally another implied related risk premium strategy involves
trading dividend futures. Over the past few years dividends have
ceased to be considered a side product of equity investments,
and the assertion that they constitute an asset class in their own
right has become more and more common. Dividends can be
traded using futures, opening a new door to possible premia to
be harvested. About five quarters before expiry, dividend futures
usually undergo a profound change in their risk dynamics as the
stock tends to trade at a discount to the expected dividends. As
time passes, the discount falls. This pull-to-realized behaviour
can be harvested.
Once divided in two broad families, risk premia can then be
classified per asset class and styles, creating a two dimensional
matrix as shown below, where peer group analysis and more
in-depth analysis can be run at the bucket level.

Risk premia matrix

Carry Curve Liquidity Mom. Quality Size Value Volatility

Commodities

Credit

Equities

Fixed Income

Forex

Academic risk premia Implied risk premia

Source: Deutsche Asset Management as of November 16

Risk Premia | Q4 2016 5

Choosing providers
A broad and ever expanding universe
When it comes to providers of risk premia, there is a plethora
of choice. Most investment banks offer a range of off-the-shelf
strategies. These strategies, if one invests in a particular size,
can be more or less customized to match a clients needs.
It provides an almost overwhelming choice and as each
provider has their own views on how and what information
for each strategy is disclosed, it makes any comparison
exercise a difficult process. For this reason, it is advisable to
use filtering methods to reduce the size of the universe to a
more manageable size, allowing one to carry out a deep-dive
on the relevant risk premia remaining.
One can develop a range of quantitative methods (for example
principle component analysis) and measures that rank strategies
across variables but also take the decision to explore each group
of risk premia available to investors from a bottom up view.
Such an approach is preferable due to the fact that even for the
most simple risk premia, the implementation and trading by
each provider is different. This results in a broad range of data
matrices where risk premia are sliced and diced not only from
a statistical and cost perspective but also from a qualitative
standpoint where key construction elements are detailed across
each risk premia within a style and an asset class. Further, the
statistical perspective is easier to grasp when combined with the
analytical work done on a qualitative basis, facilitating decision
making when it comes to selecting which are the risk premia
one wishes to consider as inputs to the portfolio construction.
Risk Premia selection process
Risk premia providers
A B C D E F
Risk premia universe 200+
Portfolio
candidates Around 50
Source: Deutsche Asset Management as of November 16
6 Risk Premia | Q4 2016
Portfolio construction
Building bridges
From an investors perspective, the risk premia story is a
fascinating on-going development. Within a couple of years,
a new investment toolbox has been developed and made
available at a relatively low cost for investors. This toolbox
is extensive: available premia range from classic academic
strategies to strategies which are much more complex that
have been used by hedge fund managers for decades.
Assuming that an investor has defined a clear methodology
to assess, filter and select a sample of candidates to allocate
capital to, the next step is to define a portfolio construction
process. In the active space (excluding the case of fixed
allocations), we outline two ways to tackle this challenge,
both of them with their own advantages and drawbacks:
a systematic approach and a discretionary approach.
The systematic approach relies on a portfolio optimisation
model that rebalances the allocation on a regular basis
without human intervention. Typically, the optimisation aims at
maximizing returns while minimizing a user defined risk metric.
A classic approach is to run a variant of the risk parity model.
The systematic approach ensures adequate diversification and
the absence of hidden biases in the portfolio - it is disciplined.
The discretionary approach consists of building a portfolio based
on a qualitative decision making process. In contrast, it has
more tactical positioning and can implement allocations with a
more forward looking perspective than systematic approaches.
The main downside of the systematic approach is that the
models rely on historical data while the main downside of
discretionary approach is that the allocation can build up
unexpected biases in terms of sensitivities to some factors
and can be subject to weaknesses of human investor
behaviour such as loss aversion, anchoring and herding.
One suggested approach works on a compromise, building
a bridge between the two portfolio construction methods.
First, one can use a panel of quantitative approaches to define
weight ranges where each weight corresponds to an optimal
solution from a risk/return perspective. One can employ different
approaches to assess risk with a focus on correlation analysis as
historically correlation has had a dominant role in the success or
failure of any risk premia allocation.
The next stage is based upon ones understanding of the
behaviour of each risk premia, namely how cheap or rich one
perceives them to be, as well as macro considerations and
on-going tactical opportunities. From this a discretionary
allocation for each risk premia is made within each of the
bands resulting in a final allocation. In this vein, quantitative
methodologies are useful tools to define allocation boundaries,
and when combined with what can be seen as a macro overlay
can yield a portfolio that is more robust than either a purely
discretionary approach or a purely systematic approach.
Timing risk premia
Adding value through discretion

One of the most intensely debated and arguably the most Current carry vs 18 month average carry for selected currencies
controversial of topics in the risk premia space is whether
they can be timed or not. It is a debate which has traditionally 12%
Current Carry
polarised investors. As transparency has improved as well as 10%
the expansion of the investible universe, the discussion has 8%
18m Average

continued to evolve. 6%

4%
Lets return to our previous definition of risk premia from before:
systematic ways of exploiting persistent inefficiencies that arise 2%

in the market generally stemming from structural imbalances. 0%

While in the long run these inefficiencies allow the investor to -2%
generate a positive return, looking back through history, it is -4%
clear that there are periods that favour one risk premium over

SD

SD

ZA SD

XN D
SD

AU SD

SD

O D
CA SD

SG SD

GB D

SE D
TW SD

SD

KR SD

SD

SD
another and in extreme cases, there are periods when certain

S
LU

RU

RU

RU

FU

KU

PU

KU

RU

YU
ZD

W
U
BR

JP
ID

IN

EU
risk premia will underperform for a significant amount of time.

H
N

N
M
Determining the drivers of this under/outperformance can be a Source: Deutsche Asset Management, Bloomberg as of November 16
difficult task and harder yet is the prediction of when the change
in these drivers will occur. Certainly for some risk premia such
as momentum, determining when a trend will start or break
would be the Holy Grail for investing. As such timing certain
risk premia can be a very difficult task and many risk premia
investors will choose to accept this and instead implement a
Conclusion
purely passive or risk parity approach to investing. The move from a black box to a glass box
However, this may not be the case for all risk premia. Premia
that aim to capture an arbitrage or carry spread can be
monitored on a historical basis and if one accepts that over The recent spark in interest for risk premia has led to a
time, asset prices will tend to mean revert to their historical proliferation of products and solutions on offer for investors.
norms then it is possible to build a framework for determining The approaches in some cases vary significantly and
whether a risk premia is currently cheap or expensive. understanding their different nuances and behaviours is
This is perhaps best illustrated by looking at a carry strategy crucial for successfully investing in the asset class. Our belief
if we look at the chart on the right we can see the current FX is that careful provider selection is paramount and that while
carry being compared to historical averages for a number of portfolio construction can be enacted on a largely systematic
currencies. In this example, it would indicate that we should basis, there is value to be added employing discretion in order
allocate more to emerging market vs developed market FX carry to tactically position the portfolio and to time certain premia.
premia as the former looks much cheaper through this lens.
The same idea can be applied to other asset classes such as This recent growth is understandable as investors look more
equities, commodities and fixed income. for a low cost alternative to investing in traditional hedge
funds as they become increasingly more discerning about
Another take on timing risk premia is to use them as a tool their investments with regards to transparency, costs and
to implement more directional tactical investment decisions flexibility and we believe risk premia investment solutions
in a similar way to how a macro hedge fund may invest. offer a very compelling response to this problem. However,
For example, if we consider more traditional risk premia in the only time will tell which approaches will be successful and
equity space; an investor might go long the S&P and short which may lack substance when it comes to performance.
the risk free rate if they want to take a directional view on the
US stock market. The same can be applied to fixed income or
commodity instruments if an investor also has a directional
view on those markets and wants to take on the corresponding
risk for investing in them. Certain risk premia may also lend
themselves to trading on a risk on/off basis such as liquidity or
emerging market bias premia (for example long the MSCI EM
index/Short S&P 500) and if an investor has an opinion on the
market direction or regime for these, they can implement their
risk premia investments accordingly. This approach allows a risk
premia investor to take on a more tactical approach to investing
in the strategy using their own discretion.

Risk Premia | Q4 2016 7

Risk considerations
The hedge fund strategies are not capital protected nor are they capital guaranteed. Investors in the hedge fund strategies should be prepared and able
to sustain losses of the capital invested, up to a total loss. The value of an investment may go down as well as up and past performance is not a reliable
indicator of future performance. Hedge fund strategies are complex and may not be suitable for all investors and no assurance can be given that the
investment objective will be achieved. Investments in hedge fund strategies are speculative and involve a high degree of risk. Investors should be aware
of the attendant risks including, but not limited to the potential for higher fees and lack of strategy transparency. Hedge fund strategies may employ
a single strategy, which may result in a lack of diversification, and consequently higher risk. Hedge fund strategies may also use leverage, which may
increase profits, but may also magnify losses. The hedge fund strategies are intended for professional investors who, based on their own investment
expertise or that of their financial advisor, understand its strategy, characteristics and risks. Past performance is no guarantee of future results; nothing
contained herein shall constitute any representation or warranty as to future performance. Further information is available upon investors request.

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