Costs are paramount in investing in risk premia

As the cost of extracting risk premia in the market remains high while returns have diminished, investors have to be aware of investing in strategies that look good on paper but have execution costs that don’t justify the benefit of implementing those ideas. 

Paul Fraynt, vice president and head of risk premia at Franklin Templeton-owned K2 Advisors, had studied the success of risk premia strategies comparing theoretical versus real-world performance after execution costs. 

Fraynt said they had found a number of superannuation funds currently invested in risk premia, with those allocations coming down to a classic four-by-four structure. 

However, in many of those quadrants, the size of remaining premium versus the costs to extract is a suspect. 

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“They split the entire investment universe into equities, fixed income, commodities and foreign exchange and that’s by asset class; by style that would be momentum, carry, value and maybe sometimes defensive,” Fraynt said. 

“The idea was to find a strategy for each quadrant, so up to 16 different quadrants, and we found in many of those quadrants the source of premia that exist after costs are not justifiable.” 

Despite the historical strong performance of risk premia strategies, results and experiences were still mixed when considering the brokerage costs for buying and selling. 

Fraynt said their idea was to not just go beyond what people would consider best execution, but by trying to find a better or cheaper way, but at the same time his asset management firm aimed to invest in non-traditional risk premia strategies that were less crowded and worked better. 

“What we find is that many of the existing strategies may look attractive in a backtest, but until asset managers can reduce costs dramatically these strategies do not become attractive,” Fraynt said. 

“It’s difficult to say if classic risk premia strategies have become attractive or unattractive, but recent experience last year and frequently this year have showed the classic strategies have been suffering or have not delivered attractive returns.” 

“What I would be careful about here is that the cost we incur to extract the premium after best execution still does not justify in our minds a desire to include those strategies.”