Bank Risk Premia Indices: Unbankable?

Exploring Factor Investing Across Asset Classes

August 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

• Factor investing can be pursued across asset classes
• Risk premia products sold by investment banks have generated mostly unattractive returns since 2006
• The idea of risk premia indices is great, but the implementation has been poor

INTRODUCTION

Monoculture can be considered the biggest threat to our food supply and therefore our livelihood. Although our diet may seem varied, about 20 species of plants make up 90% of our food consumption. The risk for our society is that any of these vital plants can be affected by disease, which has happened plenty of times before.

For example, before the 1950s, almost all bananas sold were a variety called the Big Mike, but that was largely wiped out by a fungus, which caused significant economic issues for the Caribbean nations growing these. However, although we might miss bananas terribly if they get wiped out again, it naturally would not threaten our survival.

Much worse was the potato famine in Ireland in the 1850s that led to approximately 1 million deaths from starvation and another million to flee the country. The Irish were highly dependent on potatoes and a microorganism that likely originated in Mexico caused potatoes crops to fail on a large scale in Ireland and the rest of Europe.

For those that enjoy wine, in the late 19th century the phylloxera epidemic destroyed most of the European vineyards, which was introduced to Europe when avid botanists in Victorian England collected specimens of American vines in the 1850s. The epidemic devastated vineyards and was only tamed when hybridization allowed to introduce elements of resistance to this pest from North American grape varieties. 

The adequate strategy for farmers and consumers is therefore to diversify and decrease their dependency on just a few plants. In a similar fashion, diversification is essential when investing and should be applied to plain beta as well as alternative beta. The former refers to asset classes like equities or fixed income and the latter to factor investing. The final result should be a portfolio diversified both across factors and assets classes. 

Most investors are likely familiar with factor investing in equities, yet fewer are aware the same methodologies can be