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Distinguishing Traditional Risk Premia, Alternative Premia, and Factors

Article Quant Q&A · Author: Gogo78
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Summary

The document compares traditional asset-class risk premia with factor investing and alternative risk premia (ARPs). It frames factors as return sources within established markets, such as equity value, size, momentum, and quality, which may have different correlations from broad market exposure. ARPs are presented as similar ideas applied across other assets, including currency carry and commodity strategies based on futures curve shape or exposure to less liquid contracts. Covered-call selling is mentioned as a possible way to harvest a volatility-related return source.

The proposed benefit is diversification: these strategies may improve a portfolio's risk and return profile if their return sources are sufficiently distinct. The response also cautions that terminology and fees can reflect marketing as well as genuine differences, and that the reliability of many such premia remains uncertain. It provides conceptual examples, not empirical tests, precise definitions, or implementation guidance. The classifications are therefore illustrative, and whether a strategy earns a persistent premium requires evidence beyond the labels used to describe it.

Key ideas

  • Factors describe return sources within traditional asset classes, such as equity value or momentum.
  • Alternative risk premia apply related ideas to markets such as currencies, commodities, and options.
  • Diversification benefits depend on whether a strategy's returns differ from broad asset-class exposure.
  • Commodity curve positioning and currency carry illustrate non-directional or relative return sources.
  • The document cautions that marketing language can obscure costs and that persistence is uncertain.

Tags

Factor investingCarryCommoditiesForexVolatility
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# Difference between Risk Premia, Alternative Risk Premia and Factor Investing?


# Difference between Risk Premia, Alternative Risk Premia and Factor Investing?












I'm reading about this three concepts but still can't see the difference between the three of them, can someone please explain the main difference between three of them ? Thanks

## Answer by demully (score 3)

https://quant.stackexchange.com/a/53978

OK, I'll share a lot of the scepticism voiced in the comments to the OP above. There is an important marekting>reality dimension here. The problem is that if an investor wants a core traditional risk premium like Treasuries or the S&P, there's an ETF costing single-digit basis points. Institutions can do liquid futures (or swaps on interest rates) at the same or less. A lot of the new terminology "adds value" in much the same way that Nestle takes cheap coffee and turns it into a pricier "Nespresso". Some healthy scepticism is warranted here.

But in fairness, "much the same" is not the same as identical. The basic concept with ARPs and Factors is that there are families of risk premia embedded within the traditional asset classes and their "risk premia", that are not fully correlated with the latter. This lack of correlation generates (fingers crossed) diversification benefits, "the only free lunch in finance", that can improve the risk-reward compared to the vanilla asset class. Which is the basis (if it works) for those higher associated charges.

So the classic "factors" within equities are small-cap, value, momentum, and "quality" (whatever that means, however that is measured). Conceptually if the theory is right, one could construct a portfolio long of these factors that is zero-beta of the broader stockmarket; and thus represents an independent source of returns.

ARPs are much of the same, but traditionally found more in other asset classes, rather than equities. A classic example (if not cliche) is the FX carry trade. Higher interest rate currencies pay off for being, generally, higher-risk currencies to hold.

But perhaps a cleaner expression of concept lies in commodity markets. Commodity returns are obviously dominated in the short-term (but not WTI last month!) by spot price movements. Over the longer-term, roll dynamics can accumulate to matter more. So one ARP, analogous to the FX carry trade, is to long-short commodities in backwardation/contango respectively. This is a risk premium within commodities, that does not depend on commodity prices higher or lower. As such it is deemed/described as "alternative". Another one is to hold the front three contracts and roll 1/60th (given 21 trading days a month) every day from front to 3rd; while selling the traditional front-month roll (that killed WTI last expiry). In essence, you get paid (fingers crossed) for taking the illiquidity beyond front-month. Again, it's a commodity trade; but it's not a directional bet on commodity prices. As such, it becomes "alternative".

One could also choose to see covered-call selling of stocks in the same light, trying to harvest a volatility effect (because usually implied > realised) from stocks. Which is related to but different from buying/selling stocks.

The jury is still out on whether any of this stuff actually/reliably works; but hopefully that explains the essence of distinction in terminology?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.