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The ABC’s of the ARP: understanding alternative risk premium

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Abstract

Alternative risk premium (ARP) has experienced significant growth as an investment category in recent years. While considerable educational efforts accompanied this growth, gaps and misunderstandings persist. This paper provides a detailed definition of and contextualization of ARP as well as a comprehensive review of its academic roots, explaining that ARP sits at the confluence of decades of research on empirical anomalies, hedge fund replication, multi-factor models and data snooping.

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taken from Hedge Fund Research, Inc. (HFR). The bullets list the typical underlying approaches. (Note that these are not the HFR sub-strategy descriptions.)

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Notes

  1. Rennison and Staal (2010), Tien et al. (2010), Mesomeris et al. (2012), Little and King 2012, Turc et al. (2013, 2016), Jenkins et al. (2013), Kolanovic and Wei (2013, 2014, 2015) to list but a few.

  2. These friction-related dynamics that may explain the gap between finance theory and empirical findings are summarized in Table I.1 in Pedersen (2015): Modigliani-Miller irrelevance of capital structure vs. capital structure matters; two fund separation where all investors invest in the market portfolio and cash vs investor select different portfolios depending on their individual funding constraints; capital asset pricing model versus the influence of liquidity risk and funding constraints on expected returns; law of one price and Black-Scholes framework for pricing derivatives vs arbitrage opportunities impact derivatives pricing; Merton’s rule on exercising a call option vs optimal early and conversion; real business cycles and Ricardian equivalence regarding the irrelevance of macroeconomic policy on finance vs credit cycles and liquidity spirals that drive the interaction of macroeconomic policy, asset pricing, and funding constraints; and Taylor’s rule regarding monetary authorities impact on interest rates vs two monetary tools impact on interest rates and collateral polity.

  3. Note that a few of the constituents in Table 1 arguably could reside in a different column—primarily the event driven strategies. Convertible bond arbitrage is one example. Because the strategy typically assumes some mispricing in the convertible bond, this table classifies convertible arbitrage as convergence. But there are many possible convertible arbitrage trades involving various hedges of delta, rho, vega, gamma, and credit, some of which might support slotting the trade under carry instead of convergence. Share buyback is another example having attributes of quality (balance sheet integrity) and relative value (long positions in negative net issuance companies coupled with negative positions in diluting companies). With few exceptions, however, strategy placement (Table 1) is intuitive.

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Authors and Affiliations

  1. Wellington Management, Boston, MA, USA

    Stephen A. Gorman

  2. EDHEC Business School, Nice, France

    Frank J. Fabozzi

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  1. Stephen A. Gorman
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Correspondence to Frank J. Fabozzi.

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Gorman, S.A., Fabozzi, F.J. The ABC’s of the ARP: understanding alternative risk premium. J Asset Manag 22, 391–404 (2021). https://doi.org/10.1057/s41260-021-00231-3

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