Exotic Beta Revisited

Abstract

The authors propose portfolios comprising simple and intuitive risk premiums (exotic betas) that are transparent and cost effective, perform well in different market environments, and are uncorrelated with equities. They are an alternative to traditional portfolios that are defined by their asset class allocations. The authors show that exotic beta investing offers a better risk–return profile than risk parity and hedge fund replication and that adjusting exposures to capture variation in risk premiums further improves performance.

As an alternative to traditional portfolios that are defined by their asset class allocations, we propose portfolios comprised of simple and intuitive risk premiums, which we call “exotic betas.” The factors underlying the exotic betas are transparent and cost effective to implement and perform well over a variety of market conditions. In addition, our portfolios are uncorrelated with equities because we proactively hedge all the exotic betas against fluctuations of global equity markets. In our analysis, we study the properties of the exotic beta portfolios in stages. We start by simulating an implementable version of each exotic beta and compare their properties with those of a simple global equity portfolio. We find compelling evidence that exotic betas typically deliver higher Sharpe ratios, smaller drawdowns, and very low correlations with equities (by construction) and other known factors. Next, we build an equal-risk combination of exotic beta factors that is analogous to risk parity and compare the portfolio with asset class risk parity, hedge funds, and hedge fund replication. Owing to its long-only exposure to traditional asset classes and substantial equity risk, the asset class risk parity portfolio retains a high correlation with equities, and it underperforms both exotic beta and hedge fund strategies. After imposing additional conservative assumptions on forward-looking expected returns, we perform a mean–variance analysis in which the assets of choice are global equities, global bonds, risk parity, hedge funds, and exotic beta. The resulting optimal portfolios hold a combination of global bonds, hedge funds, and exotic beta; global equities and risk parity are not held because of their limited diversification benefits and their relatively lower expected Sharpe ratios. Finally, we examine the predictability in the exotic beta risk factors using straightforward metrics of value. We find that dynamically adjusting the exposure across exotic betas to capture the time variation in risk premiums further improves the risk–return profile of the strategy.

Authors’ note: This article is intended to educate readers about the concept of exotic beta. It is not an offering document for any investment vehicle, a recommendation to buy or sell any particular assets or fund, or a proxy for any portfolios that are currently managed, or may in the future be managed, by Kepos Capital. In addition, this article (1) does not constitute investment advice and (2) does not take into account any individual personal circumstances or other factors that may be important in making investment decisions; no advisory or fiduciary relationship is created by the distribution hereof.

Editor’s note: Robert Litterman is executive editor of the Financial Analysts Journal. He was recused from the referee and acceptance processes and took no part in the scheduling and placement of this article. See the FAJ policies section of cfapubs.org for more information.