Alternative Risk Premia: Valuable Benefits for Traditional Portfolios

Key Points

  • Most investors seek to earn a 5% annualized return above inflation to securely meet their financial needs in retirement. With today’s low expected returns across financial markets, most mainstream portfolios, including the typical advisor portfolio, are poised to fall well short of this mark.
  • An alternative risk premia strategy—one that harvests robust factor premia via long–short exposures to mature and varied asset classes, preferably in a straightforward, systematic, and transparent framework—provides attractive absolute return prospects and materially improved odds of achieving long-term return targets.
  • A systematic alternative risk premia strategy can deliver valuable benefits beyond attractive returns, such as improved portfolio diversification and reduced downside risk.

For most investors, earning less than a 5% annualized total return above inflation means they will likely fall short of meeting their financial needs in retirement. A couple of years ago, our colleagues West and Masturzo (2016) invited investors to try the “5% challenge,” posing the question: What are the odds your portfolio will earn an annualized real return of 5% over the next decade? Since launching the challenge two years ago, of the more than 53,000 portfolios created, only 14% have topped this mark. Unfortunately, from today’s starting point of low interest rates and elevated equity valuations, most mainstream portfolios are doomed to fall short. The 5% challenge proves difficult even for the relatively diversified portfolios recommended by the average financial advisor.

We see a wide gap between 1) the long-term return most investors base their planning decisions on, and 2) the annualized return their conventional portfolio is poised to realize over the coming decade. In this article, we explore one path with the potential to close a portion of this gap without materially increasing portfolio-level risk. We propose adding a liquid and transparent systematic alternative risk premia strategy as a core alternative allocation to complement investors’ mainstream-centric portfolios. This strategy appears to offer a compelling option which should raise an investor’s odds of clearing the 5% real return hurdle.