By Yazann Romahi
Terms such as smart beta, advanced beta and alternative beta are often mistakenly considered synonymous. However, there are significant differences, ones which investors need to be aware of as they examine the possibility of incorporating these types of strategies within their portfolios.
We argue that smart beta refers specifically to the creation of superior long-only indices in the traditional investment space. In contrast alternative beta aims to capture the systematic component of hedge fund returns using both long and short positions. This long/short approach means these portfolios can be constructed so as not to be influenced by the broad rise or fall of any underlying asset class.
Hedge funds tend to explicitly pursue absolute returns, generally offering attractive risk-adjusted returns and potentially also low correlation to traditional investments. However, investing in hedge funds themselves has been beyond the reach or inclination of many investors. Challenges have included lack of transparency, lack of liquidity and high costs (or associated high capital charges).
The rise of the ‘alternative beta’ concept, which is increasingly becoming investable, is an interesting case study in how alternative investment approaches are being reassessed.
The fund management industry used to think about hedge fund managers as pure alpha generators, where all of their returns were produced by manager skill. However the academic community made strides in decomposing the drivers of hedge fund returns to understand what proportion is truly attributable to investor skill. Their findings have shown that systematic exposure to risk premia rather than pure skill drives a significant part of return. This has lead to the distinguishing of genuine alpha from the portion of return more correctly described as ‘alternative beta’ or ‘hedge fund beta’.
More recently, this concept of alternative beta has been made investable through the launch of vehicles by both investment banks and asset managers. Essentially, alternative beta is about providing investors with exposure to the risk premia (systematic exposures for which an investor expects to be paid) associated with several alternative strategies across a range of hedge fund styles, including equity long/short, merger arbitrage, convertible bond arbitrage and global macro/CTA, either in isolation or through diversified offerings.
An attraction of these strategies is that historically, the returns generated through exposure to these alternative risk premia have exhibited little performance relationship / correlation with each other, or with traditional investments in global stock and bond markets. Combining non-correlated alternative strategies into a single portfolio helps to diversify risk and generate more consistent returns over time.
Additionally, because they are rules-based strategies, they benefit from more competitive fees than hedge funds and tend to provide a high degree of transparency and liquidity – allowing investors to buy and sell the fund on a daily basis.
Importantly, these vehicles are different from hedge fund index replicators, as they are about understanding the drivers of hedge fund returns and then seeking to capture them by direct investment in securities and the use of financial derivatives.
In an environment where investors have concerns over equity market volatility and where fixed income investments risk exposing investors to capital losses, exposure to other sources of return will become increasingly important. As investors increasingly push the boundaries in search of accessible alternatives, the concept of alternative beta has become a more significant part of investors’ toolkit.
Yazann Romahi is portfolio manager, JP Morgan Funds – Systematic Alpha fund
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