Nirvana for investors is finding an asset class that shifts their efficient frontier upwards and to the left, thereby boosting their aggregate portfolio’s risk-adjusted returns. Conceptually, this results from diversifying the portfolio and focusing on the return-enhancing characteristics of the additional investments.
Hedge funds have become a popular source of diversification as evidenced by their rapid growth in assets, which have swelled to nearly $3 trillion.1 Despite this growth, questions remain about the ability of hedge funds to generate sufficient returns to offset the management and performance fees associated with active management. Proponents of alternative beta (or “Alt Beta”) strategies highlight return drivers similar to those found in hedge funds, but with better liquidity and lower fees. Though these characteristics seemingly make Alt Beta a viable substitute for a hedge fund portfolio, institutional investors may encounter some challenges or necessary trade-offs when investing in Alt Beta strategies.
What is Alt Beta?
Characterizations of Alt Beta can be difficult because a standard definition, implementation methodology, and index for Alt Beta return streams are not widely available. However, in general, we define Alt Beta as a group of strategies that intend to provide liquid and transparent exposure to compensated risk factors or premia with low correlations to global equity and fixed income markets.2 These diversifying properties can be achieved through the long/short format typical of hedge funds. To qualify as Alt Beta exposures, premia3 should be sustainable (i.e., not easily arbitraged away).
A major issue with evaluation of Alt Beta is the relative ‘newness’ of the strategies. Track records are typically short, making it difficult to evaluate return profiles over multiple investment cycles. Back-tested results often provide a biased view of expected returns.4 Even if available, historical performance may not foretell future performance if investors overcrowd the strategy (and because forecasting future results from past performance is generally not a good idea).
Alt Beta investors are also exposed to common hedge fund risk factors such as financing risk given the use of leverage, non-linear risk profiles due to the use of derivative instruments, and counter-party risk. Thus, the due diligence process is not unlike that of traditional hedge funds, which requires ongoing monitoring and oversight.
Lastly, part of the appeal of Alt Beta strategies has been lower advertised fees, but the actual costs necessary to execute the strategy may be higher than anticipated. These additional costs may include fund expense fees, borrow costs for the short portfolio, and execution costs from time and frequency of trading. Given the flexibility in strategy design and parameters that impact trading activity and turnover, taking such costs into account ex-ante is crucial. As with hedge fund investing, the aim is for the resulting return stream to be sufficiently high to offset fees and transaction costs.
A Viable Substitute?
Because the risk premia from Alt Beta strategies may also exist in various forms within hedge funds, these strategies may be thought of as viable substitutes for traditional hedge funds. Instead, both approaches can serve a complementary role in institutional portfolios as they are distinct in how they generate returns.
Alt Beta strategies and hedge funds both aim to provide diversifying returns streams to the traditional equity and fixed income risk that dominates most institutional investor portfolios. In addition to exposures to alternative risk premia, hedge fund strategies also include other return drivers that can be defined as pure “alpha.” Alpha reflects manager skill in that it results from active management decisions such as security selection, trade construction, market timing, and sector rotation. A criticism of hedge funds, however, is that such alpha is small, elusive, and expensive to access.
In order to analyze whether this critique is valid, we decomposed the returns of hedge fund strategies into traditional market betas, Alt Beta proxies, and alpha (Exhibit 1).5 Our findings are nuanced. For Macro hedge funds, roughly 80% of what would traditionally be considered alpha disappears when accounting for Alt Beta proxies. However, for other strategies that are more reliant on security selection, such as Relative Value, alpha is not well explained by Alt Beta. To a large extent, these results are explained by the variation in security selection across strategies. Macro funds typically take few security-specific bets, and hence mainly reflect general risk factors. At the other end of the spectrum, relative value funds focus on individual securities, which are only partially explained by general risk factors.
Overall, the extent to which Alt Beta strategies can be considered a substitute for hedge funds seems to depend on how much of the alpha return stream (which varies markedly across strategies) an investor is willing to give up. In other words, one might not give up much in the macro sector but more in others.
Finally, what matters in the end are comparative returns, net of all fees. As shown in Exhibit 2, outright substitution of Alt Beta for hedge funds results in meaningfully lower risk-adjusted returns, offsetting the benefits of lower fees. In conclusion, while Alt Beta may be a cost-effective substitute for certain hedge funds, it is not a replacement for a portfolio that is fully diversified across risk factors and alpha return streams.
|November 2012 – September 2015||Alternative Beta Strategy6||Hedge Fund Portfolio7|
Source: Hedge Fund Research, Barclays, PAAMCO
1 According to HFR (2015) estimates.
2 See Carhart, Cheah, De Santis, Farrell, and Litterman, 2014, Exotic Beta Revisited, Financial Analysts Journal 70, 24-52.
3 We consider premia that provide exposure to trend, carry, value, and volatility strategies trading across equity, fixed income, currency, and commodity markets, though some have identified more than 300 different factors that could be included in Alt Beta strategies. See Harvey, Campbell R. and Liu, Yan and Zhu, Heqing, …and the Cross-Section of Expected Returns (February 3, 2015). Available at SSRN: http://ssrn.com/abstract=2249314 or http://dx.doi.org/10.2139/ssrn.2249314.
4 Please contact PAAMCO for additional information on this topic.
5 The exhibit illustrates how much of the initial estimate of alpha is explained by the Alternative Beta factors. In this analysis, hedge funds are proxied by the HFRI index suite. For each HFRI index, alpha is first calculated as the excess return over U.S. and international equity markets. Next, alpha is calculated as the excess return over a stepwise regression where variables are selected from the following universe: U.S. equity market, international equity market, equity size, equity value, equity momentum, equity reversal, FX carry, FX trend, FX value, commodity carry, commodity trend, bond carry, and bond value. These constitute our Alternative Beta factor for each index. Equity market factors are sourced from Kenneth French’s data library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html), while the international equity market factor is the excess return of the MSCI World ex U.S. Index over the U.S. equity market. Alternative Beta proxies are sourced from the Barclays Cross Asset Risk Premia suite where available, as this suite had the longest composite live track record found in our data survey (back to November 2012). [Proxies that have only been available more recently include a greater proportion of back-tested results and may overstate returns.] The bond value factor is constructed as the excess performance of the Barclays U.S. Corporate High Yield Index over the Barclays U.S. Intermediate Treasury Index.
6 As represented by the Barclays Cross Asset Risk Premia Index, gross of any associated swap fees.
7 As represented by the HFRI Fund of Funds Composite Index.
Alexandra Coupe, CFA, CAIA, CQF, is an Associate Director at PAAMCO. She is the Head of Asset Allocation Research and is a member of the firm’s Strategy Allocation Committee.
Garrett Norman, CFA, is an Associate Director at PAAMCO working in Portfolio Management.
Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.
This document contains the current, good-faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.
Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore, Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.