Alternative beta raises the bar on hedge funds

Here’s a paradox for financial advisers to consider: As it relates to traditional indexing, we would never invest in an active manager in long-only equity without benchmarking them to the relative index. But in the hedge fund world, we’ve accepted that returns are all the result of idiosyncratic manager skill.

As more and more hedge fund data has become available and academics started to analyze hedge fund returns, that long-held belief has been tested. What analysis has shown is that a significant component of hedge fund returns is in fact not manager skill, but systematic exposure to risk premia, in other words, beta.

The increased understanding of these alternative beta factors coincided with the development of other investment vehicles that can offer exposure to these factors – and the end result is that alternative beta ETFs are raising the bar on hedge funds.

Access to beta for hedge fund strategies spans four broad categories:

Equity Long/Short: Invests in top-ranked stocks while shorting bottom-ranked stocks from a universe of developed market stocks. Strategies captured include momentum, value, size and quality.

Global Macro: Seeks some of the liquid and systematic risk premia captured by macro hedge funds such as momentum and carry across fixed income, currency and commodities.

Event Driven: Includes merger arbitrage, which focuses on the deal-risk premium factored into the price of a merger-target stock until deal completes, as well as a number of other event-based strategies such as index rebalancing arbitrage.

Convertible Bond Arbitrage: Focuses on the illiquidity and small-cap premia available in the convertible bond market by capturing the underpricing of the embedded optionality

Hedge fund investments are attractive to investors – and therefore advisers – as they can help provide diversification, uncorrelated returns to traditional investments and can help improve the overall risk-adjusted performance of a portfolio. However, these investments typically have higher fees, limited liquidity, low transparency and require advisers to identify and evaluate separate hedge fund managers to access different strategies.

(More: Smart-beta ETFs take in billions in new assets.)

Alternative beta solutions look to access the systematic (beta) portion of returns for different hedge fund styles efficiently and without the shortcomings typically associated with direct investing through hedge fund managers.

ACTIVE-PASSIVE DEBATE

The increased interest in these alternative beta vehicles is due partly to the active passive debate. However, we must remember that the academic literature itself in hedge funds is relatively new. And more importantly, the industry’s ability to make these strategies available to investors through lower cost, transparent and liquid vehicles is also relatively new. First, through mutual funds and now, through ETFs.

(More: Vanguard rolls out actively managed factor ETFs.)

The availability of alternative beta through mutual funds is only about 10 years old. Over that time we’ve increasingly found ourselves in an environment where equity market valuations have become rich and the outlook for fixed income returns mixed given the likely rate trajectory. As a result, there has been an acute need for diversifying strategies and alternative beta has provided an ideal solution.

As it relates to alternative strategies, increased fee pressure and the transparency associated with alternative beta will ultimately result in a barbelling of the industry – on one end you’ll have hedge funds with high active share and top performance and at the other end you’ll have alternative beta.

Yazann Romahi is CIO of Quantitative Beta Strategies at J.P. Morgan Asset Management.

Related Topics: JPMorgan Chase & Co.