THE BETA REVOLUTION
Both long-only active managers and hedge funds have come under considerable scrutiny as our understanding of return drivers has improved.
As investors have moved beyond the narrow definitions of alpha and beta which classic finance theory puts forward, there is today greater understanding about building investment strategies as a combination of certain return drivers.
Thus, more of what used to be taken for alpha has become beta.
According to Yazann Romahi, CIO of Quantitative Beta Strategies, JP Morgan Asset Management (JPMAM): “This more nuanced approach to alpha and beta has raised the bar for long-only equity investors to justify active fees, to prove they are able to deliver skill-based alpha beyond just the ability to capture given factors.”
Even hedge funds – the alpha promised land – have not been immune from the beta revolution. Similar to the progression of alpha/beta separation in traditional investments, the thinking around the drivers of returns for hedge funds have also evolved. It has been shown that hedge fund “alpha” can in fact be broken down into a component attributable to ‘hedge fund beta’ – long/short exposures that capture some form of risk premia – and a second component which is true idiosyncratic alpha. The systematic component of hedge fund returns (‘hedge fund beta’) can now be delivered in a more liquid and cost-efficient manner.
“Understanding that a significant portion of returns to various hedge fund styles come from this exposure to risk premia has opened the door for the creation of liquid long/short vehicles,” Romahi says. This, of course, has become known as alternative beta.
A BETTER BENCHMARK?
By allowing alpha and beta to become more delineated, alternative beta strategies have effectively created new benchmarks against which hedge funds can be measured (just as smart beta has for long-only active managers).
As Andrew Beer, managing partner and coportfolio manager, dynamic beta at Beachhead Capital Management, says: “Factorbased, top down replication of certain strategies like equity long/short is the most reliable way to build a legitimate benchmark for a hedge fund portfolio. It really raises the bar for the allocator: if the hedge funds you pick don’t consistently beat the liquid, low cost version, then what’s the point?”
Romahi estimates around 50% of assets invested in hedge funds are in styles that “lend themselves well” to being captured in a liquid and systematic manner, namely equity long/short, global macro and merger arbitrage. But the list of strategies morphing from alpha to beta is ever-increasing. New research shows even event-driven strategies – previously thought to be unsuitable for a beta approach given the idiosyncratic nature of their returns – can be captured in a liquid, low cost and transparent form through alternative beta.
