This could open the door for DC funds to be able to access low cost exposure to alternatives and effectively diversify their funds in a way that was simply out of the question before. Not only due to the costs, but because hedge funds were less transparent and offered insufficient liquidity.
This is a “paradigm shift” in the investment management industry, says Yazann Romahi, global head of quantitative strategies & research, multi-asset investment solutions at JP Morgan Asset Management.
“It’s about identifying disaggregated returns from the the rest and seeing how much is idiosyncratic risk premium,” says Romahi.
“Then you go about capturing it from alternative routes, by creating building blocks to access low-cost, transparent, daily liquid returns.”
It sounds simple, but of course it isn’t. The skill an active manager demonstrates is not straightforward and comes from how they blend and time the risk premia. This cannot be replicated in an index or other product; there are components of the return and risk premia that are valuable in and of themselves, which is why hedge fund managers have exposure to that risk in the first place.
Much of the buzz has been about the application of ‘smart beta’, but Rohami is keen to differentiate between smart and alternative beta. He says the long-only nature of smart beta cannot possibly replicate the drivers of hedge funds’ strategy and ply them by investing directly in securities.
Drago Indjic, an independent consultant and former CIO of Sunningdale Capital, would tend to agree.
“By replicating any index of hedge funds, you are building a passive market equivalent for a universe that is actively managed by clever people, not captured by following smart betas that are indexing static formulas,” says Indjic.
“Most importantly, the reverse as well as long exposure alternative beta products are obtained as physical cross-asset, long/short replicating portfolios, not as synthetic index products.”
The confusion that exists between smart and alternative beta strategies is understandable. Some of these approaches have been in use for more than a decade, but there was no unifying description and so they appeared to some as opaque as hedge funds – people simply didn’t get it.
But smart beta is not going to do the same for investors as alternative beta strategies will, says Indjic.
“Smart beta is not hedged enough and still nudges allocators to select single products rather than daily manage their portfolios,” says Indjic. He adds that all new betas are hedging instruments too, and he would far rather be able to take either long or reverse exposure in something that is not going to produce drawdown of more than a few percent than something with a huge potential drawdown.
“Remember, in the last last 15 years, equities have seen drawdowns of 40% to 50% on two occasions,” he says. “Why people are buying into them beats me.”
Even now, a number of large managers and pension funds – F&C, Railpen, Hermes included – are only taking small steps in the smart beta arena to replace elements of traditional long-only equity and fixed income exposure, but not alternatives.
“It is very hard for them to think about alternative beta until they complete the evolution to smart beta,” says Indjic.
Romahi is bullish on the potential growth of alternative beta as he sees it as the single greatest factor to increase choice for investors, though he accepts many will jump to the conclusion that you can capture hedge fund returns in a passive manager.
This passive tag is likely to prove something of a red herring for many people, and is exercising some who take exception to its use in relation to smart – or alternative – beta.
“Once you move away from the market (beta) which is a consensus view towards factors or groups of factors, you have made an active decision and so that introduces an element of active management,” says Vanguard’s Huver. “The use of these terms create confusion.”
This isn’t a spat between active or passive managers, either. Apart from the fact that a third of Vanguard’s money is run actively, Rohami says beta offers more opportunities for active managers as well.
“At an overly-simplistic level, if everybody was buying the S&P 500, the 501st company would by definition be undervalued,” he says. “The big players in alternative beta are a mix of passive and active managers because there has been a focus on providing smart beta.”
The reason for the smart beta focus is easy – it is long-only and therefore something many asset owners are comfortable with, but because it is long-only, there is a lot more capacity than for a long-short strategy, he adds.
The price is always important, never more so than with the DC charge cap imposed upon default funds. However, Indjic believes alternative beta can not only be competitive, but can also “produce exposure to hedge fund or CTA managed futures premia, long and reverse with very little synthetic and little counterparty risk”.
This makes sense from the perspective of cost/reward, with alternative beta being priced similar to exotic beta like emerging markets ETFs and other less common indices, though even the latter still attract fees of around 1%.
“Minimum variance index tracking would appear more protected than many other things that are long-only in the smart beta space,” adds Indjic, “but only in alternative beta can I see a clear sense of cross-assets, hedging and active risk control – and all this can be packaged for 1% or less.”
While the marketing sounds attractive and the price is appealing, Irvine strikes a note of caution for investors who think they’ve found the goose that lays the golden egg.
While the investment thesis is “plausible”, their returns are simulated and “the actual performance history of such funds tends to be more limited and for the most part much less exciting,” he says.
“Investors thinking about making long-term decisions for their DC pots should treat such products with considerable caution and only invest after doing significantly more due diligence than they do with other asset classes they invest in and continue to monitor the funds after investment.”
Comments