Searching for alternative beta
Bfinance’s Chris Stevens (pictured) reports on a recent manager search for alternative beta strategies for a large US corporate pension scheme with USD10 billion in assets under management.
The client had previously considered and rejected investing into hedge funds for reasons of transparency, cost and liquidity as well perceived potential headline risks. Alternative beta strategies were considered as a viable alternative to a hedge fund allocation enabling them to introduce diversifying return streams to a portfolio of otherwise traditional asset classes whilst addressing these perceived drawbacks.
Following board education sessions as to the benefits and limitations of such strategies as well as a factor-based risk analysis of the client’s portfolio to assess which alternative beta strategies would provide the best fit with the objectives, the client’s investment committee approved a meaningful strategic allocation of 10 per cent of their portfolio (USD1 billion) into alternative beta strategies.
For the purpose of this strategic asset allocation, alternative beta strategies were defined as liquid, multi-asset, fully systematic strategies that were broadly independent of the direction of underlying markets over the longer term. We further classified alternative beta into two sub-strategies; Alternative Risk Premia, and Hedge Fund Betas. Alternative Risk Premia are market independent returns that exist as a result of bearing systematic risks in markets arising from either risk transfer, behavioural biases or structural constraints from other investors. Although exact terminology is open to interpretation, we categorised five individual premia that are typically present in many alternative beta products: Value, Momentum, Carry, Low Risk and Quality.
With a few specific exceptions, these premia are generally present across the four major asset classes of equities, fixed income, currency and commodities. In contrast, Hedge Fund Betas were defined as the static systematic part of a hedge fund strategy prior to the addition of manager discretion/skill in order to attempt to enhance returns. Here the range of constituent strategies can be quite broad, however we focused on the three most prevalent strategies; Merger Arbitrage, Trend-Following and Convertible Bond Arbitrage.
Each risk premia / hedge fund beta was examined in terms of its diversification benefit in the context of the client’s portfolio (being typical of many institutional portfolios in terms of asset allocation), and they were all shown to be meaningfully diversifying to the client’s portfolio relative to a corresponding allocation to global equities (from which the alternative beta allocation is to be funded). Across the various alternative risk premia / betas it was noted that carry-based risk premia and Convertible Arbitrage and Merger Arbitrage sub-strategies were slightly weaker diversifiers than the other substrategies.
Trend-following was shown to be not only a good diversifier overall, but could also be expected to add even greater diversification benefit during prolonged downturns in traditional asset classes. These results are in accordance with prior expectations and are likely to be common results for many institutional portfolios. bfinance recommended to conduct an alternative beta search in two main areas; broad multi-asset, alternative risk premia managers and core trend-following managers.
The weighting between the two targeted strategies would be dependent on the presence of trend-following in the broader alternative risk premia strategies, but the ultimate aim was to have a meaningful total allocation to trendfollowing within the overall alternative beta portfolio given its attractive diversifying characteristics.
Key Lessons for Investors
Alternative beta is a rapidly developing universe with some attractive fee offerings from credible managers wanting to raise assets and gain critical mass in new strategies and vehicles. Early bird pricing can be attractive.
Although the majority of managers offer flat fee pricing, many managers are open to discussing performance fee options in order to better align their interests with the investor.
There is a large enough universe for manager search projects; comprising mainly large, multi-capability asset managers with a strong quantitative capability as well as products from systematic hedge fund managers launching higher capacity strategies alongside alpha products. Specialised boutiques are also present in a small number.
There is a high level of dispersion in qualitative aspects of investment processes within alternative beta, in terms of the risk premia targeted, the number/range of models used, methods of implementation and portfolio construction. This is far from being a commoditised strategy with the level of complexity in investment processes varying widely.
Backtested track records are prevalent. The systematic nature of alternative beta means that managers are able to provide simulated or pro forma return streams pre-dating the launch of specific products. Scepticism and an experienced eye are required to assess the quality of such track records and a focus on capability rather than performance will provide superior results.