Written by: Yazann Romahi, Chief Investment Officer, Quantitative Beta Strategies
Alternative beta—accessing hedge fund returns in a liquid low-cost and transparent manner.
The aura of mystery that surrounds hedge funds has allowed them to present their returns solely as a consequence of manager skill, or alpha. Recently, poor aggregate performance has challenged this perception. Have hedge fund managers lost their touch? The truth may rather be that the drivers of their returns are misunderstood. Beta research lifts the lid on the hedge fund black box. What it reveals is that a large part of the returns of many hedge funds can be attributed to factors widely known in the investment world. These factors can earn premia for taking risks that other investors do not want to (or cannot) take.
So-called hedge fund (or alternative) beta represents a way to understand hedge fund returns. It also offers a low-cost, transparent and liquid means of investing in hedge fund strategies. Hedge fund beta is, in many ways, no different from the market risk premium (or equity beta) that so shook up the world of mutual funds when passive investments became available. The figure below highlights some parallels in the development of equity beta and the newer hedge fund beta.
The alternative beta premia that help to explain hedge fund returns, far from being the cutting edge proprietary ideas that hedge funds claim, are often commonly used and well understood. In some cases they have appeared in academic literature for decades, and many can be systematically captured at comparatively low cost. Indeed, alternative beta can explain a large fraction of the returns across hedge fund styles including equity long/short, macro/CTA and event-driven.
A systematic strategy targeting alternative beta differs from what has historically been known as hedge fund replication. Rather than attempt to achieve the goal of hedge fund investing by mimicking backward-looking hedge fund exposures, an alternative beta strategy builds exposures proactively from the bottom up, the way a hedge fund would.
Alternative beta investment vehicles can implement their strategies with complete transparency since the premia they earn are economically justified and should therefore be persistent. They arise from behavioral biases, structural constraints or rational risk preferences. Hence, while alternative beta exposures can become crowded or expensive in the same way as traditional asset classes, “alpha decay” does not erode the premia available for a committed long-term investor.
Alternative beta, then, has the potential to duplicate, to a great extent, the ability of hedge fund investments to tap alternative sources of return. Just as with hedge funds, the weak correlation of alternative beta factors to markets makes them an attractive diversifier. In addition, since alternative beta factors bear little correlation to one another, diversifying across as broad a range of alternative beta strategies as possible can serve to mute volatility, a particularly useful property during periods of less attractive hedge fund strategy performance.
Advances in our understanding of alternative beta have two far-reaching implications. By providing, in effect, a passive hedge fund benchmark, alternative beta can help traditional hedge fund investors to identify true alpha generators and better understand performance. Perhaps most exciting, innovations in the delivery of investable alternative beta strategies threaten to disrupt the high-fee, opaque and illiquid hedge fund model, bringing the benefits of hedge funds to investors for whom they were previously out of reach.
Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.
J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
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