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Written by: Yazann Romahi , Chief Investment Officer, Quantitative Beta Strategies
As the concept of beta has transformed markets, powering the phenomenal rise of passive investing, ongoing research has extended its application. “Alternative beta” can be used to analyze hedge fund returns, shedding light on the formerly obscure and proprietary factors behind hedge fund performance.
It turns out that to a great extent hedge fund returns reward risks arising from exposure to known factors. Just as index investing rewards broad market exposure, so alternative beta will reward exposure to factors such as price momentum, simple carry strategies and the relative performance of attractively and unattractively valued securities.
The exhibit shows just how much progress we’ve made in decomposing the return factors in the three most common hedge fund styles. It shows the annualized volatility (or variation around the average annual returns) for each style according to its HFRI Index, the most commonly used hedge fund benchmark today. The proportion of variation directly attributable to the static factors—not to the insights of the average hedge fund manager—is substantial. It ranges from somewhat less than half for macro hedge funds to nearly two-thirds for event-driven strategies to four-fifths of the variance in the equity long-short style.
A revolution in hedge fund benchmarks
This observation has given rise to two important trends. First, by tracking the premia, or compensated risks, that drive hedge fund returns, we can establish objective benchmarks for hedge fund performance. Funds that match alternative beta returns are merely harvesting the premia. By the same measure, we can attribute the excess returns in funds that outperform the alternative beta benchmark to a hedge fund manager’s skill in timing or security selection.
This benchmarking feeds into a second important trend. Because we can now identify alternative beta premia, we can invest in them directly and combine them to construct passive investment portfolios. In other words, not only can we pinpoint the premia, we can replicate them without the liquidity constraints of traditional hedge funds and at much lower costs.
Hedge funds 2.0
The theory behind alternative beta benchmarking and investment is not new, but the practice has advanced considerably in recent years. Existing hedge fund replication uses conventional market indexes to duplicate hedge fund performance. It works to an extent, because hedge funds do not, on balance, hedge out broad market beta entirely. It misses the mark strategically, however, because by investing in traditional market indexes, hedge fund replicators fail to access alternative beta premia, so they do not truly diversify portfolio returns. The new generation of alternative beta replication manages to access the premia by investing directly in the same assets as hedge funds, using leverage and derivatives and taking short positions as warranted.
Investment implication
As we anticipate a long-term environment of modest market returns, we believe that investors will have a greater need for wide-ranging diversification—a need which alternative beta can help meet. For those who can access hedge funds, alternative beta research has produced an objective performance standard. For more cost-conscious investors, alternative beta can provide an altogether new layer of diversification: an efficient and liquid exposure to hedge-fund-like returns.
Learn more about alternative beta and our ETF capabilities here .
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