JPM AM’s Yazann Rohami asks: Is alternative beta ‘investable’?
Yazann Romahi, who is part of the JP Morgan Asset Management Solutions Group, argues ‘alternative beta’ is different to ‘smart beta’.
A paradigm shift is taking place in the investment management industry. Historically, the ability to gain diversified alternatives exposure was reserved for investors choosing to afford hedge fund fees and for those willing to subject themselves to hedge funds’ liquidity constraints. The lack of transparency of such vehicles also necessitated a high level of due diligence, thus limiting access to the most sophisticated investors. More recently, the advent of vehicles that have made the concept of ‘alternative beta’ investable has provided investors with a compelling substitute.
To be clear, this concept is distinct to the concept of ‘smart beta’. As will be shown, alternative beta strategies seek to capture the systematic component of hedge fund returns and are usually long/short in construction. In contrast, smart beta normally refers to the creation of superior long-only indices in the traditional investment space.
The fund management industry used to think about hedge fund managers as pure alpha generators, where all of their returns were produced by manager skill. Gradually however the academic community tried to decompose drivers of these returns to understand what proportion is truly attributable to investor skill. Their findings have shown that systematic exposure to risk premia rather than pure skill drives a significant part of return, leading them to distinguish genuine alpha from the portion of return more correctly described as ‘alternative beta’ or ‘hedge fund beta’.
Alternative beta refers to the return from exposure to risk factors in global capital markets beyond traditional long-only exposures, often requiring shorting to capture efficiently. Hedge fund strategies, such as equity market neutral, global macro, merger arbitrage and convertible bond arbitrage all provide exposure to a range of alternative risk factors that are beneficial to the portfolio level beyond the alpha they may offer. When we separate the contribution of simple risk exposure from that of skill-based alpha, this essentially delineates active and passive management. The concept of alternative beta therefore extends the concept of beta or passive management into the alternatives space.
Until relatively recently, this idea has been a theoretical exercise. However, with the advent of a rising number of mutual fund strategies built around the concept of alternative beta, such as JP Morgan Funds – Systematic Alpha Fund, it is becoming increasingly investable. Strategies once thought of as the preserve of hedge funds are thus becoming more readily accessible, in transparent and lower-cost vehicles available to retail investors.
Importantly, these vehicles are different from hedge fund index replicators or hedge fund-of-funds strategies. They are about understanding the drivers of hedge fund returns and then seeking to capture them by direct investment in securities.
One possible approach is to build diversified strategies that enable investors to access a broad range of uncorrelated risk factors. These could include:
• Equity market neutral: invests in top-ranked stocks while shorting bottom-ranked stocks from a global developed market universe, capturing momentum, value, size and quality factors in a beta, sector and region neutral fashion.
• Global macro: seeks to capture some of the liquid and systematic risk premia common to macro hedge funds, incorporating fixed income, currency and commodity strategies
• Merger arbitrage: focuses on the deal risk premium factored into the price of the merger-target stock until the deal completes
• Convertible bond arbitrage: focuses on the illiquidity and small cap premia available in the convertible bond market by capturing the underpricing of the embedded optionality.
By using a number of different strategies, one can achieve a more diversified return profile, which helps to reduce risk. While this approach will be appropriate for some investors, other vehicles have also emerged which will allow investors to gain targeted access to specific styles, for example merger arbitrage.
So what are the tangible implications of alternative beta? A key attraction of traditional hedge funds has been that their returns are uncorrelated to the traditional sources of return that investors already own, allowing the creation of more efficient portfolios. By identifying the beta component of hedge fund returns and increasing the ability to access them, alternative beta permits a more democratic exposure to hedge fund returns than typical investors have historically been able to get. As these returns move beyond the domain of hedge funds, we may see investors broadly rethinking their alternative allocations.
Beyond making hedge fund type returns available to a broader range of investors, the liquidity of alternative beta should also make the concept of interest to investors familiar with traditional hedge fund investments. Accessing some of the simpler hedge fund styles through a core allocation to alternative beta would allow these investors to make more significance allocations to satellite exposures that are either less liquid in nature or to strategies in whom investors have high conviction in the underlying manager’s ability to deliver alpha.