Can "Alternative Beta" be used to improve returns?

“Alternative beta” refers to risk exposures, commonly exhibited by hedge funds, which can be mechanically replicated (either long, short, or dynamically) as portfolio risk factors. If alternative beta factors can be identified which replicate the systematic exposures from successful hedge fund strategies (such as long-short equity, convertible bond arbitrage and merger arb) then in theory these "alternative beta" exposures could become investable propositions, either as stand-alone products, or as portfolio risk factors.

Here is our listing of the best "alternative beta" papers, from the last few years:

Factor Investing and Risk Allocation: From Traditional to Alternative Risk Premia Harvesting (EDHEC, 2016)
This comprehensive 62-page paper by EDHEC-Risk Institute examines factor investing beyond traditional factors, exploring the use of alternative risk premia to replicate hedge fund performance and to generate attractive risk-adjusted performance. The authors argue that such strategies achieve relatively low out-of-sample explanatory power, regardless of the set of factors and the methodologies used.

Alternative Beta (bfinance, 2015)
Factor models are very much in vogue at present, with "smart beta" strategies particularly popular. In this 12 page paper, bfinance examines ‘alternative beta’, which extends beta investing into the alternative investment space. There is no widely-accepted definition of "alternative beta", but bfinance explains it as a systematic and passive capture of risk premia beyond traditional equity, bond and credit market exposures, using alternative investment techniques. For instance, common hedge fund styles and strategies can be replicated using systematic algorithms which mimic those strategies. For this reason, alternative beta is sometimes referred to as ‘hedge fund beta’.

Hedge funds in strategic asset allocation (Lyxor Asset Management, 2014)
This 60-page white paper looks at hedge funds in the context of Strategic Asset Allocation. The author proposes a new methodology for classifying hedge funds, which better represents their underlying characteristics. In order to do this, hedge funds are considered based on their sensitivity to common risk factors. This then allows the investor to find a better way of integrating hedge funds into the asset allocation of a diversified multi-asset fund. While analysing the return characteristics of hedge fund styles, the author examines biases in hedge fund databases, survivorship bias, fat tail risk, non-normal distributions, performance persistence. The decomposition of returns into risk factors naturally leads to a discussion of hedge fund replication. The benefits and risks of investing in hedge funds is considered, before developing a recommended process for intelligently incorporating hedge funds into a multi-asset portfolio.

Passive Hedge Funds (Tupitsyn and Lajbcygier, 2015)
The authors of this paper demonstrate that the majority of hedge fund managers aren't active but passive. To show managerial skill, improved performance should accumulate as a result of active management. The authors find, using generalized additive models, that most hedge funds show only linear factor exposures (about two-thirds of them). As a result, they are “passive”. These “passive” managers generally perform better than “active” managers. In conclusion, the authors demonstrate that many “active” managers eventually become "passive", despite initial nonlinear risk exposures.

Multi Asset Alternative Beta (Fulcrum Asset Management, 2015)
Alternative beta refers to risk factors that are available beyond traditional long only equity and fixed income investments. In this paper, we analyse multi-asset trend, carry, and volatility returns, explaining why they exist, the benefits they confer to a traditional balanced portfolio, and the risks. The benefits of combining the three strategies are explored, along with how they have fared recently in markets dominated by central bank intervention. Our results show that adding multi-asset alternative beta strategies to a balanced portfolio, either singularly or as a group, leads to significant enhancements in terms of improved returns, lower volatility, and lower drawdowns.

Hedge Fund Replication (Aon Hewitt, 2013)
This article will examine whether hedge fund replication has done a good job of providing the targeted return characteristics, and also whether those targeted characteristics are a desirable addition to an institutional portfolio.

Alternative Beta - redefining alpha and beta (JP Morgan, 2014)
Alternative beta (alt beta) strategies extend the concept of “beta investing” from long-only traditional strategies to strategies that include both long and short investing. Although alt beta approaches have relevance for different categories of alternatives, this paper focuses on hedge-fund-related strategies, currently the most prevalent form.

ABOUT THE AUTHOR
Andrew Perrins is a former Actuary and Asset Allocator. After qualifying as an Actuary, he worked for 15 years in investment management, serving as Director of Asset Allocation for Abbey Life and for Chase Manhattan, before setting out on a more entrepreneurial path. 

To contact him, email andrew.perrins@savvyinvestor.net