25 April 2019

Alternative Beta: Shielding Investors From Volatility

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Volatile markets and an uncertain economic outlook have underscored the importance of global diversification in recent months. Concerns on the prospects for fixed income are widespread in light of a maturing 30-year bull bond market and the inevitability of rising rates. 

Meanwhile, the considerable highs that developed equity markets have reached of late means that this asset class enjoys less obvious valuation support than it did 18 months ago.

Reports of various professional investors increasingly 'going to cash' to safeguard assets is a reflection of lower conviction and potentially reduced future opportunities in traditional asset classes.

Against this backdrop, given the unrelenting need for non-correlated, diversifying returns, many multi-asset investors are considering how they can reasonably enhance the alternatives exposure of their portfolios. 

Simply put, alternative investments such as hedge funds tend to have a risk, return, liquidity and correlation profile that differs from traditional asset classes, making them a valuable diversifier to a balanced portfolio. The potential for generating absolute returns is clearly an attractive opportunity for investors too. 

Beyond reach 

If we look closer at hedge funds, they tend to explicitly pursue absolute returns, so generally provide low correlation to traditional investments and offer attractive risk-adjusted returns. 

That said, investing in hedge funds themselves has been beyond the reach or inclination of many investors. Issues have included lack of transparency surrounding these investment vehicles and their process, lack of liquidity and high costs.

The challenge, therefore, is to think about alternative ways you can capture the returns associated with hedge funds. Specifically, investors might consider whether the return streams that hedge funds generate really need to be packaged in vehicles that present such challenges.

A growing understanding of the fundamental drivers of hedge fund returns has allowed asset managers to develop strategies that offer exposure to the diversifying components of hedge fund returns, in more appealing vehicles, at a more competitive cost and with greater liquidity. 

Technical talk 

A significant amount of 'alpha' from hedge funds can actually be attributed to 'hedge fund beta'.  Much like the progression of alpha/beta separation in traditional equities and fixed income with the rise of passive investing, accessing so-called 'alternative beta' involves isolating the systematic, non-manager driven component of returns available from common alternative investment strategies from the alpha generated by individual managers. 

Conceptually, there is no difference between traditional beta and alternative beta, in that they both result from systematic exposures to some risk factor. 

In practice, a key difference is that to capture alternative beta, there is a requirement for shorting, which makes it less straightforward than capturing beta in the traditional investment space. 

Nonetheless, alternative beta can be captured using relatively simple, rules-based investment strategies with vanilla underlying instruments in UCITS-regulated, daily tradeable vehicles. As investors increasingly recognise the potential benefits of this transparency and accessibility, the concept is becoming more mainstream in the industry.

Underlying strategies  

Indeed, many of the underlying strategies used to capture the various alternative betas would be familiar to long-only investors. Some examples include: 

• Momentum investing: this exploits the fact securities that have performed well tend to continue to perform well, whereas those that are going down tend to continue to fall.

• Value investing: this takes advantage of the fact that cheap stocks tend to outperform expensive stocks over time.

• Carry investing: this exploits the fact that higher yielding assets tend to outperform lower yielding assets.

Significantly, however, the long/short nature of the alternative beta strategies allows the exposure to the underlying asset classes to be eliminated, which makes them truly diversifying to a portfolio of traditional assets. 

In an environment where the investment case for traditional asset classes such as equities and bonds appears increasingly cloudy, exposure to non-correlated sources of return will become ever more important.  

Click here to access the full article on Professional Adviser. 

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