The Factor-Driven Alpha Fund Strategy: Growing in the US, UK & Europe

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Factor-based alpha strategies including smart beta and risk premia are most prevalent in the US, but are also quickly growing in regions such as the UK, Europe and Australasia. Investors in Scandinavia, Japan and Australia have been particularly early adopters outside of the US, though factor-based strategies are now becoming global.

In many ways, the growth of these strategies and proliferation of smart beta and risk premia products reflects portfolio managers’ push back against products which were becoming ever-more complex while remaining largely opaque.

The pursuit of ‘alpha’ – or the active return on an investment strategy which is not derived from general market movements – has created a galaxy of highly-complex hedge funds and other financial products.

These approaches often lack transparency and clearly-defined rules, while investors incur fees when including them in portfolios. In many cases, investors pay high relative costs for alpha (as is the case with active fund management).

But partly thanks to the rise of indices which have an actively-managed slant, many investors are demanding lower fees and a general move back to the fundamental building blocks of investing; and are including dynamic, rules-based risk premia products in their portfolios.

A hedge fund is an alternative, speculative-driven instrument which usually targets high absolute returns. Typically set up as private partnerships among large investors, this strategy type has become a common component in the alpha portfolios of big institutional investors.

The appeal is that hedge funds can offer huge gains irrespective of broader financial market conditions. But this niche part of the market is in many ways unregulated and its strategies flexible, which has allowed hedge fund investing to become increasingly intricate and complicated and as such the source of returns is not always easy to analyse. In addition to their opaque nature, hedge funds are also illiquid and include lock-up periods during which investors are unable to redeem or sell their investments.

Cue a push in recent years back to the drawing boards, facilitated by risk premia and other related strategy types which offer a rules-based alternative to generating positive alpha returns.

A growing number of hedge funds are incorporating, and actively managing, portfolios of risk premia. Hedge fund managers are using their expertise to create value in this space, while offering a certain level of transparency to investors, particularly if the underlying strategies are rules based.

Risk premia refers to a set of investment strategies which aim to produce alpha returns through long-short positions that target market inefficiencies. Part of the attraction is that while hedge funds are relatively highly correlated to global equity markets, risk premia returns have the potential to be far less correlated since they single out and target specific risks in a more systematic approach.

The shift towards risk premia mirrors a similar move from passive indices and mutual funds into low-fee smart beta products which target market inefficiencies in a similar way to risk premia, but using long-only positions.

Smart beta strategies assign alternative weightings to traditional benchmark indices in an effort to beat the returns offered by the benchmark (arguably making this an alpha strategy). Smart beta products incur lower fees than active fund management while retaining some of the elements of hands-on portfolio management.

These approaches have garnered the interest of investors in the UK and elsewhere in Europe, particularly in Nordic countries.

A recent report by Ignites Europe quoted French asset manager Tobam as saying its US credit strategy had attracted strong fund inflows from investors in the UK. Smart beta strategies focusing on fixed income investments still make up only a small proportion of the relatively new smart beta world, but Tobam identifies the UK as a key market.

The performance of smart beta strategies is compared relative to major benchmark indices. In the UK, these often include the FTSE 350 index or other indices in the FTSE range.

A number of smart beta and risk premia products which have been successful in the US have started to become available in the UK, including funds which target stocks based on factors such as sales performance or return on assets.

Important to note is that a smart beta strategy or mutual fund which targets a region such as the UK will also bring exposure to markets such as the US, Europe and Asia, depending on the footprint of its constituents.

Investors have a number of different alpha strategy types at their disposal – each of which can work in isolation or in a complementary way that maximises the risk-adjusted returns of a fund. In addition to producing alpha, these approaches can be used in the management of risks.

Some argue that in theory, factor strategies should render themselves ineffective over the long run, a number of studies have shown that they produce market-beating returns over long time horizons.