Smart Beta, Risk Premia and Hedge Fund Replication

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Alternative beta strategies are growing in number and popularity partly because they are able to replicate the return sources of hedge funds. Models including smart beta (the name of which is contested) and risk premia target the underlying factors responsible for much of a hedge fund’s returns.

Hedge funds are popular investment vehicles because they can use derivatives and other sophisticated investment techniques to generate strong returns for investors – usually on an absolute basis which means returns can be made when financial markets are in decline.

But the hedge fund world is relatively exclusive as it caters mainly for institutional and ultra high-net-worth investors who are able, and prepared, to wait out lock-up periods.

Until recently, this has meant most investors were not able to capture the returns offered by hedge funds. Replicating how they operate is not an easy task given that the hedge fund world is opaque and the source of returns difficult to pinpoint.

But the rise of quantitative investing, where statistical analyses are applied to identify underlying sources of return, has boosted the hedge fund replication industry.

Hedge fund replication is also being fuelled by the high fees that hedge funds charge clients and the newfound availability of low-cost alternatives. Investors worldwide are looking to cut fees amid low global returns and the growing number of cheaper products.

Companies like IndexIQ offer exchange-traded funds (ETFs) and mutual funds, among other products, which aim to replicate the returns of hedge funds in a transparent and cost-effective manner.

Hedge fund replication can be effected by reproducing the portfolios of hedge funds, though this has limitations since hedge funds are not transparent about their holdings and portfolios can change frequently.

Conversely, alternative beta strategies make use of quantitative analyses to identify the underlying risk factors responsible for high returns. An individual factor, such as momentum or value, can be found across several asset classes, including equity markets, currencies and commodities.

Alternative beta strategies straddle between active fund management and passive investing, offering the possibility of generating alpha (or market-beating) returns in a low-cost manner. They can also provide greater liquidity than hedge funds – an important feature since many hedge fund investors were left reeling in the midst of the global equity crash as they were unable to exit their holdings.

Some asset managers, particularly in Nordic countries, have already closed their internal hedge fund units and are looking for cheaper ways to access alternative beta factors. Others, though, believe alternative beta strategies should simply complement hedge fund portfolios and add to diversification.

Alternative beta strategies

Smart beta strategies are alternatively-constructed indices, or custom indices, that can target underlying factors in an effort to yield above-market returns.

Smart beta is quickly growing in popularity as it offers an attractive alternative to traditional size-based benchmark indices, or to actively-managed mutual funds, which incur higher management fees.

Long-only smart beta indices target relative, risk-adjusted returns, which are compared against an appropriate size-weighted benchmark such as the S&P 500 Index of large US stocks. Smart beta investing applies active management to passive fund tracking, with the aim of targeting alpha returns, controlling risk, or adding diversification to a portfolio.

Meanwhile, long-short risk premia strategies offer absolute returns and can either substitute for, or complement, hedge fund portfolios. As an example, a risk premia strategy can involve buying an alternatively-weighted smart beta equity portfolio while short selling the benchmark S&P 500 Index against which its returns are compared. Any outperformance of the smart beta portfolio relative to the benchmark will be captured as an absolute return.

In both cases, investors can be rewarded for targeting a specific risk, or underlying factor, which can be the source of hedge fund returns.

For example, a smart beta portfolio could target stocks which pay high dividends or which are undervalued relative to their intrinsic value. The corresponding risk premia strategy would buy into these factors while short-selling low dividend stocks and overvalued shares, respectively.

Common alternative beta sources, which are believed to be the underlying return drivers for many investments, include value, small size (since smaller stocks tend to perform better than large ones over the long run), quality, and low volatility (this factor can be used to control risk while sometimes also
producing alpha returns).

Hedge fund replication involves building a portfolio of alternative betas in an effort to mimic hedge fund returns, or gaining exposure to common underlying return drivers.

The term ‘beta’ is a measure of a stock or portfolio’s volatility relative to the market’s. As such, this financial risk measure can also quantify the returns from an investment which can be attributed to market returns. Many market commentators, however, believe
that volatility should not be used as a proxy for risk.