Amid many Alternative Risk Premia (ARP) launches, some are asking if ARP is likely to replace hedge funds. We expect ARP can expand the liquid alternatives market, without taking assets away from hedge funds. ARP strategies are generally based on transparent and well understood risk premiums that can be accessed through liquid markets. These risk premiums seem very powerful and persistent over multiple decades, but some of them have shown weaker returns over the past decade. Sharpe ratios from many standalone risk premiums, such as trend-following, currency carry trades, and value investing in equities, appear to have waned. Whether this is cyclical or structural remains to be seen, but ARP strategies do not generally appear to be using the very latest models, techniques, and data sources.
And ARP strategies may become progressively less likely to replicate hedge fund returns, as hedge funds are increasingly seeking to differentiate their strategies from generic risk premiums (and of course from their own ARP products). For instance, every equity market neutral manager I have interviewed stresses how their returns and factors are lowly correlated, or uncorrelated, to generic factors such as value, growth, momentum and quality that some ARP strategies are based on. Similarly, many CTAs demonstrate how their strategies use alternative data, some non-trend strategies, trade different time frames, and trade more and/or different markets.
The real prize for ARP would be making inroads into the more fee-sensitive markets for ETFs, mutual funds and pension funds, all of which are larger and faster growing than hedge funds.
CTA strategies trading alternative markets, including OTC markets and esoteric exchanges, have not been packaged into ARP products, probably because many of these strategies have limited capacity and hence can command traditional hedge fund fees. This illustrates the general point that more scalable strategies are being put into ARP products. Additionally, less liquid hedge fund strategies, such activism, event-driven special situations, direct lending, distressed debt, and many other alternative credit approaches – designed to pick up illiquidity and complexity premia – have not appeared in ARP products.
With these strategies and some liquid approaches such as concentrated long/short equity, returns are expected to come substantially from idiosyncratic or security-specific alpha. This may require labour-intensive discretionary analysis and structuring from hedge fund managers, and experts including lawyers and specialist advisers. It is not clear whether a low flat fee can generate enough revenue to cover these costs, and incentivise managers to spend many years working on activist or distressed special situations to unlock value.
The real prize for ARP would be making inroads into the more fee-sensitive markets for ETFs (c.$4 trillion), mutual funds (c.$30 trillion) and pension funds (c.$40 trillion), all of which are larger and faster growing than hedge funds. The same markets are targeted by long only offerings from many hedge fund managers. A small bite of these markets could equate to far more assets than a potentially cannibalistic bite of the hedge fund market.
Many larger hedge fund managers now offer a menu of “smart beta”, “alternative beta” (ARP) and pure (or mainly) alpha strategies, serving different market segments. Larger asset bases can absorb the growing costs of data, technology, staff, regulation and compliance, generating a win-win situation for investors across the full suite of products.
Commentary
Issue 134
Editor’s Letter – Issue 134
July | August 2018
Hamlin Lovell
Originally published in the July | August 2018 issue