Until recently one of the most common ways of accessing hedge funds has been through the use of hedge fund of funds (FoF). According to Hedge Fund Research, Inc (HFR), by the end of Q1 2008, FoFs managed US$800 billion, representing some 43% of total hedge fund assets. In the last few years, however, investors have discovered a new way of acquiring similar exposure, but with significantly more liquidity, transparency and capacity, without long lock-ups, all while eliminating the heavy layered fee structure so characteristic of FoF products. These strategies/products go by various names, one of which is ‘Alternative Beta replication’. The idea behind Alternative Beta replication is to capture the main systematic ‘beta’ exposures (risk premia) that are available in markets and that are part of any FoF. Replication occurs through the use of liquid, exchange-traded instruments.
Once the ‘beta’ portion is accounted for, investors can then concentrate on the ‘alpha’ portion of hedge fund returns. These are the hard to find, hard to generate, skill-based returns, which are derived from non-systematic sources, and are great portfolio diversifiers and return enhancers. For these alpha returns, most investors are very willing to put up with a bit of inconvenience and even pay a premium for it.
By putting the two together, a new Alpha-Beta separation investment paradigm emerges. By adopting this new perspective of separating hedge fund return sources, smart investors gain more efficient and cheaper access to hedge fund returns with a more attractive return/risk profile. In this article, we explain the impetus for this new trend, and introduce the logic behind it so that investors can better judge if this might be something for their alternative investment portfolio.
The evolution of Alternative Beta
The investment community welcomed the emergence and growth of the hedge fundindustry with great expectations: new return sources would be available that would also diversify investment risks. New investor money poured into hedge funds. The industry grew, reaching US$1.8 trillion in Q1 2008. But disappointment followed. As shown in Table 1, direct hedge fund investments in recent years have failed to match the high returns of previous decades. FoF returns have trailed single fund investments (see Table 1).
Funds of hedge funds were in many ways victims of their own success. Their underperformance was partly due to additional fee layers included in their products. Also FoFs’ returns were increasingly derived from various beta return sources and their value added (their alpha returns) became increasingly smaller or even disappeared under increased competition, excessive diversification and additional fees. Yet, the investment risks and restrictions remained the same or worsened: fund/company specific (Amaranth 2006, Peloton 2008) risks and lack of transparency remained, and the redemption terms worsened: longer notice periods and lock-ups, less frequent redemption dates and tighter ‘gates’.
The hedge fund industry responded by introducing a number of investable indices that aimed at providing instruments that tracked a broad set of hedge fund returns. As we now know, these were not the answer to investors’ needs. Due to adverse selection and, again, additional fee layers, these products failed to track their target indices and to provide acceptable returns. Refer to the HFRX Global Hedge Index in Table 2.
The issue of catering to investors’ needs is yet to be addressed. In the sections to follow, we discuss the idea of Alpha-Beta separation, and show, via research results, market observations and evidence from live products how this new paradigm functions. The alpha returns of 1188 FoFs are measured and estimated against one of the most successful alternative beta replicator strategies, Blue White Alternative Beta (BWAB).
Analysis of return sources & risks leading to Alpha-Beta separation
In hedge fund investing, it is common to refer to a number of seemingly distinct strategies: for instance, equity long/short, event-driven arbitrage etc. However, strategies like these are often not well-defined in economically meaningful ways, making the task of investment portfolio construction and effective risk management rather challenging. In response to this situation, a new approach has emerged whereby the focus is on different return sources and their associated risks, instead of on the artificial strategy names assigned to them. Also critical was coming up with ways of obtaining these returns in a least cost and low risk manner. This novel approach is based on the following observations and notions:
By unbundling different types of returns and risks, the ‘black box’ of hedge fund investing can be converted into a much more ‘transparent box’. (See Fig.1).
It is practical to define beta returns and risks as those that can be modelled and alpha returns as those that cannot be modelled but are not random returns either. It follows from this that the identification and measurement of alpha returns requires that the beta returns and risks be first identified and measured. In the next section, beta return and risk identification, and replication are discussed and analysed with a reference to the Blue White Alternative Beta strategy. This is then used to measure hedge fund alpha returns from FoFs.
Alternative Beta return replication
The most common approach to Alternative Beta return and risk identification and measurement, and replication, is based on factor-based models promoted by Professors Fung, Hsieh and Naik (FHN) since 1997, and related research by other academics and practitioners. Since early 2007, many variations of this replication approach have been implemented as investable investment products. The main providers of such live investment strategies include Blue White Alternative Beta Strategy by Blue White Alternative Investments Ltd, Deutsche Bank’s ARB, Goldman Sachs ART, Merrill Lynch FI and Partners Group ABS Index (Green Vega). In addition, JPMorgan publishes its Alternative Beta Research Index for benchmarking and research purposes (non-investable).
Blue White Alternative Beta (BWAB) strategy is based on the published research and further non-published developments by Professors Fung, Hsieh and Naik, and the strategy has been implemented and operated in a close consultation with them. As the main underlying theories have been extensively published and presented in many forums, conferences and publications, only the main features of Alternative Beta replication are discussed and contrasted in this article. The main differences between the available factor-based Alternative Beta replication strategies relate to the target being tracked and the complexity of the employed model. Whilst many replication strategies use linear factor models and aim to track some indices or non-disclosed targets, the BWAB strategy utilises a factor model that not only captures the non-linearities in hedge fund returns, but also provides significant left-tail risk protection by deploying a number of positively convex long-volatility look-back straddles.
The BWAB strategy does not resort to data mining when estimating the Alternative Beta parameters and weights, based on a target portfolio of a carefully selected, but large group of ‘smart money’ managers. Pre-selected sets of factors based on rigorous academic research are employed and all estimations are performed and measured out-of-sample.
Specifically, the BWAB strategy does not track any averages whether they be indices or manager averages, as averages are deemed not to be worthwhile tracking. The objective is to capture the above average performing segment of the main Alternative Beta returns, and their risk premia over a longer holding period, using only liquid, exchange-traded instruments.
The BWAB strategy does not take directional views or make discretionary positioning decisions, other than those necessary for prudent risk budgeting and risk management. The BWAB strategy is an absolute return strategy targeting a monthly return volatility of 6% (annualised) – the strategy has no benchmark. It is stressed that by construction the BWAB strategy, like any Beta replicator strategy, yields only beta returns and no alpha returns. As shown in Fig.2 and Table 3, when compared with other Alternative Beta strategies from Goldman Sachs, Deutsche Bank, Merrill Lynch, or the investable HFRX Global Hedge index, the BWAB strategy performed at par with the best and performed particularly well during turbulent market periods, maintaining a low volatility at bond-like levels and experiencing much smaller draw downs than other strategies.
Identifying alpha returns
Only when the Alternative Beta returns of a fund (or an FoF) have been identified and replicated, can its alpha returns be analysed in relation to the given set of Alternative Beta factors, or with respect to a suitable Alternative Beta Strategy. The non-attributable returns (other than random returns) can be viewed as alpha returns. By their very nature such unique alpha returns cannot be modelled and replicated. Therefore, capturing alpha returns must remain in the domain of the most skilled hedge fund managers. Likewise, the identification of such managers belongs to well-informed and experienced investment advisors. In constructing such an alpha-only fund, the approach that we use is to select first, on the basis of detailed qualitative fund research, a selection of ‘best of breed’ potential alpha producers. The second step involves measuring fund results against various Alternative Beta factors and then also directly against the BWAB strategy returns and factors. The objective of this is to eliminate those managers who turn out to have significant Alternative Beta exposures and only small alpha returns.
A portfolio of significant net-of-fees, alpha-only returns is very valuable in any investment programme as they possess non-systematic risks that are orthogonal to Alternative Beta risks, and can themselves be easily further diversified in normal market conditions. Typically, alpha-only funds are hard to find and they have only limited capacity. These are reasons for their higher fee structure and inconveniences they can, and often do, impose.
Do FoFs add value above Alternative Beta strategy replicators?
In a recent research6 piece which examined a universe of 1188 FoFs during the period from May 2007 to May 2008, it was found that less than 3% (or 35) FoFs produced a positive alpha over an Alternative Beta replicator, in this case the BWAB strategy was used. The frequency distribution of the alpha returns of the 1188 FoFs is presented in Fig.3.
From 2003 to 2007, from a total of 785 FoFs in 2003 and increasing to 1448 in 2007 the percentage of the FoFs that generated a positive Alpha above the BWAB strategy returns, declined from 22% to 4% (with 2006 possibly being an exception to the trend) (See Fig.4). Since a large majority of FoFs do not add value over and above Alternative Beta replicators, it is rational for investors to consider replacing their FoF investment with a portfolio of two separate portfolios: a suitable Alternative Beta Strategy replicating fund and an alpha-only FoF.
Alpha-Beta Separation and recombination generates superior returns
The superiority of an investment programme based on Alpha-Beta separation versus an average FoFs investment is demonstrated with the following example: a 50% investment is made into an Alternative Beta replicating strategy (Blue White Alternative Beta Strategy) and it is combined with a 50% investment into an Alpha-only FoF strategy (Blue White Diamond Strategy). Fig.5 presents the evolution of the investment value of this combined strategy, and compares it to the return values of other comparable FoF indices/benchmarks forthe period January 2004 to May 20088. The combined Alpha-Beta strategy produced significantly higher returns with lower return volatilities, and smaller draw-downs than the average FoF strategy or investment in an investable index (HFRX GH). Refer to Table 4 for comparative statistics.
Other Attractive Features of Alpha-Beta Separation
Alpha-Beta separation is, however, not just about a more attractive return/risk profile, there are other very tangible features that hedge fund investors will appreciate. For instance, on the Beta side in one sweep, operational, counterparty, credit and liquidity risks can be minimised and transparency greatly enhanced. This occurs because the Alternative Beta strategy carries no issuer or counterparty risk, no valuation risks and practically no company specific risks as only liquid, exchange-traded instruments are employed. This also means that neither is capacity nor liquidity an issue or a constraint. There are no redemption restrictions, lockups or gates, ie. investors can readily access their capital. Practically, all risks are measurable, systematic risks, readily diversified across all main systematic factors deployed. Also, the fee expense savings are substantial: a management fee of less than 1% compares very favourably with cascaded fees of 5-7% that is typical of FoF investments.
On the alpha side, there are no systematic market risks, only idiosyncratic risks that are uncorrelated with each other and with the systematic risks on the beta side. As the alpha returns are independent, they can be searched for and researched independently, and then made to compete for capital on their own merits. This facilitates an effective and focused searching for the hard-to-find but most valuable alpha returns, capital allocation, as well as mitigation and management of the idiosyncratic risk. The usual FoF inconveniences remain on the alpha side, but these are more than compensated by the attractiveness of the uncorrelated alpha returns.
Many institutional investors have been shifting towards this new paradigm of Alpha-Beta separation. They recognise, understand and have experienced first-hand the dwindling added value of FoFs. As FoFs generate less and less value-added, it is in the best interest of the investor to replace them with a more efficient and manageable investment programme based on Alpha-Beta separation, so that they too can enjoy superior net returns with lower risk.
This article will also be published in The Euromoney Hedge Funds & Alternative Investments Handbook 2009
ABOUT THE AUTHORS
Jaakko P. Karki is CEO/CIO of Blue White Alternative Investments Ltd. Jaakko has been managing Alternative investments since 1996 as a CIO of Funds of Funds and Director of multimanager programmes. He has a PhD in Finance from the London Business School.
Drago Indjic is an Investment Manager at Blue White Alternative Investments Ltd. Drago has over 15 years of experience in the financial industry, including the Hedge Fund Centre of the London Business School.
REFERENCE & READINGS
1. Lipper TASS estimated that the size of the hedge fund
industry was $ 1.75 trillion at the end of Q1 2008, and
HFR reported $1.87 trillion for the same period.
2. According to Ibbotson and Chen (2006), the cascaded fees
amounted to 5-7% of assets under management,
which is approximately half of the quoted average hedge
fund return of 12.7% for the period from Jan ‘95 to Apr ‘06.
3. Notably by Fama and French in 1989, William Sharpe in
4. The views and opinions presented in this article are solely
of the authors. Professors Fung, Hsieh and Naik act as our
academic advisers and information providers.
5. However, JPMorgan’s Alternative Beta Research Index can
be used as a reference point as it is based on comparable
underlying theories and application.
6. Alternative Beta Systems Inc, Newsletter 2008:1.
7. When tested statistically at 95% confidence, one cannot
reject the null hypothesis of no statistically significant
positive Alpha and, therefore, the result of these 3% of FoF
producing a positive Alpha can be a random result.
8. The returns prior to the inception of the strategies are
based on out-of-sample simulation or back-tested.
9. Some leading asset managers, like AP Funds in Sweden
and PGGM in Netherlands have already re-structured into
Beta and Alpha units. These are referenced in “Alternative
investment debate”, Euromoney magazine, 2 May 2008
and “Pension Fund Investment World Nordic 2008”, 19-21
May 2008, Stockholm, Sweden