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Get Smart About Alpha and Beta

Introducing alternative beta, smart beta's not-too-distant cousin.

Josh Charney, 12/10/2013

"Smart beta" exchange-traded funds and mutual funds are everywhere these days. Morningstar has found at least 165 of these products, which attempt to gain broad asset-class exposure using non-market-capitalization-weighted schemes, often using factors such as value, momentum, and quality. Collectively, they have raised $113.3 billion in total net assets, up from $73.4 billion a year ago. This is surprising, considering the utterly confusing marketing efforts surrounding these products. Is smart beta a form of active investing, or better passive benchmarking? Are they traditional investments, or alternative?

The idea behind smart beta makes sense in theory. Investors should load up on certain risk factors that have earned time-tested outsized returns instead of buying high (winners that have increased in market value) and selling low (securities that have declined in value) with a market-cap index. The indexlike, lower-cost packaging also makes sense. When a strategy can be implemented with simple rules, investors shouldn't pay high fees. Smart beta may be creating a more thoughtful system of measurement and shedding light on what some managers have been peddling as alpha for decades.

Alternative beta is smart beta's not-too-distant relative. Instead of taking only long bets to gain access to certain risk factors, alternative beta is usually a rules-based long-short strategy. There aren't that many products that market themselves as alternative beta, perhaps because they wouldn't be able to charge high fees, but also because of the general lack of understanding about alternative investments. Here is what one should know about alternative beta, and some of the better ways to access it.

When Is Alpha Really Beta?
First, the basics. Beta is exposure to a ubiquitous risk factor, such as the equity market. Mathematically, the beta of the market is 1.0. If an equity fund has a beta or market exposure of 1.3, and the market returns 10%, the fund is expected to return 13% (10%*1.3). If instead the fund returned 15%, we could say the fund generated 2 percentage points of alpha, which is typically defined as a manager's ability to overweight the correct securities and sectors. But the manager may not have skill at all. It could be that we have been using the wrong definition for beta.

Herein lies the problem with alpha. For alpha to be meaningful, one must use the appropriate market index. An investor might mistakenly think a small-cap fund is generating alpha if comparing it with the S&P 500. The absence of good alternative beta benchmarks is exactly why many hedge fund managers look so good. Compared with a standard index market, many hedge fund strategies look good on a risk-adjusted basis, justifying their insanely high fees. But that comparison would be flawed. Many hedged strategies, such as merger arbitrage, are based on a common "alternative beta," which exhibits a risk/return profile that is distinct from common market-based indexes. In order to evaluate merger arbitrage, one could instead look at the entire universe of stocks that are targets in announced merger deals. Taking this alternative beta one step further, one could create a benchmark that takes a short position in the acquisitor companies in stock-for-stock transactions. The result is a beta based on deal risk, which is what merger arbitragers are compensated for. It's possible to create alpha in merger arbitrage by selecting the most profitable deals, but alpha is tough to identify, unless first one correctly defines the beta.

In 1997, William Fung and David Hsieh were the first to start defining hedge funds by their various style factors (later referred to as alternative betas). Fung and Hsieh cited two components to alternative beta: location choice and trading strategy. For location, the duo pointed out that hedge funds have an array of asset-class choices at their fingertips (such as currencies and emerging-markets stocks). Trading strategy, however, meant that besides long-only wagers, hedge funds also could be short these asset classes. Fung and Hsieh were the first to show that hedge funds exhibited significantly more systemic risk than previously thought, and much less alpha that previously believed. [1]

Cloning Alternative Beta
Following the discovery of alternative beta, researchers started wondering if there was a way to replicate hedge fund alternative beta in passive forms. Besides merely characterizing an investable universe as the passive benchmark, such as the entire investable market for merger arbitrage, researches started thinking using various market factors to gain exposure to alternative betas. Fung and Hsieh, for instance, found that long-short equity hedge fund exposure can be mimicked through a combination of long small-cap and short large-cap stocks. For equity market-neutral, Lars Jaeger shows that those funds exhibited exposure to the Fama-French momentum and value spread factors. [2] However, Jaeger and Andrew Lo take the thought process a step further, attempting to clone various hedge fund strategies and bring their alternative betas to market.

The final step needed to launch an alternative beta product was to pinpoint which instruments would best mimic hedge fund or alternative betas. Jaeger, and later Lo, built models to show that one could use liquid futures or forward contracts based on market indexes to replicate hedge fund strategies. For instance, convertible arbitrage could be thought of as a 34.9% exposure to bonds, a negative 19.3% exposure to the S&P 500, and a 31.8% exposure to commodities (Lo used a total of six factors). [3] In 2008, AlphaSimplex Group, where Lo is the firm's founder and chairman, launched Natixis ASG Global Alternatives GAFAX, which seeks to replicate the hedge funds in the HFRI Hedge Fund Index. The returns have been middling (the fund boasts a 3-star rating and a qualitative Morningstar Analyst Rating of Neutral), but at least the product has served to introduce the concept of alternative beta to investors. (Goldman Sachs Absolute Return Tracker GARTX and Bronze-rated IQ Alpha Hedge Strategy IQHIX also attempt to produce hedge fund or alternative beta.)

Josh Charney is an alternative investments analyst at Morningstar.

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