Smart beta thinking can be applied to hedge fund strategies, commodities, and foreign exchange to provide a more attractive option for investors than a purely active or passive approach, according to a white paper by consultancy firm bfinance.
Using the term “alternative beta”, the firm’s report described methods of accessing hedge fund ideas such as arbitrage through systematic-like methods, similar to the risk premia models used in equity smart beta products.
“Alternative beta strategies may be an efficient way of accessing the diversifying characteristics of hedge funds for those investors that, for legal or regulatory reasons, are not currently able to access these return streams,” the consultancy said, “or for investors that simply do not wish to take the illiquidity, high fees, and lack of transparency that can be part of hedge fund investing.”
The report cited the example of merger arbitrage. In alpha-focused hedge funds, managers select specific merger or acquisition deals in which to invest, typically shorting the buyer and buying the company to be acquired, according to the expected movement of the stocks.
In a beta version of the strategy, bfinance said the manager could “apply the long target/short acquirer strategy to all announced deals” in an effort to capture the broader merger arbitrage risk premium.
“It is not strictly an arbitrage (riskless profits from the mispricing of identical/similar instruments), but over time has positive expected returns from bearing the particular risk involved (underwriting insurance on deal completion),” bfinance wrote. The consultancy reported that backtests “seem to demonstrate that a large proportion” of returns from alpha managers can be captured.
bfinance also highlighted convertible arbitrage, carry, roll yield, and volatility as potential “alternative beta” candidates. The volatility risk premium—described by the consultancy as “exploiting tendency of implied volatility to be greater than realised by being short an option, long an asset”—can be applied to equities, fixed income, commodities, and foreign exchange.
However, bfinance warned that hedge fund strategies were not simple to mimic.
“In order to capture alternative betas the use of complex alternative investment techniques is necessary,” the firm said. “Manager skill is required on both the definition and implementation of these strategies, which may involve frequent trading, leverage, shorting, and derivative use.”
“Manager selection therefore remains as important as it is in selecting a hedge fund, with a particular focus on the background of the manager in the research and implementation of quantitative investment strategies alongside robust operational infrastructure,” bfinance added.
Given the emerging nature of alternative beta strategies, investors should carefully scrutinize backtested data from managers, the firm said, “to make sure that transaction costs and market impact have been accounted for”.
“The market capacity of certain alternative betas is clearly limited, particularly in less liquid strategies such as convertible arbitrage and strategies that require instruments to be available for shorting,” bfinance said. “The equity style premia are much more scalable.”