Q CIO: When we last spoke, I asked you to define alternative beta. We are beyond that now—but is the market? Do they have a deep, comprehensive understanding of what this means, and do any investors—regionally or by client type—have a particularly strong understanding and focus on this?
Landes: We have seen the interest in and understanding of alternative beta/risk premia advance significantly over the course of the last six months. This is not surprising given investors’ increasing willingness to embrace alternatives for their diversifying potential. There is a growing understanding that extracting returns from a traditional asset-allocation mix is going to be challenging. And of course the cost advantage that an alternative beta approach can offer makes them compelling as well. We have been engaged in conversations with many investors who want to build low-cost, uncorrelated, and diversifying multi-strategy alternative beta portfolios with daily liquidity. In some cases, our conversations have been educational— helping investors understand the benefits of factor-based investing and the persistent drivers of return that we see and capitalize upon across asset classes. We are also meeting with investors who already recognize the payoffs associated with the systematic risks across asset classes and structures. These conversations are more about the algorithmic approach utilized, how we pick the various alternative betas, the structure and pricing of the alternative beta indices that we use, and how we evaluate counterparty risk and portfolio construction. While the understanding and interest in alternative betas varies according to region, I would describe the interest in the topic as having advanced significantly over the course of 2015.
Q CIO: For those investors who do understand the issues surrounding alternative beta, what goals are they seeking to achieve? These are sophisticated individuals and funds—they must have some specific objective that is most common when allocating.
Landes: I think that we need to consider both investor goals and their objective when allocating separately. For many of the investors that we are talking with, reducing portfolio correlation with overall markets is a significant goal, and alternative betas have the advantage of being a “true diversifier,” by which I mean portfolios that are built with securities and structures that are uncorrelated with one another, and have low or negative beta to traditional directional asset classes. Based on our research, if you look at the returns of a diversified basket of alternative betas, you will see that the correlation of their return to each other and to the market overall is very low—an average of .04. So for any investor seeking to diversify, alternative betas are very compelling—even more than a long-only smart beta approach. Among investors who have embraced the approach, we see a couple of consistent broadly defined objectives: replacing current, expensive hedge funds that are delivering beta and pricing it as if it were alpha, adding to an existing alternatives allocation with alternative betas, and employing alternative betas to smooth out the lumpy return of an existing portfolio.
Q CIO: Institutional capital is growing, but not infinite. Where are investors taking capital from to fund alternative beta strategies, and where are they bucketing them?
Landes: We have seen investors fund by either redeeming from their underperforming hedge funds, or by reallocating from traditional buckets. Investors who allocate from their existing hedge fund bucket may do so because an alternative beta portfolio offers a similar range of diversifying “betas” typically found in a multi-strategy hedge fund or a fund-of-funds, but at a lower cost than traditional hedge fund vehicles (e.g. 75 basis points flat vs. 2% plus a 20% performance fee).
Q CIO: Institutional capital is also demanding—and oftentimes getting—customized strategies. How common is it to customize alternative beta exposures for large institutions, and how customizable is your offering?
Landes: As I mentioned, we can build a standalone multi-strategy, multi-asset class portfolio, where all five asset classes and all of the long/short, arbitrage, and relative value structures are represented. We can also build a customized “completion portfolio,” which is meant to complement factor exposures represented in a particular portfolio. For example, despite their efforts to diversify, an institutional investor may find themselves with significant exposure to momentum or trend, and with little exposure to value and quality within equity or to other diversifying factors such as short volatility and carry/curve. The first step in building a customized portfolio is to analyze and identify the array of factor exposures that exist in the current portfolio, and then to build the complementary portfolio relative to the factor exposures that are already present. Since there is now a wide array of alternative betas to choose from, there is significant flexibility in building customized portfolios using alternative betas.
Q CIO: What are the objections that you are hearing to an alternative beta approach?
Landes: To implement a risk premia strategy, you need to employ leverage and derivatives, and those are still troubling words for some investors. In our case, it’s important to remember that the levels of leverage used are relatively modest, and that the leverage is applied to the entire portfolio not an individual security. We also get questions on the execution costs of internally built alternative beta indices versus externally built alternative beta indices. Our team has done a lot of thinking on this, and as it turns out there is a significant trading cost advantage enjoyed by the investment banks that provide the externally built indices, and much of that advantage is embedded in the price of the alternative beta. On the more complex swaps, I am not convinced that we (or anyone) could execute at a lower cost. External alternative beta indices also allow a manager to tap into the significant intellectual capital across a range of institutions instead of being parochial. That is a big advantage. In the end, I think that we will see many alternative beta providers go with a mix of internally built and externally built indices depending on cost efficiency.
Q CIO: Is transparency an issue?
Landes: In our case, we have total transparency to the underlying holdings, which is an advantage. Generally, liquid alternatives are associated with more transparency than traditional hedge funds, but because an alternative beta strategy employs a quantitative component, it can appear more “black box.”
Q CIO: Institutional capital is also, it must be said, more skittish now than in the past, following the correction of August and September. How have alternative beta investors, specifically, reacted?
Landes: The beauty of alternative betas is that we are more focused on the persistent sources of return embedded in the equity market, such as the tendency of cheap stocks to outperform expensive stocks, than questions like “What is the Fed going to do?” That said, our team is located within the greater global asset allocation group, so we have inputs from more than 20 peers on these macro questions. This is a terrific advantage when we make tactical adjustments. August and September were good proving grounds for the alternative beta concept. Most individual alternative betas held up quite well, especially relative to the dramatic downside performance of global equity and credit markets. For example, in August, specific risk premia such as equity momentum and equity quality held up quite well during a very difficult month for equities. A couple of other examples of risk premia that held up well were interest rate momentum and interest rate curve. As one might expect, some of the volatility related strategies such as FX volatility came under significant pressure. We believe it is critical that investors build an actively managed and well-diversified basket of alternative betas in order to take advantage of changes in their return behaviors and patterns. We do not believe that an alternative beta/liquid risk-premia portfolio can be passively managed.
Q CIO: When we speak about this subject next, what’s the topic going to be? We are moving along a spectrum, from definitions to allocations to customizations to investor reaction. What comes next?
Landes: Alternative betas are still in their early stages and must now prove their ability to generate consistent returns with limited risk. Investors are continuing to study the concept in a desire to understand more of the structure and how liquid risk premia might fit into their portfolios. We are quickly getting to the stage where investors are making small allocations as a proof of concept. If alternative betas do well during the proof of concept stage, then they will become mainstream allocations in either a multi-strategy standalone form or as a completion portfolio. The adoption has varied from geographic region to region; we have found the Australian market is quite far along in their willingness to allocate to alternative betas while other markets, such as the US and the UK, continue doing very focused research.
I think that we will also continue to talk about investor attitudes toward hedge fund allocations. I think that we are moving in a direction where investors will own a limited and concentrated basket of hedge funds that have proven to be true alpha generators, and will seek to accomplish their broader diversification goals by using daily liquidity alternative beta portfolios.
Columbia Threadneedle Investments manages more than $470 billion in assets under management for individuals and institutions, as of September 30, 2015. They offer a broad suite of investment capabilities, with over 300 investment professionals and a long history of competitive performance. To learn more about Columbia Threadneedle Investments, please visit their website at columbiathreadneedle.com/us/institutional. The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes and investment strategies described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.