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Alternative Beta: What It Is, and Why It’s Important

The portfolio strategy allows investors to gauge genuine alpha while diversifying risk and offering transparency and lower fees.

Terms such as smart beta, advanced beta and alternative beta are often mistakenly considered synonyms. There are significant differences, however, which investors need to be aware of as they examine the possibility of incorporating these concepts into their portfolios.

The rise of alternative beta, which is increasingly becoming an investable metric, is an interesting case study in how investors and observers are reassessing their approaches to alternatives.

The fund management industry used to think of hedge fund managers as the ultimate generators of alpha. Recent academic research has shown, however, that much of hedge funds’ returns has more to do with systematic exposure to risk premiums, rather than to pure human talent. Thus has arisen the term alternative beta, or hedge fund beta: the distinguishing of genuine alpha.

We at J.P. Morgan Asset Management argue that smart beta refers specifically to the creation of superior long-only indexes in traditional investing. In contrast, alternative beta aims to capture the systematic component of hedge fund returns using both long and short positions, meaning that portfolios can be constructed so as not to be influenced by the broad rise or fall of any underlying asset class. Hedge funds tend explicitly to pursue absolute returns, generally offering attractive risk-adjusted returns and potentially low correlations to traditional investments. There have been challenges, however, such as minimal transparency, lack of liquidity and high costs and associated capital charges.

More recently, this concept of alternative beta has been made investable through the launch of vehicles by both investment banks and asset managers. Essentially, alternative beta is about providing investors with exposure to the risk premiums — that is, systematic exposures for which an investor expects to be paid — associated with several strategies across a variety of hedge fund styles, including merger arbitrage, long-short equity, convertible bond arbitrage and global macro, either in isolation or through diversified offerings.

Part of what makes these approaches attractive is that, historically, the returns generated through exposure to these alternative risk premiums have exhibited little performance correlation to one another or to traditional investments in global stock and bond markets. Combining noncorrelated alternative strategies into a single portfolio helps diversify risk and generate more consistent returns over time.

Additionally, because these are rules-based strategies, they benefit from more competitive fees than do hedge funds and tend to provide a high degree of transparency and liquidity, allowing investors to buy and sell the fund on a daily basis. It should be pointed out, however, that these vehicles are different from hedge fund index replicators. The reason: They are really based on a manager’s understanding of the drivers behind hedge fund returns and the attempt to capture them by direct investment in securities and the use of financial derivatives.

In an environment in which investors have concerns over equity market volatility and in which fixed-income investments risk exposure to capital losses, other sources of return are becoming increasingly important. As investors push the boundaries farther in search of accessible alternatives, the concept of alternative beta has become a key implement in the investor tool kit.

Yazann Romahi is portfolio manager of the Systematic Alpha Fund and head of the quantitative research team in the Global Multiasset Group at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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