Alternative Beta, in the context of risk premium oriented investing, is a concept that extends the idea of traditional passive investing into the alternative investment space. Alternative beta refers to risk premia which are available in the global capital markets beyond traditional equity or fixed income related long only investments. Generally risk premia are returns (above the risk-free interest rate) as compensation for taking systematic risks (risks which in the context of modern portfolio theory cannot be diversified away). Alternative risk premia are those that relate to active investment strategies including techniques beyond the traditional long only investment. These techniques are often associated with the activities of hedge funds (such as short selling, leverage, and derivatives trading).
Investment theory today commonly separates the return of an investment into the contribution resulting from risk exposure (risk premium) and one resulting from skill-based investing (alpha). This forms the academic basis for active and passive investing (indexing).
Separating returns into alpha and beta can also be applied to determine the amount and type of fees to charge. The consensus is to charge higher fees for alpha (incl. performance fee), since it is mostly viewed as skill based. The topic has received increasing levels of attention due to the very rapid growth of the hedge fund industry, where investment companies typically charge fees dwarfing those of mutual funds with the motivation that hedge funds produce alpha. Many investors have started to question whether hedge funds really provide alpha or just some “new” form of beta (i.e. alternative beta).
This question was first implicitly raised in 1997 by William Fung and David Hsieh in an influential paper on empirical properties of hedge fund returns (Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds). Following this paper, several groups of academics (such as Thomas Schneeweis et al.) started to explain past hedge fund returns using various systematic risk factors (i.e. Alternative Betas). Lars Jaeger was the first to address the related question whether investable strategies based on such factors can not only explain past returns, but also replicate future ones (Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investments in Hedge Fund Strategies Deliver?. His book (Alternative Beta Strategies and Hedge Fund Replication (Wiley)) provides an overview on the scientific approaches, the current state and the future of Alternative Beta and Hedge Fund replication (see also his interview on Opalesque.TV).
Different betas based on different investment exposures
Traditional betas can be seen as those related to investments the common investor would already be experienced with (examples include stocks and most bonds). They are typically represented through indexation, and the techniques employed here are what is called “long only”. The definition of alternative beta in contrast requires the consideration of other investment techniques such as short selling, use of derivatives and leverage – techniques which are often associated with the activities of hedge funds. The underlying non-traditional investment risks are often seen as being riskier, as investors are less familiar with them.
Separation of Alpha and Beta
Viewed from the implementation side, investment techniques and strategies are the means to either capture risk premia (beta) or to obtain excess returns (alpha). Whereas returns from beta are a result of exposing the portfolio to systematic risks (traditional or alternative), alpha is an exceptional return that an investor or portfolio manager earns due to his unique skill, i.e. exploiting market inefficiencies. Academic studies as well as their performance in recent years strongly support the idea that the return from hedge funds mostly consists of (alternative) risk premia. This is the basis of the various approaches to replicate the return profile of hedge funds by direct exposures to alternative beta (hedge fund replication).
Hedge fund replication
There are currently two main approaches to replicate the return profile of hedge funds based on the idea of Alternative Betas:
- directly extracting the risk premia (bottom up), an approach developed and advocated by Lars Jaeger
- the factor-based approach based on Sharpe’s factor models and developed for hedge funds first by professors Bill Fung (London Business School), David Hsieh (Fuqua School of Business, Duke University) et al.
Source : Wikipedia