Managers turn to deconstructing alpha and beta

Updated with correction

At the request of their institutional clients, hedge funds-of-funds managers are researching ways to combine beta-isolating risk factors and alpha-producing hedge funds to offer cheaper, higher-return, more diversified strategies.

Hedge fund managers have used risk factors to inform their implementation and timing of trades for years, but the move by hedge funds-of-funds managers to identify, analyze and deconstruct hedge funds' sources of alpha and beta is, for the most part, only just revving up in response to client demand, observers said.

The nascent trend is fueled to some extent by investor desperation, given the poor outlook for returns from traditional equity and fixed-income investments for the foreseeable future, observers noted.

“Investors, however reluctantly in some cases, have turned to alternatives for return. Adding alternative beta sources is right in the crosshairs of what institutional investors want now,” said Keith Haydon, chief investment officer, based in the London office of Man Group PLC's FRM hedge funds-of-funds unit.

Risk-factor investing assumes that risk premiums — the return from holding assets that carry risk — can be identified by a wide array of factors beyond simple market risk. Those risk premiums usually are captured systematically through passive replication strategies or through portfolios constructed using a combination of risk factors. The range of risk factors tracked is wide, including value, size, momentum, quality and volatility, sources said.

Firms that are taking a close look at alternative beta as a means to provide clients with solutions — primarily better returns, liquidity and diversity — for their hedge fund or overall portfolios certainly hope the endeavor will turn into a money-making strategy.

Among managers that are investigating risk-factor investment opportunities are Blackstone Alternative Asset Management and Pacific Alternative Asset Management Co. LLC.

The transition from a research project to the rollout of a profitable investment strategy might be long, if it happens at all.

“We've been researching systematic risk-factor investing for a decade, but we weren't holding a hammer looking for a nail,” said William Park, managing director and head of investment risk and strategy, who is based in the Stamford, Conn., office of UBS Hedge Fund Solutions.

“It wasn't until recently when certain clients said they wanted daily liquidity in a portfolio of hedge funds that we started seriously looking for a solution using risk factors,” Mr. Park said.

Man FRM and UBS are among the few hedge funds-of-funds managers to have launched a hybrid alternative beta-hedge fund-of-funds strategy to date.

FRM's Mr. Haydon said there's been a recent sharp rise in interest from institutional investors in its 3-year-old strategy, which holds about $1 billion in both customized hybrid portfolios as well as in alternative beta portfolios that are managed separately to complement a hedge fund-of-funds portfolio.

Man FRM manages $11.9 billion in hedge funds of funds and customized portfolios.

UBS Hedge Fund Solutions, New York, just launched its first hybrid risk-factor-hedge fund portfolio as a UCITS —undertakings for collective investment in transferable securities — vehicle for European investors on July 15.

UBS Hedge Fund Solutions manages $34.3 billion in hedge funds of funds and customized portfolios.

Investment consultant Willis Towers Watson PLC, on the other hand, has been a “big proponent of alternative beta for more than a decade” and manages or advises on $50 billion in customized approaches, including hedge fund-alternative beta combination portfolios or beta-only sleeves for its institutional clients, said Douglas A. Smith, senior investment consultant hedge fund manager research, who is based in the company's New York office.

“We're trying to capture what hedge funds offer with much lower fees, higher diversity and more liquidity,” Mr. Smith said.

The dramatic cost savings achievable by replacing some hedge funds in a portfolio with alternative beta sources is another big driver behind asset owners' interest, said industry sources.

That's because risk-factor strategies are less expensive, generally available for a flat management fee as low as 25 basis points and no performance fee, compared to the typical hedge fund's management fee between 1.5% and 2% and performance fee between 10% and 20%.

In fact, part of the motivation behind Mr. Haydon's pursuit of alternative beta at Man FRM was a quest for cost savings because it would help to boost investor returns.

“I started looking at the problems inherent in building a portfolio of hedge funds. If you combine 20 hedge funds, each fund is designed as a stand-alone fund, and you tend to end up with a badly over-engineered portfolio that tends to be too conservative, gets more expensive over time and is inefficient when it comes to cash,” Mr. Haydon said.

By using risk-factor investments managed by Man Group sister companies, AHL Partners LLP and Numeric Investors LLC, with a flat management fee of 100 basis points or less to replace beta in a hedge fund-of-funds portfolio, rather than alternative beta derivatives products sold by investment banks, fee savings were considerable, he said.

Willis Towers Watson also eschews bank-sold derivative offerings and instead hires hedge fund managers to manage factor exposures for its clients and pays the manager only a flat management fee of between 25 and 75 basis points, Mr. Smith said. For clients using the consultant's model hybrid portfolio, which allocates 70% to alpha-producing hedge funds and 30% to alternative beta strategies, the cost savings are significant, Mr. Smith said.

PAAMCO, known for its academic research approach, is still conducting its deep dive into the area, said Jane Buchan, partner and CEO of the Irvine, Calif.-based firm.

“We think of risk factors as a complement rather than a replacement for hedge funds. They back up to thematic macro and equity market-neutral strategies and are akin to quantitative hedge fund approaches, but aren't a replacement for alpha-producing hedge funds,” Ms. Buchan said.

“Factor-based investment returns tend to be negatively correlated to hedge fund returns so they work well as diversifiers within a hedge fund-of-funds portfolio and do substantially reduce costs,” she added.

PAAMCO manages $8.7 billion in hedge funds of funds and customized portfolios.

The willingness to expend intellectual capital on figuring out whether and how best to add alternative beta to hedge fund-of-funds portfolios is not universal among managers.

“We agree with the concept of providing products and/or exposure at lower fees, but this isn't the way we approach it,” said Tracy McHale Stuart, CEO of Corbin Capital Partners LP, New York.

“In fact, these exposures basically represent the least desirable elements of our return stream. We'd actually consider shorting them if we could do so cost effectively,” Ms. McHale Stuart said, adding that Corbin's “lowest cost offerings come from accessing investments/strategies directly from hedge fund managers via co-investments or very specialized custom portfolios.”

Corbin Partners manages $4.2 billion in hedge funds of funds and customized portfolios.

Mesirow Alternative Strategies Inc., Chicago, isn't “imminently doing anything in the space, but we continue to explore ideas around this notion” of adding alternative beta to hedge fund-of-funds strategies, said Greg Fedorinchik, senior managing director and head of the firm's portfolio management team.

Mesirow Alternative Strategies manages $11.6 billion in hedge funds of funds and customized portfolios.