The investment community is beginning to question its habitual praise and compliments, not to mention the astronomical fees, showered upon hedge funds for providing alpha – returns generated not through systematic exposure to the market but through exploiting market inefficiencies and skillful stock picking.

The idea is not new, but recently it has come to the forefront with full force. There is nowadays considerable debate raging on whether the alpha generated by hedge funds is actually alpha, or what is called alternative beta, i.e. beta generated through systematic risk exposure to non-traditional assets in the market. Alternative beta returns are achieved because risk premiums were rewarded, not because the hedge fund manager was able to arbitrage inefficiencies or pick stocks with unique skill.

Why does this matter? Alpha, beta, alternative beta … who cares as long as there is a return on investment? Well, in good times, everyone enjoys the party, but in bad times, investors are prickly when it comes to paying hefty hedge fund fees (usually 2% of assets under management (AUM) and 20% of profits) if there is evidence that the manager is not getting his/her returns through particular skill but through systematic and predictable methods. Granted, a return is still a return, but the question becomes, how much is it worth? Is it worth being charged 20% of performance in fees, is it worth not always getting your money out when you want it and is it worth facing minimal transparency into what is being done with your money (hedge funds are notoriously secretive)? Well, it is definitely not worth the fees, the illiquidity and the secrecy if that return can be replicated systematically through alternative beta.

What are these ‘alternative beta’ factors and how can one gain exposure to them? Hedge fund managers expose their portfolios to risk factors such as credit volatility, foreign exchange risk, event risk, small cap, and then use leverage to further enhance exposure to these non-traditional or alternative factors. Traditional managers meanwhile achieve beta by exposing their portfolios to traditional risk factors such as equity, credit risk, large cap and so forth. Is there a way to replicate systematic risk exposure to alternative beta factors, and therefore achieve hedge fund returns without hedge fund fees?

The three gurus of hedge fund replication techniques, Professors William Fung, David Hsieh and Narayan Naik, believe they can. Credit Suisse also believes they can, for it formed a partnership with them to replicate the risk and return characteristics of hedge funds strategies in March 2008. Credit Suisse belongs to a growing list of financial institutions that are looking to Fung, Hsieh and Naik for direction on how to use securities such as options, futures and ETFs to replicate hedge fund strategies.

It’s not easy to replicate hedge fund strategies, not least because these strategies are dynamic and change as the market changes. With alpha generating platforms like Alphacet, ClariFi and Deltix hitting the market, it may be more possible than ever before to quickly test strategies and bring them to market. One can very well expect a flood of alternative beta shops appearing on the horizon.  If hedge fund returns can be replicated, the kingmakers will be separated from the wave riders, and the smaller universe of true alpha generating funds will become the new elite.


Good site for alpha, beta, alternative beta: http://www.allaboutalpha.com