Some of the leading figures in the alt investment industry have put their dignified heads together and created a vision statement, called “Perspectives: Industry Leaders on the Future of the Hedge Fund Industry.”
The gist of the paper is that firms in the industry are quickly adapting to contemporary conditions with changes in their product mix, changes that include the adoption of artificial intelligence, other disruptive technologies, and partnerships with their clients on socially responsible investing.
The largest firms are becoming very diversified asset managers, with different product offerings for different fee levels.
Many managers, at firms of various sizes, are also becoming more data focused. They rely on quantitative experts such as physicists or engineers more than before, and on a small number of star traders less.
In the words of the CEO of the Alternative Investment Management Association, Jack Inglis, “The leaders with whom we spoke are committed to make the most of the coming changes in the financial world and are enthusiastic about the opportunities to deliver for their clients.”
The paper was written by Tom Kehoe, AIMA’s Global Head of Research. Kehoe says, “The hedge fund industry was born of disruption. The leaders with whom we spoke were not only confident of their ability to adapt the the changes that they face, but are at the forefront of the transformation.”
One of the participants in the discussions behind the paper was Andrew McCaffery, the Global Head of Client Driven and Multi-Manager Solutions for Aberdeen Standard. McCaffery says that the paper demonstrates the growing voice of the clients in the industry. It is that voice that has resulted in the widening and customized character of the range of products.
Though there is broad agreement about the importance of products, the report is also clear that hedge fund firms can not be solely about their products, “They must think about how best to run their firms as institutionally-friendly asset management companies.” They must for example make a habit of deploying the best-in-class digital and mobile technologies to deliver cost-competitive solutions.
The Rise of the Betas
Early on, Kehoe defines both smart beta (also somewhat more modestly “strategic beta” or most modestly “market beta”) on the one hand and “alternative beta” on the other. Smart beta is a “transparent and rule-based long-only style of investing that seeks to improve returns, reduce risks, and enhance diversification by delivering exposure to systematic investment factors.”
Alternative beta, on the other hand, consists of rule based (long/short) strategies “designed to provide access to the portion of hedge fund returns “attributable to the systematic risk (beta) versus idiosyncratic returns derived from taking long and/or short positions.”
Kehoe makes a point of defining these terms up front because investors increasingly accept the premise that portfolio diversification comes not just from a range of asset classes, but from a range of the risk factors that drive those classes.The managers have to match and more than match their investors’ sophistication on this point.
In recent years, the number of factors and the betas associated therewith have been used by sophisticated investors and the managers who cater to them. Smart and alternative beta products such as those that are keyed to interest rate risk “are the products of years of financial innovation driven by hedge funds, which have now perfected the creation and implementation of such products.”
A Bit of Theory
The returns from “risk premia” are compensation for an investor’s willingness to take on the particular underlying risks. (Yes, the term suggests as much.)
This makes of risk premia a type of insurance, where the size of the premium depends on the relative supply and demand of a particular policy. By comparison, after a hurricane hits Florida, the demand for hurricane insurance typically rises, putting it out of balance with the supply, so the premia will increase until now insurers (the voluntary risk takers) are drawn into the market.
Much the same dynamic explains the foundations of the equity market risk premium, the value premium, the liquidity premium and the other risk premia with which the marketers of smart beta are concerned.
Much that was previously considered “alpha” is now understood to be the exploitation of differentiated risk premia, and liquid investment strategies can capture this. That is both promise and threat for hedge funds, because they have long pursued an illiquid model justified by the idea that the illiquidity is necessary to give them the leeway to do what they do.
What happens now if it isn’t?