Alternative Beta Conference Notebook

ART, meet ABI…

Picking up on Goldman Sach’s Absolute Return Tracker and Merrill Lynch’s Equity Volatility Arbitrage Index, JPMorgan is now in the hedge fund replication game.

Their new Alternative Beta Index now adds ABI to ART and “EVAI” in the hedge fund replication lexicon. The product was developed with the help of Duke’s David Hsieh and LBS’s William Fung and Narayan Naik. JPMorgan’s entry in this market addresses the common concerns that many pension fund have with hedge funds: fees, transparency, liquidity (especially in times of distress). Their approach begins with three buckets of hedge fund strategies: equity hedge, fixed income, and global macro/CTA. Then, they map these major categories onto 8 factors that are dynamically traded by the ABI model.

According to Lakshmi Seshadri of JPMorgan, ABI produces higher information ratios than traditional hedge fund indexes and can be efficiently leveraged. As a result, it will be offered in several formats (swaps, notes etc.) and will be launched in early Q2 of this year.

State Street: Factor Modeling Not Just for Cloning

It’s becoming apparent that Alpha Male brings down the average IQ in this conference room.  Here’s even more proof: like Lars Jaeger, Chris Woods, Senior MD of Absolute Return Strategies at State Street Global Advisors, is also trained in classical physics.

Woods says that factor modeling isn’t just a tool for hedge fund replication, but also an important part of managing a good old fashioned fund of funds.  In fact, his fund of funds allocation strategy is based on the work of MIT’s Andrew Lo and his company Alpha Simplex.

At first blush, Alpha Simplex’s factor modeling methodology is quite straight forward. But it turns out to be more complicated than it looks. One big question, says Woods, is whether to use the same factors across all strategies. Using a common set of factors works well for long-term investors, but short term performance must be explained in terms of the unique factors underpinning that particular strategy. Further, each manager might require their own specific factors (in fact, SSGA kicks off the factor modeling process with new managers by actually asking the manager to self-identify appropriate factors.)

To complicate things further, the unique factors explaining the short term performance of each hedge fund strategy is constantly changing, leading to the requirement for factor rotation. Furthermore, the best factors might also depend on the current regime (e.g. a high volatility regime vs. a low volatility regime).

Obviously comfortable with the highly complex quantitative aspects of this topic, Chris Woods provides a good counter-balance to Alpha Male’s decidedly modest intellect.

PGGM: Beta Drives Our Processes and Organization

Notwithstanding the recent hype about alternative beta, Jelle Beenan is just about the only guy in the world with the actual title, Head of Alternative Beta. His employer PGGM (see previous posting) manages 70 billion Euros for Dutch social services workers. And taking its cue from many aspects of Dutch society, PGGM seems to be comfortable pushing the frontiers of accepted norms.

Case in point: PGGM organizes itself internally into three groups: beta, enhanced beta, and alpha. Enhanced beta actually includes real estate, private equity and infrastructure as well as Beenan’s alternative beta. Both the beta and enhanced beta groups are allocated capital, while the alpha group is not provided any capital. Instead, the alpha group must borrow from the beta desk at market rates. To authorize an allocation of capital to a particular alternative beta, Beenan must firstly answer several questions:

  • Is the risk appropriately rewarded?
  • Is it structural and enduring over time?
  • Can be captured systematically?
  • Is PGGM uniquely able to realize the benefits of the factor (e.g. liquidity premiums)?

PGGM is a prototypical alpha-centric organization. Not only does it bifurcate and individually manage alphas and betas, but it goes several steps further by establishing an organizational structure that supports this strategy.

AlphaSwiss: Hedge Fund Replication Just a Special Case of Alternative Beta

Like Pawlowicz Maurus Bossi (see previous posting) has dedicated his life to uncovering new ways to invest. Bossi is CEO of AlphaSwiss, a Zurich-based firm specializing in non-traditional betas. He makes it quite clear that alternative beta refers to much more than just hedge fund replication. In fact, hedge fund replication is just a special case of alternative beta.  Many of his sources of alternative beta are derived from or delivered by long-only managers. Assembling these betas in a way that might replicate certain hedge fund strategies is just one way to use these betas.

Raphael Douady: Don’t Assume Linearity

The capital asset pricing model is based on a linear (straight line) relationship between the return of a security and the return of the market. But hedge funds often have non-linear relationships to underlying factors. According to research on 1,000 hedge funds conducted by Raphael Douady’s firm Riskdata, only 29% of hedge funds can be described using the traditional linear regression. The remainder were better explained by non-linear models that include a squared or cubed term. So using a linear model to calculate the beta of a fund (or stock) may yield a positive alpha where one actually doesn’t exist.

Douady also said that hedge fund returns may not be that random after all. Serial correlation – the correlation between one month’s return and that of the previous month – exists in approximately a quarter of all hedge funds he studied. Another 50% of funds’ monthly returns show a significant relationship to the performance of certain markets in the previous month.

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