By Christopher Faille
One of the scariest things about hedge funds is the loss of liquidity that such an investment involves, with lock-up periods, redemption suspensions, wonder about what is in the “side pockets,” and worry about getting caught in the clanging gates.
Credit Suisse Asset Management (CSAM) has put out a white paper on “Enhancing Liquidity in Alternative Portfolios,” which offers a way by means of which some investors may expose themselves to hedge fund results while banishing gate-related nightmares.
Jordan Drachman, head of research, and Peter Little, head of portfolio management and implementation, for Liquid Alternative Beta (LAB), prepared the paper, which makes the case that investors can to a large extent replicate the return and risk characteristics of the hedge fund industry without the sacrifice of liquidity that actual investment in hedge funds typically involves.
CSAM’s LAB is a set of indexes designed to mirror the aggregate return profiles of hedge fund strategies. These are:
- CS Long/Short Liquid Index;
- CS Event Driven Strategies Liquid Index;
- CS Global Strategies Liquid Index;
- CS Merger Arbitrage Liquid Index;
- CS Liquid Alternative Beta Index.
As the names alone indicate, these indexes are distinct from one another not merely in the strategies that they are designed to mirror but in their degree of granularity. The “Liquid Alternative Beta Index” seeks to reflect the performance of the whole of the hedge fund industry. The “Global Strategies” index seeks to reflect the return of all sectors that cannot be defined as either Event Drive (which of course includes Merger Arb) or Long/Short Equity.
How is this possible? Drachman and Little attribute the beginnings of the work that has become LAB to underlying academic research by Professors William Fung, David Hsieh, and Narayan Naik, who have worked on the questions surrounding alternative beta for over a decade. They have collaborated with the CS research team in developing and refining the algorithms for LAB.
In a seminal paper published in 204, “Hedge Fund Benchmarks: A Risk-Based Approach,” Fung and Hsieh made the case that there just seven asset-backed style factors (ABS) that together can explain up to 80 percent of the variations in the monthly return of hedge fund portfolios. The seven ABS are as follows: the excess return on the S&P 500 index; a small-minus-big factor (the difference between small and large capitalization stock indexes); the yield spread of the U.S. 10-year Treasury over the three-month Treasury; the change in the credit spread of Moody’s BAA bond over the 10-year Treasury bond; and a final three factors consisting of excess returns on portfolios of lookback straddle options (for currencies, commodities, and bonds).
Alpha, understood as the skill of individual hedge fund managers, does not show up on that list. Indeed, from the point of view taken by LAB and the academic research on which it is based, alpha rather disappears. This happens, the paper says, because “while individual hedge fund managers may have highly idiosyncratic views,” the idiosyncrasies disappear as one steps back, so that “the average exposure of hedge funds … can be explained by time-varying exposure to liquid markets.”
Each of the seven factors identified by Fund and Hsieh can be observed directly from market prices. This is the crucial fact about their model, which set the stage for its use in the replication of hedge fund industry exposure. Nonetheless, the possibility of such a model doesn’t make it easy. Many of the factors that the CS LAB has to model require customization.
Beta can be separated, analytically, into “traditional beta” and “alternative beta.” Traditional beta factors generally have well-known proxies, which one can take off the shelf, so to speak. For example, the bond yields factors in the model are important for the distressed debt portion of an event-driven strategy. For this purpose, the iBoxx high yield liquid index serves as a store-bought proxy of bond yields. But tracking the event-driven sector also requires – to address its “alternative beta,” a homemade mergers and acquisitions proxy, customized to reflect results on the long side of companies that are being acquired and on the short side of the companies that are doing the purchasing.
The white paper includes a case study about how a pension fund “with a diverse allocation to hedge funds” might use LAB to increase its own liquidity.