This article was originally published in Institutional Investor on 13 June 2019. See the original article here.
Research shows investors expect challenges regarding returns and volatility, and they are eyeing up strategies in line with that belief
Investors understandably don’t like being charged active fees for beta-driven returns dressed up as alpha strategies, especially during periods of low interest rates and increasing volatility. But that’s exactly what many long-short equity funds have been delivering for years.
A recent report released by Institutional Investor’s thought leadership group found that investors expect inflation to remain subdued, returns to remain low, and volatility to increase in the near future. In this environment, survey responses revealed, two strategies are clearly favored by institutional investors looking to optimize risk-adjusted returns from their exposure to global, developed, and emerging market equities. Thematic active strategies were the most popular, followed by systematic/quantitative strategies. Thereafter, there was a sharp drop-off to other strategies.
For investors recognizing how elusive, unpredictable, concentrated, and expensive chasing alpha has become, alternative beta can be appealing as a simple, low-cost, uncorrelated and liquid strategy generating consistent returns.
“Our definition of alternative beta strategies refers to trading programs that tend to have a low correlation to traditional markets, be it bonds or stocks, and a Sharpe ratio in excess of 0.3 or 0.4, which is the historical Sharpe of the stock market,” says Philippe Jordan, President of Capital Fund Management (CFM) a quantitative asset manager founded in 1991. These programs are supported, he adds, by robust T-Statistics, data sets stretching back multiple decades and broken down into weeks and days to determine the statistical validity of strategies.
Mixing negative and positive skew
An optimum strategy of this kind, Jordan explains, is one that blends negative and positive skew, which is a reference to the distribution of returns. Long-only equity indices, he says, are negatively skewed, meaning that while stock markets tend to drift gradually upwards on a daily basis, large daily variations are generally negative. In other words, a protracted series of daily modest double-digit gains in, say, the Dow Jones benchmark are often eradicated by triple-digit falls within a single session.
Positive skew strategies, meanwhile, will generally deliver the opposite outcome. In a long-term trend following program, for example, poor average daily returns over an extended period can be followed by large gains when the trend breaks out. “If you are short volatility, for example, and there is no directionality in the market, on most days you can expect to collect nickels and dimes,” Jordan explains. “But when volatility eventually blows up, the strategy should pay out, like an insurance policy.”
“Our alternative beta products combine multiple alternative beta strategies which are independent from each other and provide a mix of positive and negative skew characteristics,” says Jordan. “The result of our back tests is a portfolio with reduced overall negative skew producing a Sharpe ratio of 0.5 to 0.7 over time, where the stock market has a Sharpe ratio of 0.3 to 0.4. This is also achieved with an average correlation to the major benchmarks of below 30%, and should be priced at below 100bp.”
A compelling alternative for long-term investors
This makes the alternative beta methodology compelling from a quantitative perspective for investors maintaining a long-term exposure to the strategy. “We work to deliver a steady return over the long term within investors’ chosen average volatility preferences, but the distribution of the underlying return will vary from year to year depending on the risk constraint,” Jordan explains. “If we run a portfolio with a 10% average volatility, and if we say for ease of calculation that we’ll deliver a Sharpe of 0.5, then the average return would be about 5% in a zero rate environment.”
“But given the potential for as many as three standard deviations in any year, the returns could be as high as 15% or as low as minus 15% in extreme years,” he continues. “To earn an annual average return of 5%, investors would need to maintain an exposure to the strategy for a minimum of five to seven years.”
“So, while alternative beta delivers a metric that is less ambitious than alpha in terms of return, it generates a Sharpe ratio that tends to be above the market metrics and it carries a real portfolio benefit in the sense that it behaves differently over the long term,” says Jordan.
Managing investors’ expectations
“Alternative beta will never be as large as the beta market, because it requires a number of portfolio structuring techniques,” Jordan concedes. “For example, it involves borrowing securities to go short, which means that it will always be inherently more expensive than a pure equity beta strategy.”
This may make alternative beta sound unappetizing to investors expecting (or hoping) to see a return to the good old days in which a portfolio of G7 government bonds could generate real annual returns of 3% or 4%, with equity beta concurrently producing 7% or 8% each year. For investors who believe those sorts of return unlikely, alternative beta may become an appealing way of constructing a portfolio which balances a constant risk against a variable return.
Alternative beta has become well understood and accepted by investors over the last 10 years. But Jordan recognizes that just as the cheap beta movement championed by Vanguard (among others) took several decades to gain traction, it may be another five to ten years before alternative beta entrenches itself as a core part of investors’ portfolios – be they institutional or retail. “Its appeal is universal, although the investors that have been most attracted to it over the last five years have been pension funds from the U.S., Canada, Europe, and Australia, which have long-dated liabilities,” he says.
“As to private investors, we have a business with sophisticated investors such as platforms and financial advisors in Australia, and a partnership with a bank in Europe which is packaging alternative beta program in the UCITS format, so it is finding its way slowly into the retail market,” says Jordan. “Investors need to make sure that they maximize the portfolio benefits of reduced correlation with mainstream assets. They also need to ensure that they understand the level of risk at which they’re operating, and that the distribution of returns may be random within those risk parameters over five to seven years.”
ANY DESCRIPTION OR INFORMATION INVOLVING INVESTMENT PROCESS OR ALLOCATIONS IS PROVIDED FOR ILLUSTRATIONS PURPOSES ONLY. ANY STATEMENTS REGARDING CORRELATIONS OR MODES OR OTHER SIMILAR STATEMENTS CONSTITUTE ONLY SUBJECTIVE VIEWS, ARE BASED UPON EXPECTATIONS OR BELIEFS, SHOULD NOT BE RELIED ON, ARE SUBJECT TO CHANGE DUE TO A VARIETY OF FACTORS, INCLUDING FLUCTUATING MARKET CONDITIONS, AND INVOLVE INHERENT RISKS AND UNCERTAINTIES, BOTH GENERAL AND SPECIFIC, MANY OF WHICH CANNOT BE PREDICTED OR QUANTIFIED AND ARE BEYOND CAPITAL FUND MANAGEMENT’S CONTROL. FUTURE EVIDENCE AND ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE SET FORTH, CONTEMPLATED BY OR UNDERLYING THESE STATEMENTS. THERE CAN BE NO ASSURANCE THAT THESE STATEMENTS ARE OR WILL PROVE TO BE ACCURATE OR COMPLETE IN ANY WAY. ALL FIGURES ARE UNAUDITED.