Alt-betafunds offer hedge-fund-like investments more cheaply

INVESTORS love to complain about hedge funds, which have delivered measly returns for the past several years and are notorious for their high fees. Yet so far, most have stuck with them. One reason is that the hedge funds’ mission—to provide returns uncorrelated with overall market performance—has been hard to replicate. But a fast-growing hedge-fund-like product, known as the “alternative beta” fund, allows investors much cheaper access to a similar style of investment.

“Alt-beta”, as it is usually called, is a bit of a misnomer. The word “beta” is typically used to mean broad market returns, which can be bought into through index-tracking funds. “Alpha” is the term used to describe the premium added by a skilled fund manager. The idea driving both “alt-beta” funds and longer-established “smart-beta” ones, is that, just as “beta” can be distinguished from “alpha”, so returns can be ascribed to identifiable, predictable factors. One example is the “value” effect: ie, that undervalued companies tend to outperform the market.

Smart-beta and alt-beta funds are close cousins, but differ in their methods and in their outcomes. Both aim to automate asset selection, for example by using rules-based algorithms rather than human managers. But whereas smart-beta funds simply pick and buy assets, and hence ride the market along with other asset managers, alt-beta funds use hedge-fund tactics in search of uncorrelated returns. These include betting against (ie, “shorting”) assets and using derivatives.Compared with hedge funds, alt-beta funds are dirt cheap. They typically charge as little as 0.75-1% a year, compared with 2% annually and 20% of profits for a typical hedge fund. Perhaps unsurprisingly, they have grown fast: according to estimates from JPMorgan Chase, assets managed by alt-beta funds have increased from $2bn in 2010 to around $70bn at the end of 2016 (still nugatory compared with the $3trn in hedge funds).

A range of firms are getting into the alt-beta business: big asset managers, investment banks and funds of hedge funds. So, indeed, are hedge funds themselves. Hedge funds tend to like esoteric, niche investments which are by definition in short supply. But they also invest in mainstream, liquid assets. Taking those positions, repackaging them as alt-beta funds, and selling them on to investors offers them another source of business.

Indeed, hedge funds may not feel too threatened by the alt-beta trend. The cost and complexity of setting up the infrastructure to short assets or trade in derivatives are high barriers to entry. Moreover, alt-beta funds can be volatile. Simon Savage, director of alternative beta at Man Group, a listed provider of hedge funds, says this is to be expected: alt-beta funds are essentially “very simplified hedge funds”, without as much emphasis on mitigating risks.

Such funds may offer cheaper access than hedge funds do to certain commoditised risks. But they may also end up producing lower risk-adjusted returns, making them unappealing on their own. Most investors seem, for now, to use alt-beta funds as a complement to hedge funds, rather than as an alternative. Hedgies are not out of a job yet.

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