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Jerome Abernathy, Stonebrook Capital: Investment banks don’t want to undercut their biggest customers |
Alternative beta is becoming the must-have product on Wall Street. Given that most hedge funds derive the majority of their returns from beta, rather than manager skill (alpha), replication of this beta by investment banks and other institutions, at lower fees than those charged by hedge funds, is naturally a tempting offer for investors.
Alternative beta tends to outperform during liquidity crises such as that experienced this summer, because many hedge funds trade illiquid securities. Also, many highly leveraged hedge funds reduce their exposures, thereby locking in larger losses. Alternative beta is always marked to market and isn’t levered.
There are, at present, two main approaches to replicating alternative beta. A factor-based approach takes a portfolio of different securities and instruments and combines them in order to track the returns of the broad hedge fund industry. This is the most popular approach, and that taken by the investment banks in their alternative beta indices. Merrill Lynch can take credit for jumpstarting the trend with its launch of the ML Factor Index this year. Goldman Sachs has an index, and later entrants have been JPMorgan, Deutsche Bank and Barclays Capital.
There is also a risk-premium-based approach, where a firm will use trading systems to replicate the styles of hedge fund managers, putting them into a multi-strategy fund. The criticism of this latter approach is that those that take it tend to charge fees not short of those charged by hedge fund managers themselves.
Jerome Abernathy, formerly of Moore Capital and founder of Stonebrook Capital, says the two approaches leave a gap in the market.
"Alternative beta indices, such as those offered by the investment banks, try to deliver the returns of the overall industry by modelling broad hedge fund indices such as the HFRI weighted composite or the Credit Suisse/Tremont index," says Abernathy. "Their problem lies, however, in the distribution of this alternative beta. Funds of hedge funds and other hedge-fund-related businesses such as prime brokerage generate high margins for the banks. Investment banks, therefore, cannot be seen to compete with them. What they do instead of offering an alternative beta fund is to structure the alternative beta as a structured note or total-return swap to sell to investors. It’s going to be a long time before the investment banks decide to cannibalize their fund of hedge funds business and start offering factor-based alternative beta funds."
The vast majority of US pension funds, however, are not permitted to buy OTC derivatives, and can only invest with asset managers.
Abernathy says this leaves an opportunity for others to enter the business. "The investment banks are missing out on this enormous investor base. At the moment the figures do not make sense for them but if alternative beta ends up becoming 5% of a potential $5 trillion hedge fund industry, then the strategic opportunity is compelling."
Stonebrook launched its alternative beta fund in August, the first of its kind in the US. It invests in exchange-traded futures and securities to match hedge fund returns but its fund charges an annual management fee of just 1.5%. The fund was up slightly in August and down 1.73% in July, outperforming the broader hedge fund indices. The fund is currently being marketed in the US but it will be sold offshore to institutions. Abernathy says the firm is exploring ways of offering the product as an ETF for high-net-worth clients. "We think this is the ultimate delivery vehicle. It would be great for high-net-worth clients that require liquidity, and would offer us semi-permanent capital."