Alternative investments debate: Seeking the new alternatives

JB, PGGM When we set up the alternative beta department at PGGM, there was unease about our strategic mix. Only asset classes with a history of 30 years or longer were eligible and only if there was enough data could something be called beta and be part of the structural mix. We decided that was no longer sufficient and that the exchange-traded world is only a small part of the global economy, so there must be more risk premia around than just in traditional investing. They should not be skill-driven, but be structural. These risk premia cannot necessarily be captured by passive long-only strategies, so we set up the portfolio of strategies as a part of our mix, without specifying what it is, but with characteristics we have to work towards.

MP, USS We struggle with an exact definition. There has to be some systematic return element, alternative risk premia we can capture. This is not always clear. In commodities, the closest thing you get is the roll yield. However, there has been significant volatility in the roll yield and a lack of persistence, it raises the question of whether commodity futures is an alternative asset class or not. If there is a risk premium, you have to identify the driver? Is there a commercial hedging decision driving this premium and as such, does it share characteristics with currency? Often it’s the same risk premium across different asset class.

PB, SSgA Using the modern portfolio theory definition of beta, it is the systematic risk, meaning that you need to be compensated in bad times for holding the asset class. To me, there is only one beta, and everything else, apart from market portfolio, is some variant of an active bet.

BD, BNP Paribas Alternative beta can be defined as sources of beta that haven’t been tapped, or as the beta of the alternative investment universe. It’s the part of alternative asset returns that you can replicate using tradable instruments, which includes everything except manager skills and liquidity premiums.

BF, LBS Conventional beta refers to conventional asset classes and typically assumes a long-only buy-and-hold strategy in managing the assets. Alternative beta goes beyond this in the strategy dimension to allow for long/short strategies. The concept of risk premia refers to the systematic return you get out of combining where you invest (conventional versus alternative assets) and how you invest (the strategies you employ – long-only versus long/short as well as the use of balance sheet leverage). They are three different concepts being loosely combined here: a sensitivity coefficient (beta), the "reference" asset that we’re using (conventional versus alternative), and the systematic return or performance we get from combining them. Quite often we drop the "premium" part and just talk about alternative beta when we mean an alternative beta premium and likewise with conventional beta for convenience. It gets messy with alternative assets as not only do we have different asset classes to deal with but we also have differences in trading strategies being applied. It may be a good idea to highlight these abbreviations early on.

GD, Fulcrum AM In pension funds, it is the beta of alternative assets, which means the market return without skill, from assets like property, commodity or timber. In hedge fund land, it has become connected to hedge fund replication and the debate about whether you can turn hedge fund returns into risk premia which match the performance of hedge funds.

AM, Watson Wyatt What strategies do you have?

GD, Fulcrum AM Our alternative beta strategy is divided into a passive half and an active half, which we combine into a fund called Alternative Beta Plus. The "Plus" part is an active series of trading or hedging strategies on top of the passive part of the fund. The passive part is a series of risk premia that we define from the equity, bond, commodity, currency and volatility markets. There are a dozen to 20 risk streams in the fund. They’re not dissimilar to what some pension funds are starting to do directly, because in some cases they are building those risk streams themselves, whereas elsewhere in asset management people are buying real hedge funds or replicators, because they don’t feel they can do it themselves.

JB, PGGM We try to find the betas that match our profile. With the hedge fund replicators, people are trying to emulate something that is already there.

GD, Fulcrum AM I call it a hedge fund replacement vehicle, not a replicator, because I don’t believe it can exactly replicate hedge fund returns on a monthly or quarterly basis.

JB, PGGM The idea of hedge fund replicators is great for analysis and risk management purposes for asset classes, investment strategies or risk premia that have no data. But for investment decisions the qualitative analysis remains key. The replicators might enable you to implement strategies that are not passive long but still structural. The idea is great, and if there is enough liquidity for a big fund like ours, even better. Some of the new asset classes are capacity-constrained. But why would you use these different risk streams to build something that is already there? You can already buy hedge funds, so why not use the replicators to capture your ideal return, volatility, and correlation profile?

GD, Fulcrum AM That’s feasible, but hedge funds have intrinsic disadvantages: illiquidity, opaqueness and fee structure. In exchange for those disadvantages for a hedge fund’s fund-of-funds portfolio, some of them clearly give you an alpha return. So, if you accept that a hedge fund replacement vehicle cannot generate the same alpha, but charges lower fees and gives you greater liquidity, many investors may prefer that for at least part of their alternative portfolio.