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Alternative beta: The must-have alternative

Two approaches to replication leave a gap in the market.

Jerome Abernathy, Stonebrook Capital

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.

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