Alternative investments debate: Seeking the new alternatives
The rise of alternative beta strategies seems inevitable as investors chase greater levels of diversification in their portfolios. What are the secrets of alternative beta’s success and what obstacles can still impede its progress?
• Alternative beta means different things to different people
• Hedge fund replication is set to be a big growth industry
• It can be easily accommodated alongside existing strategies and products
• Derivatives are also increasingly easy to access and use by investors
AM, Watson Wyatt What is alternative beta, and why is it interesting?
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.
JB, PGGM But using the same building blocks you could create something that suits a specific investor better than just a hedge fund.
GD, Fulcrum AM You could. A fund of your size and sophistication can do a lot of this itself, but a lot of other investors want to access the same risk streams but not necessarily through hedge funds. This is filling that gap. It will grow, provided that it does well.
AM, Watson Wyatt Does replication makes sense?
BF, LBS A hedge fund is a business. We’re not talking about replicating a business here. Replicating hedge fund strategies is about delivering the income or return stream of (generally) matured hedge fund strategies. When using alternative beta or hedge fund replication strategies you’re picking smart strategies (not picking smart hedge fund managers), but even so, there is still a portfolio management component that cannot be ignored. You could handle that in house, and just focus on the ingredients (or alternative risk premia). Regardless one should not underestimate the importance of putting the ingredients together. Depending on how you wish to use alternative beta strategies, there is no general rule that tells us which part is more important. Therefore to assess whether alternative beta strategies have worked (ex-post), we need to be clear about the application we had in mind.
MP, USS We see it as an additional tool. It’s a way to build a programme where we can get liquid scalable exposure to the majority of hedge fund returns, and on top of that we can try to find that alpha via single-manager hedge funds. The reason these models were developed was to better understand hedge fund returns and attribution. So it’s an added dimension that we can use in benchmarking potential managers. And their liquid nature helps us in risk management. We can manage our portfolio more dynamically than if we just had single managers with six-month lock-ins and gates.
AM, Watson Wyatt Paul, how was your product developed and what does it seek to do?
PB, SSgA We looked at several providers and I was impressed with what Bill [Fung] and David [Hsieh] were doing. They’re going to the essence of the problem. They’re not over-designing it. State Street brings our institutional ability to deliver return streams cheaply, so the match was good.
AM, Watson Wyatt What fee level are we talking about?
PB, SSgA Depending on the mandate, 100 basis points and lower.
AM, Watson Wyatt Substantially less than the active alternative.
GD, Fulcrum AM I don’t see alternative beta funds, hedge fund replicators, as hostile to hedge funds. They’re growing together. As they grow, it’s going to be harder to create alpha, and justify the fees charged by alpha creators. Demand from the funds of funds for direct investments in hedge funds will continue. But you can do some of the same things in an alternative way, which is more liquid with lower fees. There are two ways in which these alternative products are structured. One is pure passive alternative beta, for example a package of long equities, or long emerging market versus developed countries, or long bond duration, or long credit, driven by regression techniques. Many of these funds started fairly badly, because all these risk premia have blown out during the credit crunch. Other more sophisticated funds have a second leg to their risk, which attempts to be long volatility or long gamma, and in our case replicates trading strategies of hedge funds so that they can do well when risk premia do badly. That’s the way hedge funds behave. They haven’t sat in equity beta for the last six months. They’ve sharply reduced equity risk, well ahead of what the regression techniques have suggested. To have an automatic part of the fund which does that can be advantageous. Without that some funds have had a tricky experience, because the passive risk streams have lost money.
BF, LBS There is an extra dimension to fees, and that’s fee risk. When a hedge fund manager is presented with the daunting task of having to generate high returns in a shrinking spread environment, the tendency is to look to leverage to bridge the gap. Demanding high fees as a product provider, quite often justified by good performance in the past, carries a different dimension of risk – how do you deliver positive net returns in lean times without adding funding risk? Having lower fees reduces that risk.
BD, BNP Paribas When ETFs arrived they didn’t kill the mutual fund industry. They became an alternative way of accessing equity beta.
AM, Watson Wyatt Institutional fees have gone up over 10 years. Passive management has not cut aggregate costs – quite the opposite, given the move into alternatives.
BD, BNP Paribas It makes the good managers look better, and it eliminates weaker players. If it enables the good managers to charge more for value creation, that’s good. When replicators are established, the models will recommend that prudent investors allocate assets to replicators, just like they would allocate assets to beta via ETFs or trackers. They’re complementary. Scalability is an issue. A large institution can only buy so many hedge funds without driving down returns. But they could diversify their decorrelated pocket through replicators. In that case you’re not looking for returns as much as for correlation with other asset classes you may hold, and risk/return characteristics which will enable the risk of your portfolio to come down. In terms of structured products, we can write more complex derivatives on replicators than on single hedge funds or on funds of funds. When you sell a derivative on a hedge fund you have to take into account the blow-up risk, the jump risk, the fact that managers may assign capital to more volatile strategies without telling you. This restricts the universe of solutions. With a replicator, we have visibility over what we’re writing derivatives on. An innovative way to get value back to the investor is by either charging less, 100bp or lower for just a delta one replicator, or if we charge hedge fund fees, we throw in an additional 20% exposure to the upside or some downside protection. We could not do that in a hedge fund.
GD, Fulcrum AM Fees relate to supply and demand, and depend greatly on the skill of the manager. The good ones will naturally ask for as much as they can. In hedge fund replication, fees of around 1% with some performance are the norm. As assets under management increase, for hedge fund replicators that are purely passive and not trying to add any skill factor, fees are likely to come down.
JB, PGGM The hedge fund industry is blamed for charging high fees, but the buy side should take some blame, because we pay them.
PB, SSgA So much of the traditional active manager’s return is generated by beta. If you strip out the alpha-only bit and look at the absolute fee you paid on that small amount, guess what? It becomes close to hedge fund-like fees.
AM, Watson Wyatt Paul’s right. A traditional manager’s fee, as a proportion of alpha, is far higher than people think, because their alpha is low. But whatever the fee structure adopted, we’re comfortable as long as they’re not going to take more than 50% of the alpha relative to the replication strategy which we can buy at 100bp.
BD, BNP Paribas This is something we can embed in structured products. You can go short these replicators, and say: ‘I’ll charge you only the outperformance of a hedge fund over the benchmark of the industry, which I replicate according to this algorithm’. It becomes a powerful benchmarking and cost reduction tool, although different from what had been envisaged.
BF, LBS In order to determine what is the "fair fee (price)" for talent (alpha) one needs price discovery on fees, costs, liquidity, risk-adjusted performance and structuring. However, there are value-added features of replication products that are otherwise unavailable in standard hedge fund vehicles. For example, with a structured hedge fund programme, even if a replication product performs at the same level as other products, the mere presence of improved liquidity terms and overall transparency from including replication products is likely to reduce structuring cost. Therefore, the value of alpha-beta returns is not always linearly separable in the context of a structured product—there are other aspects to consider.
JB, PGGM If a benchmark develops you could see the same bad behaviour we have in liquid markets. Hedge funds as active managers start looking at the replicator-benchmark and avoid deviating too much from it, because it would endanger their performance fee. Then you get exactly the behaviour you didn’t want from the hedge fund.
Put to the test
GD, Fulcrum AM At least we are beginning to see real money in benchmark-type products. But it’s in its infancy. Many products have been switched on at a bad time. It’s going to be a while, maybe two or three years, before investors become comfortable with what strategy works best.
BF, LBS It’s a good time to start. You are being put to the test under the worst possible conditions.
GD, Fulcrum AM That’s true. We switched on on November 1, the absolute peak of the risk premia, and our fund has performed in line with hedge funds during that time, so I feel comfortable with it.
MP, USS If you did benchmark the hedge funds, you would find out which ones can truly generate alpha. But we probably already know who the good managers are. The problem is getting access to them in sufficient size, and the potential for alpha decay as their funds increase in size. There’s an inherent conflict.
AM, Watson Wyatt Are replicators a direct challenge to funds of hedge funds?
GD, Fulcrum AM There is a permanent role for funds of hedge funds as well as replicators and individual funds. There’s been no cannibalization at all, because the industry has been growing fast enough.
BF, LBS In the same way you have trackers, ETFs and mutual funds, you have replicators, funds of funds and hedge funds. And you move towards more value added as you move towards the individual hedge fund and towards beta benchmark. The fund of funds is a middle ground. They’re still skilled in selecting funds and allocating capital to those that are doing well at the right time.
AM, Watson Wyatt I struggle with the after-fees argument, especially when you put in capacity as the extra dimension and the alpha decay as managers grow.
GD, Fulcrum AM Hedge funds introduce strategies and leverage and trading frequency otherwise not found in standard equity/bond portfolios. So they’re improving the risk/return frontier, even if no manager skill is involved – that’s part of the case for alternative beta.
BF, LBS Fund of funds offer due diligence, risk management and other operational services – not all of these services are required in replication products. Leaving the performance comparison aside, these are other features that should be considered when we consider whether investors are getting their money’s worth.
JB, PGGM Our judgement of the funds of hedge funds we select is that they can do a better job than we can do in specific areas.
MP, USS Some people in the fund of funds community see these products as a challenge, but others are interested in using them as they see them as a way of increasing their ability to dynamically risk manage their portfolios. We see them as a useful portfolio management tool complementary to hedge funds. It should be seen in the same way by the funds of funds.
BF, LBS That is consistent with what some sell-side providers of replication products say – especially those looking to offer these products in a derivative form. Their guess is, over time, that their book may well be net short. There is likely to be demand for replication products from risk management applications other than as an investment vehicle – the flexibility point. Derivative products do offer the convenience of going long/short this type of product in a simple, timely, convenient manner, thus outsourcing the construction/management of the underlying (risk premia) to the investment banks.
GD, Fulcrum AM We manage funds of funds and alternative beta funds. It seems a lot easier to hedge the alternative beta fund against market risk. We know what’s in it, we can think about whether we believe hedge funds are hedged and try and replicate their strategy. We rarely hedge a fund of funds against market risk. However, the single-manager risk cuts the other way. If an alternative beta manager takes too much risk and loses a lot of money, the investor is typically taking 100% of that risk. You diversify that single manager risk in a fund of funds.
PB, SSgA The hedge fund community has specific risk in that a lot of strategies that had a specific quant bet suffered severely in August, whereas we had a generic quant bet, a small/large value/growth thing, and we didn’t suffer to the same extent.
AM, Watson Wyatt The rise of passive management made traditional active management more benchmark-hugging, with negative features. Two or three years ago, we didn’t have replicators. Will hedge funds move into new strategies for which you’ve not worked out the appropriate replication tool?
BD, BNP Paribas The replicator’s job was easier until August, because most hedge funds were short vol, or taking advantage of risk premium. The challenge is to have a product that performs with a strong long vol component. Long vol is expensive to carry. It requires a more complex strategy. You can’t roll along in fixed positions. This new environment, where short vol funds have a more difficult time, will be the true test of the replicators. Hedge funds are already doing new things. We’ll see how replicators adapt.
GD, Fulcrum AM The new volatility environment is a challenge for hedge funds too. It’s more understandable if the replicators lose money when hedge funds lose money. It would disturb me if they lost money while hedge funds made money. If hedge funds are quicker to adjust to a new volatility environment than alternative beta funds, then we’re failing.
AM, Watson Wyatt Are there new strategies that aren’t amenable to replication?
PB, SSgA Most new ideas are another form of the same thing. People have short memories and hope springs eternal.
AM, Watson Wyatt How do the replicators compare to hedge fund indices?
JB, PGGM We have hardly taken hedge fund indices into account in our analysis. A benchmark, needs to be replicable, otherwise it’s just a performance indicator.
BF, LBS Replication helps when you need to analyse performance over a long enough economic cycle to understand the risks of your investment. Replication products give you a natural link between a hedge fund strategy and the underlying assets involved– which have a much longer history than the hedge fund strategy itself – allowing us to observe its behaviour over longer economic cycles.
BD, BNP Paribas We have a replicator that benchmarks the MSCI Hedge Fund Index, which is useful for some investors. You know what you’re replicating. Just as they have a pocket of their portfolio which benchmarks the MSCI World or the EuroStoxx, then they know that whatever they buy should follow an index. It gives them comfort.
JB, PGGM But do they know what the index is? Transparency can be misleading. You know the data but do you know what is going on? If there’s no data, you have to think hard about why a strategy makes money, which is a good exercise, but it’s often forgotten because there’s so much data. I’m not against quantitative techniques, but it’s only part of the equation.
BF, LBS Exactly. An index that is merely a peer group average tells you very little about the risk of your investment. It is not investable and perhaps not intended to be so. It almost gives you an illusion of knowledge. We need another way of measuring and benchmarking hedge fund risk. We need to determine which are the return drivers of return (and therefore risk) in your portfolio? In some way, it is precisely the incompleteness of hedge fund data that led to much of the development of quantitative research in hedge funds. For now, I think we are still in the "tool building phase". There is yet to be established a benchmark hedge fund industry that helps investors identify the risk characteristics of hedge fund investing.
MP, USS What do you think investors want out of hedge funds and their replication? If you can design a product that hits my return target consistently, I don’t care about what hedge fund indices are doing.
GD, Fulcrum AM Yes, but you don’t want to give me as a potential provider the freedom to do anything I’d like in my hedge fund replicator, because then I become simply another hedge fund. You need to give me the mandate of trying to do what the hedge fund industry is doing or match their returns.
MP, USS But is it such a bad thing if you were just a hedge fund, cheap, fully transparent and liquid? Is that such a bad proposition?
GD, Fulcrum AM No, but most users want to feel this vehicle is grounded by attempting to replicate the industry’s risk/return profile and its relationships with other assets. If our fund was just a macro fund, which didn’t purport to match the index or to have the same relationships to equities and bonds, it would only be a tiny part of your portfolio, and you wouldn’t allocate the amount of risk you would to a replicator.
AM, Watson Wyatt What’s an appropriate benchmark for a replicator?
GD, Fulcrum AM We’re not near a benchmark for alternative beta yet, and I don’t even know where to look. But the replicators are trying to offer in a single stop much of what the hedge fund industry does. Replicators should do better than the investable indices, but not as well as the non-investable indices, which are fictitious anyway. What’s the point of having an index which you can’t invest in?
PB, SSgA Marketing.
BD, BNP Paribas If you’re investing just to park your money for a rainy day, you’re more indifferent to the benchmark than if you’re investing against pensioners to pay and other liabilities. Any benchmark deemed to measure the quality of the investment has to be broad.
PB, SSgA I’m benchmarked against a paper portfolio, so that’s the index I’m following.
AM, Watson Wyatt In the absence of a clear benchmark, you have to have multiple comparators. Why are you investing in this? Has it generated a return over Libor with suitable volatility, suitable correlation characteristics? Fund of funds returns are a possible benchmark, but you’re wanting appropriate managers to try to construct a more risk-managed portfolio than just the HFR index. You get round the investable/non-investable issue by looking at a real world fund of funds, which may invest in investable or non-investable funds.
BD, BNP Paribas There’s probably a number that you can gauge your benchmark by, the Sharpe ratio, for example.
JB, PGGM Sharpe ratios and the normal distribution metrics aren’t enough. We need scenario analysis. What happens in a credit crunch? Extreme events are probably more important, although most risk departments still spends 80% of their time looking at what happens within the one standard deviation area.
PB, SSgA Given that active managers prefer to sell the tails, that’s the ultimate after-manager pay-off, a little bit, a little bit, and then blow up. If we take the mortgage event, if it only happens once in 80 years, how do you do scenario analysis of that? I’m sure competent people were doing analysis, stress-testing the system, but how can you have a risk premium trying to compensate you for one-in-80-year events?
JB, PGGM Catastrophe bonds is one area where you can go to hedge fund strategy or alternative beta. Our analysis is partly based on geological data, but it’s a one-in-100-year risk. As we judge the pricing, we can recover and get a target return within 30 years, which for a pension fund, is fine, but for most investors is not.
AM, Watson Wyatt I’m interested in the trend towards finding new asset classes, new sources of return. It’s attractive for product providers to come up with new alternative betas so they can charge higher fees.
PB, SSgA You shouldn’t get compensated for something that has low correlation to the market. That’s called insurance and you have to pay for it. So where are these low correlated asset classes with positive rates of return?
JB, PGGM The positive correlation works via liquidity, and the newness of certain asset classes will provide negative or low correlation. The efficient market theory works if asset classes are accessible. If there is a low degree of securitization and there are barriers to entry, that creates the inefficiency and low correlations. Maybe the replicators will have an effect. The low correlation of the traditional hedge fund strategies will go down if the replicators ensure that hedge fund investing becomes more accessible.
PB, SSgA Is liquidity a premium or a cost? The concept of liquidity premium is over-sold. Say I take the S&P 500 Spiders. If I own them, if I then do a personal corporation, by virtue of the fact that I have securitized it, it becomes less liquid and I can mark those assets down. Have I created value? Are you going to buy my personal corporation as an arbitrage?
BD, BNP Paribas It depends what I am investing for. Whether or not I care about liquidity has a price for me.
PB, SSgA Exactly, so do you think that there are so few investors that have a long-term time horizon that they wouldn’t bid those assets up to the point where the illiquidity covers their expected costs? It’s not a return. They’re just being compensated with the costs of illiquidity.
AM, Watson Wyatt An illiquidity premium relies on there being fewer natural buyers of illiquid assets than there are assets available. There are many investors who can tolerate illiquidity, but there are fewer investors who want it.
BD, BNP Paribas If they can quantify how much it costs or how much more return they make, maybe they’re willing to tolerate it. How do you quantify that?
JB, PGGM Most investors over-estimate their own skill, because they think they can redirect things in time. The facts point the opposite way. There’s much to be said for your own discipline. I used to think lock-ups didn’t make sense, but the last couple of crises have changed my view. I don’t object to lock-ups, as long as my fellow investors have the same. They prevent erratic behaviour in the fund.
BF, LBS The real question is whether one is rewarded appropriately for accepting lock-ups. The problem investors face is that there is no easy way to properly assess the incremental benefit of lock-ups. The world of alternative investments started with opacity and illiquidity. For years the concept of a liquid hedge fund is almost an oxymoron. Finally we are getting to a point where the use of managed account platforms and replication products are gaining acceptability. It will be interesting to see how these new developments can help investor discover the price of liquidity (cost of lock-ups).
PB, SSgA Therein lies the essential difference. Beta is that true systematic risk. You can’t insure it away. I can buy life insurance, and the insurer can diversify across many lives, but he’s just going to earn an economic rent, not a risk premium for that.
AM, Watson Wyatt How do you get access to alternative asset classes.
MP, USS We chose to access alternative assets directly by in effect building an in-house fund of funds. The main barrier to this was building appropriate resources to do quality due diligence. We were never going to replicate the breadth of due diligence that a fund of funds does, but we wanted to do the 20% that added value.
JB, PGGM For us it was the opposite. With liability-driven investments, we thought about how to invest towards what we should pay out in the end. Liabilities are our benchmark. We do the theoretical exercise that you do on a cash basis, hedge these liabilities, and then you have a zero-risk situation. But that is too expensive. The contributions required from participants are too high. The next step is to take some risk which gives you the probability of a higher return. But the risk we take had better be suitable. We distinguish ourselves by our size, long-term horizon and because we are a young fund that for the next 10 years we’ll get more contributions in than we pay out pensions. So we build our risk profile around that. We also think about the added value for our participants, which is in the sophistication of our investment strategies. Alternatives should never be an aim in themselves. They should be part of what you’re trying to achieve, and if you can achieve it the boring way you should.
AM, Watson Wyatt There’s been a diversity stampede. All investors think they need alternative assets, and the price they’re buying them at is not clear. Returns may not live up to expectations. How do we know whether these assets will be attractive in the future?
BD, BNP Paribas It depends how you make the case that they’re attractive. We’ve sold one class of diversifying assets over the past year, which we call second-order assets. When you buy stocks, you’re long the market but short volatility, because the market goes down when volatility goes up. So one second-order asset is volatility. We’ve told investors that it’s 90% negatively correlated with their portfolio, so it will do well. It is diversifying. The only case where volatility is not ahead is when it goes down when the market goes down. When the market goes down a lot it never does. Do you have solid arguments with which to convince customers that you’re diversifying? A stable negative correlation with what they’re holding helps convince them.
GD, Fulcrum AM In the 1990s, Goldman sought to persuade pension funds to hold commodities. That’s partly why we devised the GSCI. We didn’t have much success until commodities started rising, and now pension funds are heavily investing. I feel the case has been vindicated, because commodities haven’t been highly correlated with equities. Recently they’ve been very negatively correlated. Even if you don’t know what the correlation is, you’re getting some benefit, because the correlation is unlikely to be perfect. Recent experience will be a big push for funds into alternative assets. They’ll see what commodities have done in 2008. They’ll see what hedge funds have done in 2008, and be more likely to believe the next alternative story.
MP, USS I understand the arguments about commodities, but I’m dubious. Commodity futures markets are deep, but huge sums are going into the front end of the curve that is distorting prices. I struggle to justify where commodity prices are today given fundamentals.
AM, Watson Wyatt A market cap portfolio would have nowhere near as much in diversifying assets as large institutions are trying to put in. There will come a point when that flow of money causes mispricing of diversifying assets or excess demand.
BF, LBS Suppose we are all dissatisfied with the dollar? Is the rush to hold gold necessary for diversification, or is it just due to uncertainty surrounding a dollar-based financial system? We have to be careful what we mean by diversification and from whose perspective.
AM, Watson Wyatt A lot of the new hedge fund strategies involve buying a return on equity of something we know and love. A lot of lending strategies are called asset-based lending now, but it’s just factoring, and I can do that without paying 2 and 20.
GD, Fulcrum AM Whether commodities are correlated positively or negatively to equities depends on the economic shock hitting the system. A negative supply shock means commodity markets go up and equities down. Positive demand shock means commodities go up and equities go up. It’s easy to think of strategies that give you misleading correlations, and economic shocks that change these. You have to understand the impact of different shocks. I would argue that commodities are not assets but may be useful parts of a portfolio.
AM, Watson Wyatt To what extent can big funds put pressure to bear on the industry to adopt best-practice fee scales?
JB, PGGM When we entered commodities in 2000 we paid about half the fees that were then the market practice. But they were much higher than what is paid now. We, and others after us, drove fees down.
BD, BNP Paribas A fund does not have that interest in tracking as many investors as possible, because it may drive down alpha on some strategies. If you’re too much of a pain, a fund manager can take other investors instead.
JB, PGGM Almost every fund provider wants a performance fee. We turned down a fund after six months’ work because cost structures were popping up without explanation. We won’t pay for things that don’t exist or cannot be justified.
MP, USS There’s been an increase in the concentration of investors in private equity, and yet there hasn’t been a concerted effort to lower fees. Even large US state funds are concerned about getting their allocation levels. They’re massively increasing private equity programmes, so there’s little impetus to negotiate on fees.
PB, SSgA State Street enters markets offering cheaper, lower-cost propositions. That’s the way pressure can be brought to bear on fees.
BF, LBS Institutions can be their own worst enemy. They tend not to enter into fee negotiation when the market is down and managers are not performing—instead, most will just vote with their feet and redeem. During better times when a manager is performing well, negotiation power is likely to rest with the manager. In the long run, for investing institutions to pose a credible threat to third-party managers so as to achieve better-quality performance for their fees, they have to be seen to be willing to manage their capital in house at what they perceive to be the right price for talent.
AM, Watson Wyatt Can we convert alpha back into beta? Are there new betas out there? Are there ways of doing familiar betas, equities, bonds, more efficiently?
BD, BNP Paribas There are hedge fund replication models that mix derivatives and traditional assets, where you try to infer the exposure in derivatives that’s hidden within hedge funds. I would like to see derivatives recognized as an asset class, or at least as an efficient way to get exposure to asset classes. This would add diversification to portfolios by adding convexity, provided it’s fairly priced.
PB, SSgA The investment management market is more efficient, transaction costs are being reduced, in large part due to derivative products. Management fees are coming down, and the average client has a much better diversified portfolio than 40 years ago. That’s the bar against which the average investor is able to own beta.
It’s a function of expected returns and the level of under-fundedness of the plan. Reasonable expected returns are low and under-fundedness is high. Fees will go up.
BD, BNP Paribas There’s been an interesting market development, making derivatives more important. Ten years ago when you sold an option on an equity index you had to carry the vol. If you sold an option on a basket of equities you had to carry the correlation. As you are able to source these risk parameters from dealers or investors, you become a middleman, and the middle man cuts the fees down. So making the derivatives market more efficient is linked to finding new sources of investors willing to sell us the risks that we package into derivatives. There is no reason why the derivatives market won’t become more efficient.
AM, Watson Wyatt For pension funds and institutions with long duration real liabilities, the biggest improvement in their ability to access beta is the derivatives market.
JB, PGGM Derivatives are a great means of accessing risk premia. The use of leverage should be the next development, and in that sense you can also better diversify because for a higher return you don’t have to limit yourself to one asset class. You can leverage up the less-risky asset classes and deleverage down the riskier assets to get a more balanced risk division instead of an asset mix.
AM, Watson Wyatt We’re using derivatives to take these tools out of the hedge fund box and apply them to the other 90% of our assets, and if they make sense for hedge funds they should make sense in the other 90% of the assets.
MP, USS We have a currency-hedging programme using derivatives. We use them to implement tactical asset allocation decisions and tactically in our equity portfolio for call overwriting. For some new asset classes we use them as a more convenient route to gain exposure, like total-return swaps, but our use is limited. In the UK we haven’t embraced the liability side of the balance sheet for pension funds.
AM, Watson Wyatt Can we do beta differently by having a different weighting system for our index?
BF, LBS If we want to properly reflect achievable returns in a rapidly changing market, a combination of alternative betas is the right way to go. Creating a benchmark out of some peer group combination of hedge funds is unlikely to work, because of the complexity of liquidity, redemption and transparency. That is not to say performance statistics are of no value, but quite simply that they should not be confused with the broader concept of an investment benchmark.
MP, USS Fundamental indexation is not a benchmark, I see it as simple hedge fund replication. It’s a rule-based trading strategy capturing the size and value premiums.
JB, PGGM It makes sense to have your own custom-made benchmark. It’s a prescription of how to implement your standard beta. But most marketing initiatives are created for a reason. For your own flexibility, if you want to implement via derivatives, it makes sense to use a market index and not to make your own customized index, because you need basic liquidity and tradable products.
MP, USS I can’t see fundamental indexation being accepted as a benchmark, because everyone’s alpha in the long-only community would immediately disappear.
JB, PGGM But if you argue that there is alpha in it, why settle for less?
AM, Watson Wyatt What does the future hold for alternative beta?
JB, PGGM I’d like the development of leverage and derivatives as risk management and portfolio construction tools.
MP, USS Focusing on hedge fund replication. We will eventually replicate all that is replicable and whatever’s left is true alpha generated by skilled managers, who we can easily identify.
PB, SSgA The development of alternative beta should continue, and it’ll pull back the curtain on active management.
AM, Watson Wyatt There’s far less alpha in this world than people imply. I’m happy to pay significant fees for genuine alpha, but I want to be able to work out what I’m paying and what that genuine alpha is. I hope hedge fund techniques will go mainstream at lower cost.
BD, BNP Paribas Whenever something new comes along, somebody replicates it for less. That weeds out inferior performers and you’re left with true alpha people are willing to pay for. If you can manufacture something for less, people will buy that. Great managers will still be able to charge any fees, but justifiably so.
BF, LBS There will always be a few "sick and wounded" who’ll be "replicated away" or replaced – it’swhat invigorates the industry.