Which Beta is Smart?

Categories: Drivers of Value
Hamlin Lovell, CFA

As new “smart beta” strategies become more popular, how can investors choose among hedge fund beta, alternative beta, liquid alternative beta, exotic beta, smart beta, scientific beta, and the many others that are increasingly available?

“Hedge fund beta” is one of many industry buzzwords, in addition to alternative beta, liquid alternative beta, exotic beta, smart beta, and scientific beta. These phrases are becoming very fashionable, and all kinds of consultants are forecasting spectacular growth for such products over the coming years. Whereas labels as “alternative beta” and “hedge fund replication” are relatively value-neutral descriptions, the terms “smart beta” and “scientific beta” are clearly normative and imply a positive value judgment that could, consciously or subconsciously, predispose an investor toward a more positive perception of such products. After all, smart is the opposite of dumb, stupid, or unintelligent, and the adjective “smart” is seldom couched in quotation marks. “Exotic” is an evocative term that is associated with excitement and mystery. These are some of the powerful marketing angles embedded in these products.

Although many marketing pitches from asset managers seem to claim ownership of these words — and some have even patented terms as “fundamental indexing” and very specific methods of constructing indices — each of the terms is a very broad umbrella. Arguably, all of these categories overlap and cover approaches that you could put to work in your own portfolio in many ways.

What Is Beta?

A “beta” measures how closely an asset moves with any benchmark. So, an index fund or exchange-traded fund (ETF), with no tracking error, should have a beta of 1 to the index it tracks. If “conventional beta” is equity market direction, then anything else can be dubbed “alternative beta.” Alternative beta could include other asset classes, such as commodities, corporate credit, emerging markets, and real estate, which you may already own.

Alternative betas can also be strategies, such as value, momentum, or carry investing, that can apply to multiple asset classes. In either case, investment products should be compared with an appropriate peer group, based on asset class and strategy; do not restrict your search to those products with specific labels.

“Exotic beta” could include ground rents, aircraft leasing, commodity swap rates, freight rates, or insurance-linked securities, including natural catastrophe bonds.

“Smart beta” is used to describe almost any index that is not weighted according to the market capitalization of its constituents. So-called smart beta indices can be equal weighted, have larger weights in smaller- or medium-sized companies or countries, or determine weightings based on fundamental data. For instance, firms with larger sales or dividend yields might get a bigger weight. “Scientific beta” indices are another name for “smart beta” indices and will often disclose a list of rules used to construct and reorganize the index.

“Hedge fund replication” — i.e., seeking to identify and replicate “alternative” or “smart” betas associated with hedge funds — can be pursued in diverse ways. Broadly, the two methods are returns-based analysis and holdings-based analysis. The returns-based approach seeks to assemble a basket of assets that would have recreated the historical returns of a hedge fund index, and sometimes an intermediate step is to identify “factor exposures” that can explain the index returns before identifying products that match those factors. The holdings-based approach seeks to mimic the actual holdings data of hedge funds — for instance, based on 13F filings — although it usually takes weeks or months before these holdings are disclosed.

“Liquid alternatives” is perhaps the broadest umbrella term. It could include any of the products above, as well as actual hedge funds packaged into a more traditional (non-etf) structure that allows for daily, weekly, or monthly dealing. Remember that products carrying the label “liquid” are not necessarily any more liquid than those without this title. There are thousands of daily-dealing mutual funds that make no mention of the word “liquid,” whereas some labeled as liquid may deal weekly or bimonthly. To assess the liquidity of an investment product, you need to first look at the fund’s dealing terms and get a handle on average daily volumes for ETFs, then you might want to decide whether its underlying holdings match the product’s stated liquidity to avoid a liquidity mismatch if everyone rushes for the exit at once.

How Did These Variations of Beta Develop?

Once upon a time, many of these strategies were not widely accessible. Regulators in many countries insisted that hedge funds be restricted to institutional investors, whereas individuals had to be “accredited” or “sophisticated” investors who would need to demonstrate knowledge or assets (or both) above certain thresholds.

In recent years, however, these strategies have become accessible to pretty much everyone. I have previously written about unintentional hedge fund investing, but there are now plenty of avenues for retail investors to make very deliberate investments into hedge funds. In the European Economic Area, investors can go for “newcits,” or UCITS hedge funds. In the United States,  investors can invest in open-ended 1940 Act mutual funds that often trade daily. Worldwide, almost anyone with a brokerage account can invest in listed closed-end funds and a growing variety of ETFs that trade throughout market hours.

So, there are already hundreds of products out there that look like hedge fund strategies, with new launches every month. The simplest vehicles use a handful of well-known indices to try to produce returns close to the hedge fund universe; they are generally not trying to add any value through security selection. These ETFs are not seeking to generate the returns of any specific hedge fund strategy, such as global macro, merger arbitrage, or long/short equity — let alone the returns of any specific fund or fund manager — but rather, they aim to perform in line with the entire hedge fund industry.

In contrast, the so-called copycat ETFs could end up owning dozens of individual stocks in their quest to keep pace with various US hedge funds whose holdings they track. So, two product types that come under the category of “hedge fund replication” could be almost polar opposites in terms of their actual holdings, with one owning broad indices composed of thousands of securities and the other concentrated into a handful of holdings.

Let’s take an example. Some hedge fund ETFs currently seem to have pretty chunky weightings in bonds because, in recent years, such weighting would have provided returns close to the broad averages for some investable hedge fund indices (even though many hedge funds own no bonds at all). Whether extrapolating from recent patterns of performance helps remains to be seen. One concern here is whether investing in a correlated asset can truly “replicate” a strategy.

When most asset classes are rising in synchronicity, it may be relatively easy to match hedge fund returns using a few indices. But when asset classes begin to decouple, will the same method work? Just as important, if you already have plenty of bonds, will such an ETF simply duplicate and add to your existing holdings? If you are seeking a genuine diversifier for your current portfolio that might make money or at least preserve capital when conventional assets are down, you might want to seek out investment strategies that are already doing something different — or could in future.

There is no limit to the categories of beta that may be dreamt up by marketers, but with research, the variety of investable products on offer may already be unprecedented.

Ultimately, the way product types are named, branded, labeled, and marketed should not be uppermost in the minds of investors. You (and your financial adviser) need to work out whether and how much any of these products will help you meet your risk and return objectives and whether they offer any genuine diversification from what you already have in your portfolio. UCITS and ’40 Act funds disclose portfolios at least twice a year, and some fund managers may do so more often. Here, the disclosure requirements of ETFs can be helpful. Although the requirement to make daily disclosures of holdings deters some hedge fund managers from launching an ETF, this transparency could assist you in assessing the product.

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