Understanding the disaggregation of investment returns can assist in building a truly diversified and robust investment portfolio.
It can also help determine the appropriateness of fees being paid and if a manager is adding value.
Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk factors. More Asset Classes Does not Equal More Diversification.
The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes. The increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this. Alternative strategies are added so as to reduce overall portfolio volatility, resulting in a more attractive portfolio risk return profile.
The inclusion of alternative strategies can assist in providing greater probability in meeting investment objectives.
An understanding of the different return and risk outcomes can be gained by disaggregating investment returns.
Essentially, and from a broad view, investment returns can be disaggregated in to the following three parts:
- Market beta. Think equity market exposures to the NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively). Market Index funds provide market beta returns i.e. they track the returns of the market e.g. S&P 500 and NZX50
- Factor betas and Alternative hedge fund beta exposures. Of the sources of investment returns these are a little more ambiguous and contentious than the others. This mainly arises from use of terminology and number of investable factors that are rewarding. My take is as follows, these betas fit between market betas and alpha.
- Factor Beta exposures. These are the factor exposures for which I think there are a limited number. The common factors include value, momentum, low volatility, size, quality/profitability, carry. These were outlined in this blog and are often referred to as Smart beta – see diagram below.
- Alternative hedge fund betas. Many hedge fund returns are sourced from well understood investment strategies. Therefore, a large proportion of hedge fund returns can be explained by common hedge fund risk exposures, also known as hedge fund beta or alternative risk premia or risk premia. Systematic, or rule based, investment strategies can be developed to capture a large portion of hedge fund returns that can be attributed to a hedge fund strategy (risk premia) e.g. long/short equity, managed futures, global macro, and arbitrage hedge fund strategies. The alternative hedge fund betas do not capture the full hedge fund returns as a portion can be attributed to manager skill, which is not beta and more easily accessible, it is alpha.
Lastly, and number three, there is Alpha. Alpha is what is left after beta. It is manager skill. Alpha is a risk adjusted measure. In this regard, a manager outperforming an index is not necessarily alpha. The manager may have taken more risk than the index to generate the excess returns, they may have an exposure to one of the factor betas or hedge fund betas which could have been captured more cheaply to generate the excess return. In short, what is often claimed as alpha is often explained by the factor and alternative hedge fund betas outlined above. Albeit, there are some managers than can deliver true alpha. Nevertheless, it is rare.
These broad sources of return are captured in the diagram below, provided in a recent hedge fund industry study produced by the AIMA (Alternative Investment Management Association).
Another key distinction, in the most beta and factor betas are captured by investing long (i.e. buying securities and holding) while alternative hedge fund betas are captured by going both long and short and generally being market neutral i.e. having a limited exposure to market betas e.g. equity market risk.
The framework above is also useful for a couple of other important investment considerations. We can use this framework to determine:
- Appropriateness of the fees paid. Obviously for market beta low fees are paid e.g. index fund fees. Fees increase for the factor betas and then again for the alternative hedge fund betas. Lastly, higher fees are paid to obtain alpha, which is the hardest to produce.
- If a manager is adding value – this was touched on above. Can a manager’s outperformance, “alpha”, be explained by “beta” exposures, or it truly unique and can be put down to manager skill.
Lastly, and most importantly, to obtain a truly diversified portfolio, a robust portfolio should have exposures to the different return and risk sources outlined above.
Accessing the disaggregation of investment returns has come increasingly available due to advancements in technologies and the lowering of transaction costs. It is also having a fundamental impact on the global funds management industry, including hedge funds.
Furthermore, the determination of institutional investors to pay appropriate fees for return sources has witnessed the development of investment strategies that appropriately match fees for sources of return and risk.
Please see my Disclosure Statement