‘Alt beta’ disrupts hedge funds
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Like 18th-century weavers, 19th-century farm labourers and 20th-century carmakers, hedge fund managers are just the latest group of workers to discover technology is finding ways to replace them.
Hedge funds ballooned in the 1990s and early 2000s with their promise of providing investors with returns that did not correlate with the wider market, and therefore could help mitigate downturns. Their high prices for offering such a service — typically a 2 per cent annual charge on the assets, plus a 20 per cent take of any profits — generally meant they were the preserve of only the largest investors.
But a growing number of cheaper products have flooded the market in recent years, known as alternative beta, a close relation of smart beta. These investment vehicles seek to automate many of the processes carried out by hedge funds, such as “shorting”, where managers bet that a stock price will fall by borrowing and then selling shares to repurchase them at a later date.
“There is this massive misconception that shorting needs to be actively managed,” says Michael Venuto. A former hedge fund executive, Mr Venuto is now chief investment officer and co-founder of Toroso Investments, which specialises in exchange traded funds.
Alt beta — also known as alternative risk premia — strategies pose the greatest threat to hedge funds that are based on the most systematic processes, follow trends and are easily replicable. By designing computer programs that can imitate these strategies, alt beta managers are able to offer similar performance at a fraction of the cost.
The result has been that swaths of investors have pulled their money from traditional hedge funds and ploughed it into alt beta funds.
JPMorgan estimates that global assets managed by alt beta funds have increased from $2bn in 2010 to around $94bn at the end of June 2017. Meanwhile, the global hedge fund industry had net outflows for six successive quarters between the end of 2015 and the beginning of this year, according to data provider HFR.
In response to the trend, JPMorgan Asset Management has launched its first two ETFs in Europe, which follow alt beta principles and are designed to replicate two chief hedge fund strategies: “long-short equity”, which makes calls on which stocks will go up and down, and “managed futures” products, which use futures contracts — the obligation to buy a security at a later date — to take on exposure to commodity markets.
The long-short equity fund will cost investors 67 basis points, while the managed futures fund costs 57 bps. The industry average for mutual funds that follow the same strategies is 0.7-1.3 per cent — below typical hedge fund fees.
Cost is not the only attraction for investors in alt beta products. If used in a mutual fund or ETF structure, investors have much easier access to their capital if they wish to withdraw, unlike in hedge funds, which typically have features such as lock-up periods that make it hard for clients to redeem their investments on demand. As a result, alt beta strategies are not only being targeted at investors who have historically used hedge funds, but also smaller investors who would not normally have considered hedge funds due to their high cost and inflexibility.
“Alt beta democratises access to hedge fund investing for a broader set of investors,” says Yazann Romahi, chief investment officer of quantitative beta at JPMAM.
Among the types of hedge fund strategies that are most at risk of being replicated in this way are: merger and acquisition arbitrage, which takes bets on companies that are involved in corporate consolidation; momentum, which invests according to the direction of the market; and managed futures.
Because of the threat alt beta poses to these strategies, some hedge fund managers have started launching their own lower-cost products as a defensive measure.
One such firm is Aspect Capital, a quantitative hedge fund with $7bn under management that uses mathematical models to follow investment factors such as momentum and value while minimising correlation with traditional asset classes. It launched an alt beta fund in July after receiving requests for such a product from clients.
Anthony Todd, Aspect’s chief executive, says not all funds that try to replicate hedge fund strategies do so as effectively. “There has been a proliferation of very low cost, off-the-shelf, naïve products. That is a dangerous proposition,” he says.
“Our programmes are a premium. They might be tens of basis points more expensive, but the risk of getting it wrong could lead to losses of hundreds of basis points.”
Mr Venuto thinks his former peers in the hedge fund industry will not be totally overrun by the rise of alt beta. Regulators have hindered the development of certain types of ETFs, including inverse and leveraged strategies, which employ hedge fund techniques such as shorting and using debt.
He also says there are certain assets that hedge funds can invest in that are illiquid and require a lack of transparency, which would be inappropriate for ETFs to use. Infrastructure would be one example.
Mr Venuto believes that just as hedge funds came up with the strategies that have informed the creation of the current crop of alt beta funds, they will inspire future generations of products.
“I don’t think hedge funds will go away,” he says. “They will become research and development labs for what will become ETFs in five to 10 years’ time.”