You can lead an investor to liquid alternative beta, but you can’t force him or her to drink it. That’s the tongue-in-cheek sort-of message behind a white paper academic study released by Credit Suisse (NYSE:CS) Asset Management this week on liquid alternative beta (LAB, for short), better known as hedge fund replication.
The report (click here to download in PDF form; click here for Credit Suisse’s LAB Web page) argues that just as index-linked investments in the long-only world have slowly but surely gained traction and acceptance, so too will LAB gain acceptance as an effective diversification and portfolio management tool – eventually.
Indeed, authors Jordan Drachman and Peter Little make the case that in a world where investors absolutely need and want liquidity but not at the expense of sacrificed expected returns, using liquid instruments to replicate both the return and risk characteristics of otherwise less-liquid strategies like hedge funds has already become a necessity for anyone looking to run a balanced, liquid, diversified (did we mention liquid?) portfolio.
In other words, you can actually force a camel, err, investor, to drink, or at least convince them to test the water.
So how does one go about building the ideal “LAB” portfolio? According to the report, the first step is to identify which traditional and alternative beta factors best represent the exposures of individual hedge fund strategies. Next is to find proxies that sufficiently represent these factors, usually custom-made ones.
The chart below offers a few examples of traditional and alternative beta factors, the hedge fund strategies to which they correspond and their respective proxies. Certain strategies’ exposures—such as long/short equity and event driven—can include a combination of traditional and alternative beta factors.
According to the white paper, the key challenge to replicating the performance of hedge fund strategies is to determine how to combine these liquid exposures in a manner that best preserves the characteristics of hedge funds, especially their risk/return profiles. In an effort to tackle this challenge, Creidt Suisse’s “LAB” team partnered with the likes of Professor William Fung of the London Business School and David Hsieh of Duke University to help prove their point.
And their findings? That seven liquid factors can explain up to 80% of monthly return variations for diversified hedge fund portfolios, and that based on identifying those seven liquid factors and quantitative factors that LAB can be created: hedge-fund-like returns and volatility by investing in liquid market instruments, with the added benefit of daily liquidity.
The paper further explains not only how LAB can replicate aggregate hedge fund returns, but also why it’s more intuitive than many think. In a nutshell, what the paper’s authors call view commonality – the notion that individual managers’ views (in the form of exposures) are aggregated in a hedge fund index and tend to cluster into common themes that drive the overall performance of the index; and exposure inertia – the notion that the large number of decision makers in a hedge fund index reduces the speed at which the common views or exposures change over time – are the two not-so-complicated keys to putting LAB to work.
Indeed, using the long/short equity sector as an example, the report uses the illustration below to show how common positions tend to cluster in certain areas (each color represents the various positions of an individual manager). These clustered positions become the prevalent themes driving the index performance, while the impact of the more dispersed exposures is muted.
The report notes that if the core themes that drive hedge fund index returns changed rapidly, multi-factor replication models obviously would have difficulty identifying them – mainly because the data is typically historical data and can quickly become obsolete if exposures change rapidly.
In reality, however, these core factors take time to change because of the large size of the pool of investment decisions that an index captures – because while a single hedge fund has relatively few decision makers and can act rapidly on its views, a hedge fund index contains hundreds of decision makers, with the chances of them reaching consensus and moving quickly in the same direction in unison remote.
A more likely scenario is that a few managers move first, and then, if their views turn out to be correct, others will follow,” the report says. “As a result, the index is only impacted if a large percentage of managers jointly switch their views and move in the same direction. This exposure inertia allows replication models to identify and track the changes in the core factors over time.
And the benefits of employing LAB? There are many, according to the report: providing hedge fund-like exposure, position transparency and daily liquidity and valuations, to be sure, but also the ability for investors to quickly and tactically increase and decrease exposures, easier “rebalancing” of hedge fund allocations, headline risk reduction and minimal capacity restrictions.
In short, the concept of LAB is not only alive and well, but actually works, according to Credit Suisse. So you can force a hedge fund investor to drink after all.
The only question in our view is what happens when everyone rushes the oasis and the water runs out.