Alternative Beta

Alternative Beta, in the context of risk premium oriented investing, is a concept that extends the idea of traditional passive investing into the alternative investment space. Alternative beta refers to risk premia which are available in the global capital markets beyond traditional equity or fixed income related long only investments. Generally risk premia are returns (above the risk-free interest rate) as compensation for taking systematic risks (risks which in the context of modern portfolio theory cannot be diversified away). Alternative risk premia are those that relate to active investment strategies including techniques beyond the traditional long only investment. These techniques are often associated with the activities of hedge funds (such as short selling, leverage, and derivatives trading).

Investment theory today commonly separates the return of an investment into the contribution resulting from risk exposure (risk premium) and one resulting from skill-based investing (alpha). This forms the academic basis for active and passive investing (indexing).

Separating returns into alpha and beta can also be applied to determine the amount and type of fees to charge. The consensus is to charge higher fees for alpha (incl. performance fee), since it is mostly viewed as skill based. The topic has received increasing levels of attention due to the very rapid growth of the hedge fund industry, where investment companies typically charge fees dwarfing those of mutual funds with the motivation that hedge funds produce alpha. Many investors have started to question whether hedge funds really provide alpha or just some “new” form of beta (i.e. alternative beta).

This question was first implicitly raised in 1997 by William Fung and David Hsieh in an influential paper on empirical properties of hedge fund returns (Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds). Following this paper, several groups of academics (such as Thomas Schneeweis et al.) started to explain past hedge fund returns using various systematic risk factors (i.e. Alternative Betas). Lars Jaeger was the first to address the related question whether investable strategies based on such factors can not only explain past returns, but also replicate future ones (Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investments in Hedge Fund Strategies Deliver?. His book (Alternative Beta Strategies and Hedge Fund Replication (Wiley)) provides an overview on the scientific approaches, the current state and the future of Alternative Beta and Hedge Fund replication (see also his interview on Opalesque.TV).