Alternative investment strategies are still considered expensive, illiquid and lacking transparency. However, the investment world has changed considerably in recent times. In addition to risk and return requirements, institutional investors have a variety of quality requirements as regards transparency, liquidity, costs and correlation to traditional investments. How can alternative strategies meet these high demands?
Alternative strategies are considered in a more differentiated way
The previously common distinction between traditional and alternative strategies – i.e. beta versus alpha – has recently given way to a more differentiated view. This change has been prompted by various developments in market structures and liquidity, but also by regulatory aspects. As a result, some of the strategies formerly described as alpha are now considered separately and referred to as alternative beta strategies. At present, a distinction is therefore made in the investment universe between traditional beta strategies (traditional long-only risk premiums, e.g. equity or bond investments), alternative beta strategies and alternative alpha strategies, with fees, liquidity, capacity and diversification characteristics varying within and between these segments. This more differentiated segmentation allows the offering to be tailored far more accurately to customer needs.
Alternative beta: Affordable access to alternative investments
Alternative strategies use techniques such as short selling, leverage and derivatives to reduce correlation with underlying markets. While alternative alpha strategies remain less liquid and lead to higher costs due to their limited capacity, the newly distinguished alternative beta strategies offer affordable access to alternative investments. They can also be a useful clever complement to reduce the overall costs of an allocation to alternative strategies. However, alternative beta strategies are by no means a new concept. What is new is that they are no longer offered under the guise of expensive alpha strategies, but are offered to investors separately – with lower fees and in liquid form. However, they also tend to offer a lower return and diversification potential than alternative alpha strategies. Within alternative beta strategies, a distinction is made between alternative risk premiums and hedge premiums.
Most commonly known types of risk premiums
Alternative risk premiums are style or factor premiums that persist over time, such as value, carry or momentum, which are recognized in scientific research and academic literature. They compensate the investor for taking non-traditional – and often non-diversified – risks.
- Value: Tendency for relatively cheap assets to outperform more expensive assets
- Momentum: Tendency of assets with recent out/underperformance to continue to out/underperform
- Carry: Tendency for higher yielding assets to outperform lower yielding assets
Clear barriers to entry for alternative strategies
These premiums are accessed by means of liquid instruments using systematic models. Hedge premiums refer to cost-effective and liquid implementations of alpha strategies. All alternative strategies have in common that they have clear barriers to entry. This is because their implementation requires very active portfolio management and specific knowledge, for example with regard to market timing. These hurdles manifest themselves differently depending on the strategy and can change over time, which requires a high level of specialization and constant further development of the models used. In line with the "best in class" approach, we recommend using a specialized portfolio manager who selects the best experts to implement alternative beta strategies.
Generate stable returns with the right mix
To invest successfully in alternative beta strategies, the right mix and a clever portfolio construction are key. Ideally, the building blocks – alternative risk premiums and hedge premiums – should be combined in such a way as to provide both affordable access and liquid implementation. At the same time, they should provide limited correlation with each other and also with traditional investments. For this reason, we recommend focusing on convergent and divergent implementations of alternative risk premiums and hedge premiums while avoiding linear strategies that correlate more closely with the market. The reason for this: Under stable market conditions, convergent strategies generate regular positive returns with relatively low volatility, whereas divergent strategies are effective in the event of large market movements such as those seen in March of this year. A balanced mix of convergent and divergent strategies therefore offers the greatest possible diversification benefit in a portfolio context. This reduces volatility, which is in line with the goal of generating stable returns regardless of market trends. This aspect is particularly important for pension funds, as they must be able to meet the pension claims of their beneficiaries at all times.
The correlation matrix (Fig. 2) illustrates how combining several alternative risk premiums delivers stable portfolio returns. If different alternative risk premiums in different asset classes are taken into account, this, together with differences in signal generation and portfolio construction, results in a more robust return profile at the portfolio level.
Hedge premiums and alpha strategies provide additional diversification opportunities. It is important to select them to provide unique alpha access, for example, through their specific approach, their focus on a particular asset class, their holding period or their investment process. They should also have limited beta compared to traditional asset classes. By smartly combining different hedge premiums and alpha strategies, it is possible to achieve a diversified breakdown across all major asset classes in the foreign exchange, bond and equity markets, as well as across selected commodities, longer or shorter holding periods and styles.
Alternative beta for first time investors or as a complement to existing investments
Alternative beta strategies offer pension funds various advantages. They offer those who have not yet used alternative strategies a good entry opportunity to diversify their portfolio without having to sacrifice too much liquidity. However, investors who already use alternative strategies can benefit too, as this allows them to cost-effectively replace or attractively supplement more expensive alpha strategies. This enables a stabilization of portfolio returns while keeping costs low.