PORTFOLIO DISCUSSION INVESTMENTINVESTMENT ALTERNATIVE BETA INSIGHTSINSIGHTS Redefiningα lpha and βeta

September 2014

Connecting you with IN BRIEF our global network of investment professionals • Alternative beta (alt beta) strategies extend the concept of “beta investing” from long-only traditional strategies to strategies that include both long and short investing. Although alt beta approaches have relevance for different categories of alternatives, this paper focuses on hedge-fund-related strategies, currently the most prevalent form. • Alt beta strategies are rules-based strategies designed to provide access to the portion of hedge fund returns attributable to systematic risks (beta) vs. idio- AUTHORS syncratic manager skill (alpha). As a result of these new strategies, a component of hedge fund returns previously viewed as alpha has been redefined as beta. • We see this redefinition of alpha as beta to be a transformational trend in hedge fund investing: –– Alt beta strategies are designed to provide access to the potential diversification, downside protection and risk-return efficiency for which hedge fund strategies are valued—in a more liquid, low-cost and transparent format. –– These strategies can complement traditional, actively managed hedge fund Soheil Galal allocations and provide more discriminating tools to support alternative Managing Director manager due diligence. Global Investment Management Solutions–Global Multi-Asset Group Alternative beta (alt beta) strategies have opened a new avenue for accessing the investment characteristics for which hedge funds have become highly valued.

These strategies provide ready access to uncorrelated returns that can help improve Rafael Silveira portfolio diversification, risk-return efficiency and volatility management—without the Portfolio Strategist high fees, lock-ups and limited transparency often associated with hedge funds.1 Global Strategy A passive, rules-based approach gives alt beta strategies the ability to provide liquid, low-cost and transparent access to the beta (vs. alpha) portion of returns typically associated with hedge funds. As a result, these strategies can be a valuable comple- ment to portfolios for investors that want to: • access investment characteristics previously available only via hedge funds • expand an existing hedge fund allocation or improve its fee, liquidity and transparency profile Alison Rappoport Associate 1 As the term implies, alternative beta strategies are not restricted to strategies designed to provide Global Investment Management exposure to the beta portion of hedge fund returns. This paper, however, focuses on hedge-fund-related Solutions–Global Multi-Asset Group strategies, currently the most prevalent form.

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• have hedge fund exposure while conducting manager due • Traditional capitalization-weighted (cap-weighted) equity diligence to initiate or enhance a hedge fund program index strategies are intended to provide exposure to • gain new perspective on the performance of active, alpha- market risk (beta) as represented by traditional, cap- generating hedge fund strategies by comparing them with weighted indices, in a cost-effective, investable format. alternative beta benchmarks • Strategic/smart beta equity strategies2 are designed to provide exposure to the risks associated with traditional, In general terms, beta is the return an investor earns for being long-only equity investing, using non-market-cap-weighted exposed to the risks of the overall market; alpha is the addi- approaches. Strategies may include equal-weighting the tional return a manager generates through skilled investing. stocks in an index or weighting the stocks based on exposures For example, returns from investing in an actively managed to factors such as value, size, momentum and volatility, in an U.S. large cap equity fund can be thought of as a combination attempt to improve the risk-return-efficient capture of of the reward for bearing market risk, or beta (as measured by general risk premia in equity markets. the correlation of the fund’s returns to those of the S&P 500 index), and alpha—the additional layer of returns the manager • Alt beta strategies, which take long and short positions, are is able to generate over the S&P 500. designed to provide systematic exposures to the factors (betas) associated with hedge fund investing, given that In both the traditional and the alternatives spaces, today’s hedge fund returns can now be separated into alpha and “alpha” is morphing into tomorrow’s beta. So-called “beta beta components. strategies” are blurring the alpha/beta distinction, introducing new terminology and raising questions in the minds of investors Q: Historically, how did beta investing arise—and why is attracted to the characteristics these strategies are designed this trend so important? to provide. RAFAEL: Initially, returns from active investment manage- Soheil Galal, Managing Director with J.P. Global Investment ment were attributed almost entirely to security selection—that Management Solutions-GMAG and Rafael Silveira, a Portfolio is, to manager skill (or alpha). Over time, more and more of Strategist with J.P. Morgan’s Global Strategy team, address that “alpha” is being redefined as “beta.” In other words, some of the key questions they are hearing from clients through rules-based strategies, these underlying drivers of regarding beta strategies in general and alt beta strategies in return are becoming more readily “investable.” That’s particular. We hope their insightful answers and definitions extremely important for investors because it means more will enhance an understanding of what alt beta strategies ways to access and combine the different components of tra- are—and what they are not. ditional and alternative returns, more opportunity to optimize management fee expenditures and more-objective bench- Question: Let’s start with some basic definitions. marks for assessing manager-generated returns. Broadly speaking, what are beta strategies? SOHEIL GALAL: Beta strategies are strategies designed to Q: Can you take us through the key developments in provide investors with the portion of returns attributable to a beta investing? market’s overall systematic risk (or beta) vs. returns attributable RAFAEL: Sure. Let’s start with market index funds—the to idiosyncratic manager skill (or alpha), using a methodical, reincarnation of market indices in an investable form (Exhibit 1, rules-based approach. next page). In 1975, John Bogle launched the first mutual fund designed to track a capitalization-weighted index. This offered Q: What types of strategies are included under the investors a passively-managed, low-cost way to gain exposure “beta strategies” moniker? to systematic market risk—by essentially buying the market. RAFAEL SILVEIRA: Market index, strategic (or “smart”) beta More recently, with the introduction of exchange-traded funds and alternative beta strategies all fit under the classification of (ETFs), investors now have additional intra-day trading flexibility beta strategies. What distinguishes them from one another are when investing in these strategies. the different markets and associated beta risks (and rewards) they are designed to gain exposure to. Specifically: 2 Although this paper focuses on strategic beta equity strategies, similar techniques can be applied to other asset classes, such as commodities or bonds.

2 | Alternative beta: Redefining αlpha and βeta Today’s alpha is tomorrow’s beta EXHIBIT 1: AN ALPHA-TO-BETA TIMELINE

1896 1957 1975 1993 1998–present Dow Jones S&P 500 Bogle launches Fama-French MSCI factor Industrial Average launched first index fund three-factor model indices launched

Stock selection key to equity Equity beta as a growth Size & value identified MSCI introduces full set returns; indices non-investable risk premium investable as separate risk premia of long-only factor indices α α α β Value α β β Small cap β β Value β Momentum β Small cap β Min volatility

Source: J.P. Morgan. For illustrative purposes only.

Less than two decades later, academic research began to iden- • Fundamental indexation, which uses different tify other systematic risks, behavioral anomalies and structural fundamentally-driven definitions of company size to inefficiencies driving equity returns, such as value, size, determine weights. These measures include total annual momentum and low volatility.3 Cap-weighted indices and their dividends, cash flow, sales and book value. associated index funds provided some exposure to these systematic risks. However, experience showed that long-only • Optimization, in which weights are found through the active managers were able to “beat” cap-weighted market maximization or minimization of some mathematical indices by “tilting” toward stocks with these particular charac- function and include procedures such as minimum variance teristics. This suggested that there were more efficient ways to and maximum diversification access these return drivers than through cap-weighted indices. • Heuristic indexation, which uses concepts such as equal weighting, market-cap weighting with restrictions Q: And the search for a more risk-return-efficient on concentration and equal risk contribution (from stocks approach to accessing these systematic risks led to the or sectors) development of strategic (or “smart”) beta strategies? Interestingly enough, the study found that each of these RAFAEL: That’s right. Research has indicated that there are approaches was able to beat a cap-weighted approach over the better equity investment approaches than cap-weighting that long run, delivering a higher risk-adjusted return. The authors can provide investors with equity exposures in a more risk- also point out that these strategies have higher turnover than reward-aligned manner. With these developments, another the traditional market-cap-weighted scheme, with fundamental slice of market return, previously viewed as alpha, was indexing having the lowest turnover. However, their research reclassified as beta. suggests that the incremental transaction cost should not be There are a variety of equity strategic beta approaches. sufficient to wipe out the excess return of the strategic beta Borrowing the terminology used in a 2013 paper by Clare, strategies over the traditional market-cap-weighted approach. Motson and Thomas, these beta strategies can be bucketed into three categories:4,5 Q: What, then, is alternative beta?

3 Among the most familiar multi-factor models is the Fama-French three- SOHEIL: Alternative beta (alt beta) extends the concept of factor model, which includes the market, size and value factors. Eugene F. beta investing from long-only traditional assets (i.e., equities Fama and Kenneth R. French, “The cross-section of expected stock returns,” The Journal of Finance, Vol 47, Issue 2 (1992); Fama and French, and bonds) to long-short investing in traditional and alterna- “Common risk factors in the returns on stocks and bonds,” The Journal of tive assets. These strategies are designed to build exposure, Financial Economics. Vol 33, Issue 1 (1993). 4 Andrew Clare, Nick Motson and Steve Thomas, An Evaluation of Alternative for example, to hedge-fund-related risk factors by following Equity Indices—Part 1: Heuristic and Optimised Weighting Schemes (March specified rules and investing in individual securities. 30, 2013). Available at Social Science Research Network (SSRN): http:// ssrn.com/abstract=2242028 or http://dx.doi.org/10.2139/ssrn.2242028. 5 Clare, Motson and Thomas, An Evaluation of Alternative Equity Indices—Part 2: Fundamental Weighting Schemes (March 30, 2013). Available at SSRN: http://ssrn.com/abstract=2242034 or http://dx.doi.org/10.2139/ ssrn.2242034. J.P. Morgan Asset Management | 3 INVESTMENT INSIGHTS AlternativePORTFOLIO DISCUSSION: beta: Redefining Title Copyα lpha Here and βeta

Q: Why do we refer to this as “systematic” risk—why HEDGE FUND STYLES AND ALTERNATIVE should this risk premium persist? BETA FACTORS SOHEIL: The deal risk premium in this trade persists because Alternative beta comes in multiple flavors that typically have many investors holding the target firm’s stock are more com- low correlation to one another: fortable with selling their positions to lock in immediate post- announcement gains than with holding the stock for a chance to • Equity long/short invests in top-ranked stocks while shorting bottom-ranked stocks from a global gain a little bit more while being exposed to the risk of the deal developed market universe, capturing momentum, value, failing. This is a logical risk-return trade-off for an individual size and quality factors. investor. However, given the nature of these deals and the advantages of diversification, taking on the deal risk premium • Global macro seeks some of the liquid and systematic risk across all deals should over the long term result in a net gain. premia captured by macro hedge funds, including term premium, fixed income carry, commodity roll yield, commodity momentum, foreign exchange (FX) carry and Q: So, like owning a market index to gain exposure to FX momentum factors. the risks of “being in the equity market,” investing in alt beta strategies is intended to provide exposure to • Merger arbitrage focuses on the deal risk premium factored into the price of the merger-target stock until the the inherent risks of hedge fund strategies, including, deal is completed. for example, merger arbitrage?

• Convertible bond arbitrage focuses on the illiquidity and SOHEIL: Yes, that’s right. And this is just one example of how small cap premia available in the convertible investors can gain access to a hedge fund style premium with- bond market by capturing the underpricing of the out paying the 2-and-20 fees often associated with actively embedded optionality. managed hedge funds. What’s more, capturing the different

Source: J.P. Morgan. hedge fund style-related betas in a diversified portfolio has the potential to offer highly risk-return-efficient access to these risk premia.

Alt beta strategies include a variety of hedge fund styles, Q: How are institutions typically accessing such as equity long/short, global macro, merger arbitrage alt beta strategies? and convertible bond arbitrage (see sidebar). SOHEIL: Most investors are relying on experts who offer high Q: Can you give an example of a hedge fund strategy or quality alternative beta strategies. We have seen some inves- factor and what you mean by constructing it through a tors that have tried to build up alt beta exposures internally. rules-based strategy that invests in individual securities? However, consider the merger arb example: While the rule may be simple, the buying, tracking and selling involved would SOHEIL: A strong example of this is a strategy for capturing be difficult for a single investor to do. the “deal risk premium” in merger arbitrage (the return for taking on the risk that a deal will not be completed, post- Q: There are a lot of terms out there—such as “alt beta,” announcement). A skilled hedge fund manager may be able to “hedge fund replication” and “liquid alternatives.” improve returns (that is, add alpha) by carefully analyzing and Do they all refer to the same thing? selecting the most profitable deals. However, the systematic deal risk premium can be captured through a more passive, SOHEIL: The term liquid alternatives (liquid alts) actually rules-based strategy, namely going long the target (acquiree) refers to an expanding category of investment approaches, stock while shorting the acquirer stock, across all announced including alt beta, hedge fund replication strategies and liquid deals, within defined parameters. versions of active alternative managers’ funds (that is, those offered in the form of U.S. registered mutual funds and ETFs In other words, we build these risk exposures from the bottom under the Investment Company Act of 1940). By some up. This approach has allowed hedge fund factors to move out definitions, less-benchmark-constrained strategies not of the halls of academia and into investors’ portfolios. confined to long-only investing in equity, fixed income and commodity markets are also considered liquid alts.

4 | Alternative beta: Redefining αlpha and βeta The common theme in all of these strategies is that they can Q: How should clients think about using alt beta provide exposure to at least some of the return components of strategies within their portfolios? actively managed alternative/hedge fund strategies but are RAFAEL: As a lower fee, more transparent, liquid way to access generally more liquid and accessible. It is important, however, alternatives/hedge funds, alt beta strategies can be incorpo- to note some of the differences between alt beta and hedge rated into investor portfolios to meet a number of objectives. fund replication strategies: Some investors are taking a core/satellite approach to hedge Alt beta strategies, as we have defined them, are designed to fund investing, using a multi-strategy alt beta portfolio to build beta exposures common to specific hedge fund styles establish a core allocation. Investors value these strategies as through rules-based processes that invest in individual securi- a way to help build a hedge fund allocation with a more cost- ties and use long/short techniques. These strategies tend to effective fee structure and attractive liquidity profile. be beta neutral. What’s more, the individual hedge fund style betas generally have low correlation to one another. Combined Alt beta strategies can also be used as placeholders while in a well-constructed portfolio, they can therefore provide an investors research active managers. Investors starting up or attractive, diversified source of hedge fund beta returns. building out a hedge fund allocation can invest initially in a

Hedge fund replication approaches the problem from a different angle. These strategies attempt to capture the performance of ALT BETA MANAGERS: AN INVESTOR hedge fund strategies based on historical statistical relation- CHECKLIST ships and then use that information to establish the fund’s exposures going forward. Overall, this is fundamentally Investors should consider their specific objectives, policy constraints and the following questions when evaluating alt different from alt beta’s real-time, bottom-up approach and beta managers: may result in significant correlation to traditional markets. ;;What are the strategy’s volatility and return targets? Q: Are all alt beta strategies created equal? ;;If investing in a multi-strategy portfolio, what are the SOHEIL: Assuming that different providers are applying the underlying strategies? same type of rules-based approach in constructing their strate- ;;What vehicles are used in implementing gies, there are going to be a lot of similarities among alterna- the strategy tive beta products. But there are significant differences as well. — for example, to what extent are derivatives employed? Does the manager have the resources required for For example, each alt beta strategy has its own volatility and effective execution? return targets. Among multi-strategy portfolios, strategy composition can differ. Even at the individual strategy level, ;;What level of transparency does the manager offer? definitions of and approaches to accessing given risk factors ;;What is the fee structure? are not necessarily uniform. ;;How liquid is the strategy? There can be differences in execution as well. For example, ;;Is the strategy designed to be neutral to traditional some managers, even within generally rules-based strategies, market beta? do express market views. Given the different construction techniques used by different managers, alt beta strategies can ;;Does the manager express market views in managing often be complementary and diversifying when used within the strategy? a portfolio. Fees, liquidity, transparency and leverage can ;;How does the strategy correlate with existing also vary. The right choice depends on the investor’s own alt beta, hedge fund or traditional allocations in objectives and sensitivities. the investor’s portfolio?

We provide a checklist for investors considering an allocation ;;What is the manager’s experience and track record in managing the various underlying to alt beta strategies (see sidebar). And because alt beta strat- alt beta strategies? egies are often imperfectly correlated, we encourage investors to diversify among those they view as the best providers. Source: J.P. Morgan.

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diversified portfolio of alt beta strategies—and then replace Q: So where do we go from here? some or all of that allocation with the skilled active managers SOHEIL: The access to alternative beta strategies in an they identify through their due diligence efforts. investable form is having a profound impact on the shape of Beyond their hedge fund allocations, investors are looking to alt alternative investing. Alt beta strategies can not only provide beta strategies as a supplement to fixed income allocations—an liquid, low-cost and transparent access to investment styles approach to gaining diversification benefits without the interest typically associated with hedge funds, they are also raising the rate sensitivity of bonds in a rising rate environment. bar for alternative managers. Before the industry accepted that there was something called alternative beta, there was no And, of course, some investors’ policy statements don’t permit beta; everything was seen as alpha. With the identification of investing in hedge funds. For them, alt beta strategies provide the systematic, beta portion of these strategies, beta becomes a way to gain exposure to the characteristics of hedge funds the bar. You have to outperform the beta. (such as diversification, risk-return efficiency and volatility management) without a major policy change. We anticipate a continuation of these advances in rules-based generation of alternative risk premia and further reclassification Q: What other applications do you envision? of today’s alpha as tomorrow’s beta. In our view, these develop- ments should benefit investors by providing more efficient SOHEIL: Well, just as traditional market indices have become access to the diversifying, return-enhancing characteristics they the benchmark against which active managers are evaluated, look for from alternatives, as well as more discriminating tools we believe there is a similar role for alt beta. Now investors can for identifying highly skilled alternatives managers. more clearly assess what portion of a hedge fund manager’s returns are idiosyncratic or non-replicable alpha vs. more readily accessible alternative beta.

PIONEERING THE ALTERNATIVE BETA SPACE: A VIEW FROM PORTFOLIO MANAGEMENT

Yazann Romahi Portfolio Manager Head of Quantitative Portfolio Strategies for Investment Management Solutions-Global Multi-Asset Group

Yaz Romahi’s development of the alternative beta investment space has moved alternative beta from a theoretical concept to an investable reality over the last five years. A key thesis in the alternative beta offering he has developed is that it raises the standard for hedge fund managers and investors. In the same way that traditional managers need to outperform traditional beta, Yaz has called for alternative beta to act as a tool for evaluating alternative investment managers as well as reducing investment fees.

Q: What is your view on alternative beta and how alpha and beta are being redefined?

ROMAHI: Hedge fund investments have entered the mainstream and become a standard part of asset allocation due to their attractive diversification benefits. As a result, academic interest in their sources of return has intensified. The academic literature has increasingly been able to describe the return drivers behind a wide range of hedge fund styles because, typically, there are common risk exposures shared by hedge fund managers pursuing similar strategies. Since these return drivers are systematic in nature, they have been termed alternative beta. Alternative beta provides access to the returns to factor risks that are uncorrelated to market risk and typically due to behavioral biases, market anomalies, systematic deviations from equilibrium or alternative risk premia. These risk factors can typically capture a meaningful portion of hedge fund returns.

Ultimately, the growing knowledge around the concept of alternative beta will lead to the reclassification of a significant portion of what is today considered “alpha.” Furthermore, increased understanding by investors of the factor risk exposures associated with different hedge fund styles will help in the pursuit of better diversified portfolios with greater transparency. The development of strategies that have made the concept of “alternative beta” investable has provided investors with a compelling portfolio solution.

6 | Alternative beta: Redefining αlpha and βeta HOW J.P. MORGAN DEFINES INNOVATIONS IN ALPHA AND BETA ACCESS Innovations for gaining exposure to the drivers of return—in index by GDP in an attempt to improve the risk-return- more transparent, liquid and/or cost-effective ways—have efficient capture of general risk premia in these markets. spawned new, often confusing terms. We provide the following • Alternative beta (alt beta) strategies are designed to provide definitions, which J.P. Morgan Asset Management strives to use exposure to the factors associated with hedge fund investing. with consistency to promote clarity in communications with Historically, hedge fund returns were attributed to alpha, or our clients. manager skill; today those returns can be broken down into Beta strategies encompass market index, strategic (or “smart”) alpha and beta components. For example, merger arbitrage beta, as well as alternative beta strategies. These strategies strategy returns can be separated into a skill-based com- generally use rules-based approaches and invest in individual ponent (alpha) and a component due to systematic exposure securities, but are distinguished by the different markets to factors inherent in merger arbitrage investing (beta). and associated “beta” risks (and rewards) to which they are Liquid alternatives (liquid alts) refers to an expanding category designed to gain exposure. of investment approaches, including alt beta strategies, hedge • Traditional capitalization-weighted (cap-weighted) index fund replication strategies and liquid (i.e., U.S. registered mutual strategies are intended to provide exposure to market risk fund) versions of alternative/hedge fund managers’ strategies. (beta) as represented by traditional cap-weighted indices, in These strategies are designed to provide exposure to one or more a cost-effective, investable format. of the return components (traditional market beta, alternative beta and/or alpha) of actively managed alternative strategies— • Strategic (or “smart”) beta strategies are designed to generally with lower fees and greater liquidity and transparency. provide exposure to the risks associated with traditional, long- only investing, using non-market-cap-weighted approaches. • Hedge fund replication attempts to mimic the performance Strategies may include weighting the stocks in an index based of hedge fund strategies based on historical statistical on exposures to factors such as value, size, momentum and relationships, which may result in a significant correlation volatility or weighting the bonds in a global government bond to traditional markets.

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