While it is true that the concept of ARP is irrevocably tied to that of hedge funds in that it seeks to harness the same risk premia that have historically gone a long way towards explaining the returns that were associated with so-called ‘hedge fund alpha’, this is where the objective comparison ends. For years, many hedge funds were associated with opaque investment approaches and investors were required to pay excessive fees in order to access this largely unquantifiable ‘magic sauce’ which promised to transform the overall performance and efficiency of their investment portfolios. Conversely, if correctly implemented, alternative risk premia strategies can offer valuable diversification into uncorrelated sources of return with complete transparency, daily liquidity and low costs.
‘Smart beta’ has quickly become a buzz term relating to something mystical that nobody really understands the true meaning of, but everyone allegedly wants because they believe all their peers are benefiting from it. However, ARP has nothing to do with this concept, since smart beta actually refers to the notion of reweighting broad equity indices based on different indicators (such as price / earnings ratios – a measure of the relative expensiveness of individual stocks) with the aim of generating a return that is fundamentally different to that derived from index tracking. The latter is inherently dependent on often random (‘un-smart’) and individually large share price movements of heavily weighted stocks due to their capitalisation. One of the early pioneers of smart beta fittingly referred to the notion of ‘fundamental indexing’. Consequently, the more popular euphemism of ‘smart beta’ is just another example of the financial industry’s amazing ability to come up with fancy names for rather intuitive concepts.
Perhaps an easier definition of ARP is to use the simpler concept of alternative beta. ARP strategies are effectively an extension to the approach of factor investing across multiple factors and asset classes – not just equities. The objective is to attract sources of returns historically referred to as alpha but which have been academically recognised as ‘hidden beta’ or risk premia. This kind of beta cannot be accessed by long-only investment approaches but instead harnesses those techniques that that have largely been employed by the hedge world – such as spread trading (long / short), the use of non-linear payment profiles (options) and dynamic exposures (leverage). ARP strategies can be defined as ‘liquid diversifiers’ due to the liquidity of the instruments in which they invest and a return profile that is designed to be lowly correlated to that of traditional assets.
Having once been considered the ugly duckling within the alternative investment universe with the invidious task of letting the beautiful hedge fund swans know that their realised performance might not quite live up to appearances, ARP has in fact grown into a beautiful white swan itself. Consequently, the concept is now establishing a very firm footprint among the global investor community, particularly since ARP strategies possess the potential to generate performance patterns which have, until recently, largely remained uncaptured, or were accessible only to the most sophisticated hedge fund managers, in a format that is also transparent, liquid and cost-efficient. But it is accurate to state that a large proportion of the ARP universe have yet to establish the length of proven track record that would entice a conservative investor (although it is worth noting that some members of the GAM Systematic team have been trading ARP for more than 14 years). Similarly, defining the size of the burgeoning ARP ‘industry’ accurately is a tough objective given our view that some ARP offerings could not accurately be described as ‘pure-play’ ARP. However, as of Q4, 2018 Cambridge Associates reported that they were monitoring a universe of 33 ARP strategies with collective assets under management in excess of USD 73 billion1 for the purposes of ongoing research – far too large, in our view, to be described as ‘niche’.