Nevertheless, the founding and managing partner of Connecticut-based quant manager AQR Capital Management persevered with this notion and as an evolution of that early insight, Asness now points out that even after accounting for the market exposure, hedge fund returns are not all alpha. Much of the industry’s returns can be better classified as hedge fund beta. Hedge fund betas are common risk factors shared by hedge fund managers (or other active investors) pursuing similar strategies. Many of these hedge fund betas can be captured through a bottom up, systematic implementation of the strategies and at the same time, hedge fund betas have an economic intuition that explains their returns. Asness is quick to point out that while investors should not pay as much for hedge fund beta as they pay for hedge funds in general, as there is no “magic” here, this still represented a sustainable and viable investment strategy to exploit.
AQR launched a product off the back of this work last year – the DELTA strategy – which is designed to provide investors with efficient, diversified, low cost exposure to a collection of underlying hedge fund betas with low leverage, improved liquidity and high transparency. The most aggressive version of the DELTA returned 26 per cent in the 12 months to September 30 after fees with a realised volatility of 5 per cent and a lower-octane version, which is what is now being marketed in Australia through an ASIC-registered local trust, returned 13 per cent after its, lower, fee. AQR is quick to point out that the return has been higher and volatility lower than they’d assume over the longterm, as this has been an exceptional 12 months, though an exceptional 12 months that saw the opposite results for many existing hedge funds. The DELTA strategy is not hedge fund replication, Asness stresses, though it shares many of its goals. It invests in the same underlying instruments that the hedge funds represented in the main indices invest in themselves, rather than replicators who use a mix of high level investments, largely futures and a lot of cash, which happen to correlate to the indices (but not capturing the spirit of the actual strategies as DELTA does).
The same is true of the alternative beta approach at Partners Group, whose ‘Risk Balanced’ strategy (which enjoys a berth on JANA’s TriplePoint hedge fund program) can provide fundamental, real-world explanations for its performance (which is 3.4 per cent net of fees for the year to September 30). For example its two biggest performance contributors in September, according to the latest investor report, were its Event Driven strategy (due to an increase in M&A activity and a directional exposure to global ex-US equities) and its Global Macro/CTA strategy (due to continuation of the carry trade and persistence of trends in the commodity markets, particularly on its long positions in cocoa and shorts in rice and wheat). Asness’ long-held view is that most hedge funds have been too closely correlated with the markets, and work by AQR shows that this correlation has been rising over the past few years.
With DELTA, the market exposure is taken out, leaving the return from systematic trading strategies which are designed to match all but two of the Tremont hedge fund index’s categories. This was clearly very helpful over the first few months of the fund’s life, the dreaded fourth quarter of 2008 when the DELTA fund was positive. AQR employs more than 65 underlying strategies for the fund. According to the AQR work, the correlation of the popular CS Tremont hedge fund index with the MSCI World Index since inception in 1994 is 0.65.
Over the past 10 years this has gradually risen to 0.91. Asness claims this as ample evidence that “not all that can be done should be done” and queries why you would want to replicate something that is not really alternative. Hedge fund beta is about capturing the risk premia associated with dynamic trading strategies rather than correlating to hedge fund indexes which he believes are poorly constructed and overexposed to market beta. Asness says that investors should not pay as much for hedge fund beta as they would expect to pay for other hedge fund investments, but the fee should be greater than a traditional index fund fee because of the greater complexity of the strategy implementation.
Most investors are still reeling from the various impacts of the financial crisis, one of which is the way correlations spiked to one. But Asness says that when he asks investors what sort of correlation to the MSCI World they would be happy with from their alternatives, the answer is usually about 0.5. With DELTA, AQR targets very close to zero. While he acknowledges that the short-term is more a case study than a proof, through some very rough markets over the first 12 months the correlation has indeed been approximately zero. The fund even made money in the cataclysmic December quarter of 2008, when almost all hedge fund strategies suffered. Asness believes that the correlations with major markets for the average hedge fund will probably decline again in the near future, but the popularity of their strategies is likely to mean that these correlations will remain “way too high”. While he says that investors should learn some lessons from the events of 2008, they should be careful not to “over-learn”. By that he means that investors generally become too risk averse after bad events, at a time when there are often more opportunities. “It’s an almost immutable law of the market that when fewer people want to do something it offers greater opportunity,” he says.
