Alternative beta

Alternative beta

Alternative Beta refers to alternative systematic risks in the context of Harry Markowitz’ modern portfolio theory. Systematic risks are risks that cannot be diversified away and are compensated through risk premia (the expected rate of return above the risk-free interest rate).

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 or outperformance). 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 skillbased. 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. The more discerning investors have started to question whether hedge funds really provide alpha or just some “new” form of 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.

To get a better overview of the difference between traditional and alternative betas, it is beneficient to separate them using the following framework.

eparation Based on Investment Exposures

Traditional betas can be seen as those related to investments the common investor would already be experienced with (examples include stocks and most bonds) whereas alternative betas will include all other types of investments. Non-traditional investment risks are often seen as being riskier, because the investor is less familiar with them. Typically exposure to traditional betas can be gained through indexation.

eparation Based on Investment Methodologies

A second way to differentiate traditional from alternative investments is to consider investment methodologies. Alternative techniques (e.g. short selling, derivatives, leverage, etc.) are often less well understood than "simple" long-only strategies and therefore regarded as more risky.

Viewed from the implementation side, investment techniques and strategies are the means to either capture risk premia (beta contribution) or to obtain excess returns (alpha contribution). Whereas returns from beta are a result of more or less passively exposing the portfolio to systematic risks, alpha is an exceptional return that an investor or portfolio manager earns due to his skill, exploiting market inefficiencies or superior information either in the traditional or alternative investment space. Some recent studies support the idea that the return from an investment mainly consists of risk premia (see diagram).

There are currently two main approaches to identify alternative betas presented in the market
# the risk premium driven approach by AlphaSwiss Group in Switzerland, as described above and
# the factor-based approach developed by professors Bill Fung (London Business School), David Hsieh (Fuqua School of Business, Duke University) et al.

The word combination "alternative beta" is a registered trademark of AlphaSwiss Group, Switzerland.


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