Smart Alpha Vs. Smart Beta: Which Strategy Is Smarter?

RESEARCH PERSPECTIVE VOL.8 NOVEMBER 2015  Alexandros Kyparissis Associate Marketing Tel.: +447843144007 Email:alexandros.kyparissis@stonemountain-capital.com Smart Alpha Vs. Smart Beta: Which Strategy Is Smarter?   The main question of an investor is the asset class to invest in and its respective weighting. The first dilemma comes with the approach to follow regarding the allocation: active (smart alpha via hedge funds) or passive (smart beta via ETFs). Investing in traditional indices is substituted by ETFs, a 25-year market with increasing popularity, which attracts $3 trillion and overtook the long-standing hedge fund industry in terms of assets under management in Q2 2015.    Figure 1. Visualisation of ETF and hedge fund asset growth since 2004.  Smart-beta investing is an active approach within passive investments as they aim at capitalizing gains through alternative weighting methods. Their purpose focuses on replicating market’s performance and not beating the market, a feature differentiating them from hedge funds trying to generate returns that justify their higher fee structure. The discrepancy between the two asset classes expands to a variety of criteria. Apart from smart-beta strategies, there are strategic beta and dynamic beta strategies which add different strategies and tactical timing respectively to smart beta themes.   Starting from the accessibility of the two alternative classes, ETFs attract the whole spectrum of investors in contrast to hedge funds, which can be accessed only by accredited high net worth individuals and institutional investors and require a high minimum investment amount. Clearly, the current prevalence of ETF’s class over hedge funds is explained by their target investors’ group and not by performance criteria or the higher fees charged by hedge funds.   Fees charged by the active hedge fund managers are much higher than the respective of ETFs, which are justified by their sophisticated investing techniques and their tailor-made solutions. Hedge funds apply complex methods and occupy a lot of analysts to provide investors with alpha generating opportunities through a thorough glance and analysis at the markets. The remuneration package includes all these costs as well as motivation fees for aligning managers’ interest with those of investors. What investors actually pay though is the ability of hedge fund managers to apply active market timing and profit maximizing moves through capital preservation.   The smartest idea that arises from the above analysis could be an ETF replicating hedge fund strategy. The question is if this could be possible given the lack of information disclosure in hedge funds’ portfolio holdings; hence a direct replication through being long and short in underlying assets is inapplicable. There are ETFs mimicking hedge fund strategies and indices, but this apparently cannot produce similar performance to those of skilled active managers, but only of the whole spectrum of hedge funds.   Investors, before joining the recent ETF stampede, should base their investing decisions on their investment horizon. More investors translate to higher trading volume and intraday volatility as prices, in contrast to other mutual funds, are changing continuously throughout the day, introducing emotional effects and irrational decisions into a well-designed strategy. Additionally, the periodic rebalancing applied from smart beta strategies ignores market changes leaving investors exposed to distressed companies.   After the analysis concerning the idiosyncrasies of both asset classes, inevitably discussion should arise concerning their performance. The author’s perspective does not consider this comparison robust due to differences in their strategies and objectives. For this perspective’s case, a simple presentation of performance in term of returns and volatility is conducted, without suggesting basing investment decisions on the figures below. Figure 2. Equity-related indices’ returns since 2007. Stone Mountain Capital Research. SPY is the SPDR S&P 500 ETF HDG is the ProShares hedge replication, that track the performance of the Merrill Lynch Factor Model. Figure 3. Fixed Income-related indices’ returns since 2007. Stone Mountain Capital Research. IBDN is iShares iBonds Dec 2022 Corporate ETF, which tracks a Barclays global index of USD denominated, investment-grade corporate bonds.  Equity-related ETF tracking the S&P500 performed better after the 2008 crisis, while the ETF replicating hedge fund returns performed worse. 2008, the year of crisis, highlights the problems of periodic rebalancing in ETFs and the consequences of being exposed to distressed firms. In the credit side, which constitutes a more complex aspect of investment compared to equities, hedge fund managers performed much better than the Barclays Corporate Bond ETF, indicating the importance of skilled and active managers who understand the markets.    Figure 4. Sharpe Ratio of ETF and Hedge Fund Indices from 2007 to 2015. Stone Mountain Capital Research. SPY is the SPDR S&P 500 ETF. HDG is the ProShares hedge replication, that track the performance of the Merrill Lynch Factor Model. IBDN is iShares iBonds Dec 2022 Corporate ETF, which tracks a Barclays global index of USD denominated,   investment-grade corporate bonds. CS-HFI is the Credit Suisse Hedge Fund Index. CS-FI is the Credit Suisse Fixed Income Index. CS-L/S Equity is the Credit Suisse Long/Short Equity Index.   In the above figure, the better risk management sought from investors is observed, justifying the higher fees charged for these services by hedge fund managers. There is a huge difference in absolute figures of Sharpe Ratio between smart beta and smart alpha strategies, despite the bigger returns evidenced in ETFs during the examined period from January 2007 to September 2015. What is of high importance and investors should consider before making decisions is that they should not regard the indices as representative for the managers existing in the class.   Alternative investments and especially hedge funds produce uncorrelated to traditional investment returns which do not follow normal distribution, leading to unreliable conclusions. The dynamics of the applied hedge funds’ strategies and the serial correlation that may arise in the returns highlight the need for considering higher moments in distribution because Sharpe Ratio is heavily affected and underestimating the actual risk. For the purposes of this perspective, drawdown and Calmar ratio are used in order to access their differences in terms of performance. Figure 5. Maximum Drawdown of ETF and Hedge Fund Indices from 2007 to 2015. Stone Mountain Capital Research.   The problems of ETFs controlling risk and offering tailor-made solutions to risk-averse investors are evident after analyzing the maximum drawdown between January 2007 and September 2015. Smart beta strategies are extremely vulnerable to market conditions and the periodic changes applied do not allow for corrections, whilst hedge funds are better equipped when it comes to facing unstable market conditions. To further expand on the risk controlling side of both asset classes a frequency of drawdown over 10% is conducted to identify the level of protection investors are getting from their choices. Figure 6. Frequency of Drawdown  more than -10., Stone Mountain Capital Research.   The above graph shows the superiority of hedge fund managers to apply techniques to minimize the probability of extreme losses and the need for intensively active approach concerning risk management. The only ETF that indicates good risk management is the one replicating hedge fund returns. Calmar ratio is used in this analysis to integrate drawdowns in the risk-return profile for the examined funds as shown in the formula below. It is an alternative to Sharpe Ratio, but accounts more for the existence of skewness and kurtosis.   Calmar Ratio= Compounded Annualized Returns / ǀMaximum Drawdownǀ Figure 7. Calmar ratio for the examined funds, between 2007 and 2015. Stone Mountain Capital Research.   Calmar ratio, examined from January 2007 to September 2015, strongly indicates the superiority of the majority of hedge fund strategies in terms of risk-adjusted returns. Investors rarely consider solely the return profile of their investments but assess diligently their risk-adjusted return profile. This perspective underlines once again that the hedge fund side is represented by the index, containing both skilled and unskilled managers, which highlights the necessity of outsourcing the best managers in the class.   This perspective suggests thorough diligence and research on managers that produce robust returns with long standing track-record and constantly outperform the indices. There are skilled managers that apply smart strategies and are able to identify opportunities that other smart strategies cannot. While, no one can declare a clear winner, this perspective tips the scale in favor of hedge funsds. Contact This perspective is neither an offer to sell nor a solicitation of an offer to buy an interest in any investment or advisory service by Stone Mountain Capital LTD. For queries please contact Alexandros Kyparissis under email: alexandros.kyparissis@stonemountain-capital.com and Tel.: +447843144007.   For further information around our research and advisory services please contact Oliver Fochler under email: oliver.fochler@stonemountain-capital.com and Tel.: +447922436360. We are able to source any specific alternative investment search and maintain relationships with dozens of best-in-class hedge fund managers. We don't pass any costs on to our investors, since our compensation comes from our mandated hedge fund managers. Please contact us, should you require further information about our solutions. Copyright © 2015 Stone Mountain Capital LTD. 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