From the February 2009 issue of Wealth Manager Web • Subscribe!

February 1, 2009

BETA Made Simpler

Hedge funds suffered through a catastrophically bad year in 2008, with performance plummeting, investors redeeming billions of dollars and fund after fund biting the dust. Assets in the sector spiraled downward from approximately $1.9 trillion at the end of the second quarter to $1.5 trillion and counting at the end of October, according to Hedge Fund Research. Can anyone possibly see a silver lining in this grim cloudbank?

"Believe it or not, this is going to have a very positive implication for hedge fund investments," says Andrew Lo, chief scientific officer of AlphaSimplex Group, an affiliate of Natixis Global Asset Management. The turnaround won't happen for another six to nine months, he says; until then, "we're still going to be in shell shock and the general withdrawal of credit."

Then, Lo reasons, investors will realize that investing in the traditional framework of long-only stocks and bonds just does not work. That is, the flexibility to be able to sell short and to diversify over other asset classes are tremendous advantages to hedge funds that traditional investments cannot easily access. As proof of this, he points to performance numbers over the last 12 months. Although hedge funds did miserably in 2008 relative to their historical standards--down 18.3% for the year, according to HFR--they handsomely outperformed the S&P 500, which was down 40%.

"Right now there's a backlash to hedge funds, and people are withdrawing money like crazy," he says. "Sometime in the third or fourth quarter, there's going to be backlash to the backlash: People are going to realize that traditional investments aren't going to be able to cut it, and they're going to have to pursue other alternatives."

Lo, who is also a professor of finance at the MIT Sloan School of Management, has spent a good part of his professional life thinking about alternative investments. He founded AlphaSimplex 10 years ago. The firm started out focusing on hedge fund products for the typical traditional investors in the sector--family offices, high-net-worth individuals and funds of funds--but in recent years has developed products for the institutional and retail markets. Recently, its efforts have focused on hedge fund beta replication strategies. Lo discussed these strategies in a phone interview on the last day of 2008--just as the tabloids were screaming the sordid details of the Madoff scandal. Lo later explained why it didn't surprise him.

What does beta replication involve?

Betas in the past have referred to the common risks that are in every person's portfolio; the most common beta is the S&P 500, or market beta. Over the last 10 years, a number of researchers have identified other kinds of common risks that are in a variety of portfolios. Therefore, these additional sources of common risk are also called betas. For example, there's a currency beta, a commodities beta; there may be a yield-curve beta, an inflation beta. Once you identify what these common risks are, you can actually measure the degree to which a given portfolio is exposed to them, and that's what the particular beta value corresponds to.

The idea behind replication is this. If you can measure the specific values of these different betas, then you can do one of two things: You can create them synthetically by using liquid futures contracts to simply provide that same level of risk exposure in a different portfolio. So if you want to have a certain degree of commodity risk--and along with each risk comes the risk premium that investors are paid for bearing that kind of risk--instead of having to invest in a cornfield, you can now invest in futures contracts that will give you some of that kind of commodity risk. If you want foreign currency risk, if you want yield-curve risk, you can take those risks in a very liquid and transparent manner using these types of futures contracts.

If you don't want these risks--that's the opposite approach that some investors would prefer--if you already have exposures because of other investments that you want to eliminate, then you can simply take the negative of the beta in your portfolio using liquid instruments; that will help you reduce the risk exposure to these various different betas.

How do you put beta replication to work in the investment products AlphaSimplex is developing?

The traditional approach to investing is: Don't put all your eggs in one basket--diversify--and to hold as many different kinds of securities in one's portfolio as possible, while making sure the risks are appropriate for one's investment horizons and objectives. Well, it turns out that that dictum is still true, but the problem is that the investment landscape has gotten a lot more complicated because of the proliferation of alternative investments--hedge funds, private equity, real estate--a lot of asset classes that weren't popular 15 or 20 years ago.

In that kind of setting, we've formulated a new way of thinking about investments. For the typical investor who traditionally invests in stocks and bonds, we've determined that having a broader set of asset classes at one's disposal can actually create a great deal more diversification benefits than the usual 60/40 mix between stock index funds and bond funds. For example, introducing commodities, foreign currencies and other kinds of strategies that make use of these different asset classes, i.e., being able to sell short these kinds of asset classes; those relatively simple innovations that hedge funds have been taking advantage of for years are now available to both retail and institutional investors.

How have you done this?

We've done it by using exchange-traded index futures contracts and bond futures contracts, commodity futures and currency forward contracts within the context of a '40 Act mutual fund. By using futures contracts that are traded on organized exchanges, we've eliminated the secrecy and opacity of typical hedge fund investment strategies. We don't engage in any exotic derivatives or special agreements that are not visible to the investor. Because these are all exchange traded, the margin requirements, all the financial arrangements are determined in a completely transparent way, and they're determined for all participants in organized exchanges like the Chicago Mercantile Exchange. So, we're not dealing in one-off instruments that can be priced in a rather creative manner depending on the manager. That's one real benefit.

The second benefit is liquidity. One of the concerns investors now appreciate...is that liquidity can be such an important characteristic of investment. It's a characteristic you appreciate most when it's not there; this past year has shown just how important it is. By using exchange-traded futures and foreign currency forwards, we maximize the liquidity of this product. That's not to say there can't be liquidity crunches that affect futures markets, but if there are, the futures markets would be the last to feel the liquidity crunch as we've seen again in 2008.

What are your observations about the Madoff affair?

The scale, of course, is breathtaking, but in a way the scale is commensurate with the prosperity that the global economy has experienced over the last 15 years. I've written elsewhere that prosperity is very much like a drug that acts to relax and cause investors to ask fewer questions. In much the same way that when you go out to dinner with friends and after a few drinks, you become more relaxed and looser, prosperity literally has the same neurophysiological effects; neuroscientists have documented that financial gain actually stimulates the same reward circuitry in your brain that cocaine does. So when you live through an enormously successful and prosperous period, as we did in the 1990s and early 2000s, we become much more complacent about risks and about our wealth, we ask fewer questions, and we find it a lot easier to trust.

And now when you mix that with, apparently, the charms of a Mr. Madoff and the whole country club atmosphere, which is also based on trust and exclusivity, it's easy to see that something like this happens. And once it does, there is no exit except to keep growing it and growing it and growing it.

Michael S. Fischer is a New York-based financial writer and editor. He can be reached at msf7@columbia.edu.

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