Exotic beta, alternative beta, alpha?

Portable alpha is so five minutes ago. The new, new investment "solutions" are exotic beta and alternative beta. Conferences are being organized, powerpoints being updated, learned papers written so these better betas must be important. Surely what matters most are absolute returns more than obsessing over which greek a particular return source belongs to. But since exotic/alternative beta is the topic-du-jour, definitions are necessary to measurably differentiate alpha from these new betas.

There are two forms of exotic beta. 1) Apply normal strategies to "exotic" assets, eg investing in African equities, timber, wine, uranium, movies or footballers. Or 2) Apply exotic strategies to normal securities, eg new trading styles or arbitrages in liquid markets. I prefer developing exotic strategies to apply to any security (traditional or "exotic") but then as a risk averse investor I am not prepared to bet on asset beta of ANY kind.

Alternative beta is NOT exotic beta. It is the expected return from an established non-exotic investment strategy that is in the public domain, has many hedge funds in the space and whose factor dependence is empirically determinable, though not necessarily constant. As hedge fund clones proliferate, many well-known alternative strategies will indeed be replicable at cheaper cost for "beta only" performance.

Alpha is best defined as the observed return minus the expected return. It is not so difficult to come up with an estimation of what a naive investor would have made in emerging markets, distressed debt or metals trading last year. Surely any outperformance of that expectation is alpha but few hedge funds operating in those areas generated ANY positive alpha in 2006. Many underperformed a replicated strategy and therefore produced negative alpha. Nowadays it is increasingly unnecessary for an investor to pay hedge fund fees for alternative beta, though many still do.

Some newer "hedge funds" claim they aren't even trying for alpha, just charging 2 and 20 to provide investors with access to exotic beta. There is almost certainly a cheaper way to get that desired exposure whether through a hedge fund clone, ETF, basket derivative or simply directly buying a few assets from the "exotic" class oneself. It is not that difficult or expensive to gain exposure to almost any "exotic" security these days.

Exotic is also in the eye of the beholder. Commodities have a MUCH longer track record than equities yet many investors still don't have a commodity allocation. Art and wine have been investible almost as long as gold so how can they be exotic? Slovenia gets classified as a frontier stock market despite being a net contributor to the EU and the average Slovenian probably enjoys a standard of living not that different to the average German. There are geographically challenged people around that still consider Singapore, South Africa and South Korea to be emerging markets which is ludicrous. Many "emerging" markets have long since emerged. Many once "exotic" trading strategies are now plain vanilla.

I just try to buy good investments and short sell bad ones. WHERE the asset is, or whether that security is classified as an equity, bond, loan, future, derivative, commodity, currency or life form isn't particularly important provided the risk can be measured, managed and easily REDUCED in a limited time frame. On this flat and interconnected planet how can anything be exotic? With the internet, free phone calls and video conferencing that actually works, nowhere seems distant. Even if you need to be physically present, no place on the earth is more than a day's flight away. There are certainly exotic investment strategies but I am not so sure there are exotic assets anymore, anywhere.

Investors pushing the envelope into the obscurest, illiquid, very low capacity instruments are likely to end up in tears with the risk/reward equation NOW so unfavorable. We have seen the extreme search for yield end badly throughout history and this time will be no different. With some exotic securities it is possible to construct an opposite pay-off or synthetic short exposure that will mitigate the risk of a disaster scenario. But with movies and footballers, for example, it is difficult to see where or what the hedge is. There are far more bad movies around than good movies, just like there are more bad stocks than good stocks, but how do you short sell a movie? Uzbek equities and catastrophe bonds are partially hedgeable and therefore acceptable hedge fund investments but is funding movies and potential sports heroes?

Diversification through multiple asset classes and numerous investment strategies is essential for all investors. But beta is NEVER exotic whereas alpha is ALWAYS exotic since it is so difficult to consistently generate. True hedge funds are in the alpha production business, NOT the movie production business or the beta bundling business.
© posted by Veryan Allen at 26.2.07