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Smart beta

Smart beta? I invest in GOOD hedge funds. As 99% of hedge fund managers are NOT good, I put client capital in the 1% of hedge funds that are good. The average is no indication of the manager universe since the data set mixes hoards of incompetent fools with very rare geniuses. Why would anyone invest in products that purport to deliver the returns of the "average" hedge fund when the average manager is useless?

Portable alpha is so five minutes ago. The "new" solution is smart beta. Conferences are being organized, presentations prepared and white papers published so these betas must be important. Beta is about the average but why invest in the "average"? Avoid the clones, replicators and unskilled copycats. My clients want smart alpha NOT smart beta.

Investors ploughing capital into alternative beta are likely to end up in tears with the risk/reward scenario NOW so unfavorable. We have seen the search for yield end badly throughout history and this time WILL be no different. With some exotic assets and structured securities it is possible to construct an opposite pay-off or synthetic short exposure that will hedge the disaster scenario. But most investors are unaware of the enormous risk in the many illiquid and poorly structured securities that have been marketed as "low risk" or even "AAA".

There are two types of alternative beta.
1) Apply "alternative" strategies to "normal" securities with new trading styles and arbitrages in traditional asset classes.

2) Apply "normal" strategies to "alternative" asset classes like timber, freight, wine, uranium, art, movies or violins.

Incredibly there are some blindly investing in what they think are hedge funds. Hedge fund beta should be avoided just like stock market beta. The average hedge fund is useless just like the average stock. Personally I favor SKILLED strategies but then as a risk averse, conservative investor I am not prepared to speculate on betas of any kind. Neither traditional beta not alternative beta. They are too hazardous for my risk tolerance. I want alpha and only alpha.

Alpha is probably best defined as the observed return above the expected return. It is not difficult to estimate of what an unskilled investor should have made in emerging markets, distressed debt or rare metals beta recently. Surely any RISK ADJUSTED outperformance of that expectation is alpha but few hedge funds operating in those areas generated ANY positive alpha despite apparently "high" absolute returns. Many underperformed a replicated strategy and therefore produced negative alpha because of their beta factor dependence. Nowadays it is unnecessary to pay hedge fund fees for alternative beta though some still do. However 2 and 20 for alternative alpha is cheap.

As for exotic beta there are geographically challenged index constructors around that STILL consider Singapore, South Africa and South Korea to be emerging markets which is plainly wrong. Many "emerging" markets have long since emerged. An "exotic" country like Slovenia gets classified as a frontier stock market despite being a net contributor to the EU and the average Slovenian has a standard of living not that different to the average German. There are NO exotic countries from an investment point of view. And I have invested in over 100 and visited many more.

With movies or musical instruments it is difficult to see what the hedge or risk offsetting short sale is. There are 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? Uzbekistan equities and catastrophe reinsurance are partially hedgeable and therefore acceptable hedge fund investments but are unmade movies and potential sports legends?

Some newer "hedge funds" claim they aren't even trying for alpha, just providing investors with access to exotic beta. Sounds like an excuse to lose money! There is a cheaper way to get that desired exposure whether through an ETF, OTC derivative or directly buying a few bellweather assets in the "exotic" class yourself. It is not that difficult or expensive to gain exposure to any security these days.

Alternative beta, like beauty, is in the eye of the beholder. Commodities have a thousands of years longer track record than equities yet many investors STILL don't have a commodity allocation. Long/short commodities should be at the core of a portfolio not its periphery. Art and wine have been investable almost as long as gold and silver so how can they be exotic? Stocks and bonds are the new kids on the block comparatively. Some investors even classify real estate as an alternative investment! Buying land and buildings has been going on for a LONG time; many centuries before those beloved "equities" appeared on the investment scene. Humans were no doubt trading caves a million years ago. Is real estate alternative? No.

Many once "exotic" trading strategies are now plain vanilla. Alternative beta is NOT exotic beta. It is the expected naive return from an established 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 such "strategy beta" performance. But as I said ALTERNATIVE ALPHA is what you want.

I just try to find hedge funds that buy things that will go up and short sell things that will go down. The way I do this is admittedly "exotic". But where the security is or whether it is classified as an equity, bond, loan, future, derivative, commodity, currency, collectable or life-form isn't important provided the risk can be managed and easily REDUCED in a limited time frame if necessary. On this interconnected planet how can anything be exotic? With the internet, Blackberries, free phone calls and video conferencing nowhere is 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 sure there are exotic assets anymore, anywhere.

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 rare and difficult to generate. True hedge funds are in the alpha business NOT the beta repackaging business. And why would investors desire "average" hedge fund returns from such a marketing concept as alternative beta? Don't get sold on alternative beta, decide to buy absolute alpha.

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