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March 22, 2013 6:25 pm

lternative beta has a wide

umbrellaBy Inigo Fraser Jenkins

A paradigm shift is taking place in fund management. For years we have all been schooled in

the idea that fund management could either be passive and track an index, or be active and

try to beat that index. There is now, however, a greater willingness to steer a middle path

that is often described as alternative beta. The pages of FTfm have, for example, carried

several articles in recent weeks referring to the switch into alternative beta that some

investors are making.

What is meant by this? The term is used in a confusing number of ways, but Nomura

suggests there are two core meanings. First, it can refer to a strategy that was once thought

of as being active, but has now been commoditised or packaged in some way, such as an

exchange traded fund. Examples of such strategies would be value investing or minimum

variance. Second, it can refer to a non-traditional benchmark, one that generally

outperforms the market-cap weighted benchmark, or is better aligned to an investors

liabilities in some way.

Why is this happening now? There are several reasons for this switch. First, the sharp fall in

the share of active management relative to passive is leading asset managers to pursue other

opportunities. There is also widespread and growing dissatisfaction among investors with

benchmark-relative concepts of return and risk, which are perceived to have failed in recent

years. We would also note that with products such as ETFs it is now much easier to take on

macro-type exposures.

In a recent research report, we brought together three current areas of debate in finance

that are seen as separate, but are set to increasingly converge as one subject area. These are

the increased appetite for multi -asset investing; the rise of alternative beta itself through

greater investment in alternative beta ETFs; and the challenge posed by the decrease in

active assets under management and what fund management companies can do in response.

Another type of strategy that has become increasingly popular in recent years is highly

active, concentrated stock-specific funds with, say, fewer than 30 stocks. This is the

antithesis of alternative beta. Such funds have gained market share over the past two years,

and offer high margins for those who are successful. These funds are likely to continue inpopularity, but will be part of an increasingly shrinking share of active stock-selection-based

assets.
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What is the business opportunity for asset managers here? One option is to offer the

underlying strategies that form the vehicles for alternative beta approaches. However, this

will be low-margin business and may not appeal to all. There are two other options: one is to

offer highly customised solutions to individual clients, combining these strategies in a way

that is optimal for their liabilities. Another option that is increasingly talked about is

dynamically switching between such strategies. So, for example, rather than allocating

tactically between an equity and a bond index, a multi-asset manager may instead decide toallocate between the carry in rates and value in equities.

There is a spectrum of approaches that can be considered alternative beta. Some will be

familiar to many investors, including style returns such as value, quality and momentum.

Other strategies will be some of the alternative index approaches that have become popular

over the past two years. These would include minimum variance strategies that try to

achieve the lowest possible volatility, maximum diversification and so-called fundamental

indices that weight stocks by accounting measures rather than market cap. All these can be

subsumed within the alternative beta trend. Recent academic work has compared thereturns of such approaches. Our research has placed valuations on these strategies, linking

them to the business cycle and is a step towards a tactical timing model.

This is a relatively new area, and the economics of how participants can best profit from it

are open to debate, offering potentially interesting opportunities.

Inigo Fraser Jenkins is

global head of quantitative strategies at Nomura
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