When you invest in an actively managed fund, your overall returns actually consist of two parts: “beta” returns, which simply match the performance of a market benchmark, and “alpha” returns, which are any gains above that benchmark. You pay higher fees for active funds, hoping for that extra “alpha.” However, a significant portion of what you get often just reflects general market movements, meaning you’re paying premium fees for returns you could get more cheaply elsewhere.
This became a point of contention for large institutional investors in the U.S. They reasoned that market-aligned returns could be achieved through inexpensive passive investments. This insight led to a crucial concept: “alpha-beta separation” in institutional investment strategies. Essentially, it means you’d aim to capture broad market returns using low-cost passive products, while seeking true “alpha” from highly skilled, specialized managers.
While individual retail investors typically don’t have access to such sophisticated institutional strategies, there’s a clever way they can emulate this approach. By combining investments in exchange-traded funds (ETFs) or index funds for their “beta” (market) returns and strategically utilizing arbitrage funds, they can aim for near-pure “alpha” returns. This article will explore why arbitrage funds are particularly well-suited for this purpose.
Crafting a “Pure Alpha” Portfolio: The Synthetic Approach
Building a portfolio designed to carry only market risk is typically done through diversification. However, constructing a portfolio for “near-pure alpha” is a more intricate process involving several steps. Initially, you’d create a standard portfolio, much like an active fund, which inherently includes market risk, company-specific risk, and sector-specific risk. The critical next step is to systematically strip away the market risk. What remains is the company-specific and sector-specific risk, which is where the potential for alpha returns lies. This intricate removal of market risk is often accomplished using index futures linked to the portfolio’s benchmark index. It’s important to note, however, that even with advanced strategies, it’s rarely possible to eliminate all market risk completely.
Understanding Residual Beta
Any remaining market risk within a portfolio, even after attempts to remove it, is known as “residual beta.” This is why such portfolios are described as aiming for near-pure alpha returns. Arbitrage funds employ a relatively straightforward method to achieve this. They pinpoint stocks where futures contracts appear overpriced. Their strategy then involves simultaneously buying the underlying stock (taking a “long” position) and selling the corresponding futures contract (taking a “short” position) to profit from this price discrepancy. This combination of long stock and short futures effectively neutralizes most market risk, leading to returns that closely resemble pure alpha.
Key Takeaways for Investors
It’s crucial to understand that arbitrage opportunities aren’t constantly available in the market. When they do appear, astute market participants typically seize them very quickly. Consequently, there will be periods when arbitrage funds might struggle to find suitable investment opportunities. During these times, these funds often allocate a portion of their assets to low-risk money market instruments to continue generating some returns. Investors considering arbitrage funds should be aware of this dynamic and how it might influence performance.