alpha

The Risk and Return Characteristics of Alpha Strategies Diploma Thesis in Corporate Finance Swiss Banking Institute University of Zurich 09. November 2007

Prof. Dr. Marc Chesney Assistant: Ganna Reshetar

Author: Mario Schlup

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Executive Summary Alpha strategies are rule-based investment strategies that aim to provide investors with superior returns and reduced volatility compared to traditional investments. The hedge fund industry that has grown fast and steadily over the past decades has emerged as the number one alpha provider to investors. However, investments in hedge funds usually require a high initial investment, that makes them a venue only for institutional investors and high net worth private investors. The trend of passive investing (indexing) that has come from the mutual fund space has also emerged in alternative investment strategies. Recently, issuers of derivative securities and hedge fund of funds have created passive, rule-based alpha strategies whose idea it is to imitate hedge fund investment strategies in a passive way. The advantage of these strategies over hedge fund direct investments is that they require less initial investment, charge lower fees (usually 1 – 1.5% p.a., no performance fee), do not have capacity constraints and are usually more transparent. Moreover, alpha strategies act, as well as hedge funds do, as excellent portfolio diversifiers. The purpose of this thesis is to analyze alpha strategies with respect to their risk exposure and return behavior. Existing literature on alternative investments has also discovered the beneficial diversification effects of alternative investment strategies due to their low correlation to traditional investments. Analyzing the effect an alpha strategy has when adding it to an existing stock and bond portfolio helps understanding these findings. Since alpha strategies are characterized as alternative investments with the properties of strategies that hedge funds employ, the characteristics of both investment instruments will be compared. At first, and in order to understand the nature of these alternative investment strategies, some basics about hedge fund strategies need to be provided. They range from a definition of absolute return strategies to the explanation of the mechanics of different hedge fund styles. Subsequently, we define the models for the alpha strategy analysis, as well as the features and purpose of variance swaps, as they are a crucial component for one of the strategies. Then, the term alpha, its origins and sources are discussed, followed by an analysis of the two sample strategies. The strategies analyzed in the thesis are one long/short equity strategy and a volatility arbitrage strategy. The benefit of these two

II alternative investment styles is their rather simple replication by using index futures and derivatives. For the purpose of displaying the risk exposure of the two strategies, we employ factor model regressions with the asset-based factor model and the Fama French factor model. The asset-based factor model is suitable for alternative investments, as it has been shown that its factors provide the models with a significantly higher r-square than with traditional factors. The results lead to remarkable r-squares, revealing the various risk factor attributions of the strategies. The main finding of the factor regressions is that both of the strategies are almost market neutral with respect to equity markets but inhere exposures (although low) to more exotic factors such as size factors and credit spreads. Neutralizing the systematic risk factors with these regressions, we found that both of the strategies generate a certain amount of alpha, although they are not actively managed. Whereas the long/short equity strategy generated an alpha of just 0.046% in the period 2000 – 2006, the volatility arbitrage strategy exhibited an alpha of 0.647% for the period 1990 – 2006. These results emphasize that alpha can indeed have its sources in specific systematic factors, such as the factors found for the strategies. That is also a reason why certain providers of alpha strategies name them alternative beta strategies instead. The performance analysis of the strategies shows that they both exhibit equity-like returns in the long-run, while being exposed to significantly lower volatility than their equity counterparts. A noteworthy attribute is the quick mean-reversion of the strategy returns after market crash scenario, especially for the volatility arbitrage strategy. In a portfolio context these characteristics combined imply that the efficient frontier can be optimized when adding alpha strategies to a portfolio. It can be shown for a portfolio consisting of stocks and bonds, that when adding the volatility arbitrage strategy as an example, the efficient frontier moves towards the upper left hand corner of the diagram. Summarizing the benefits of alpha strategies, the low correlation to traditional investments such as stocks and bonds, the high liquidity, no capacity restraints and high transparency, it is well possible that they could outperform average hedge fund managers on an after fee basis. Further developments of alpha strategies might involve cross-asset class instruments and more dynamic, rule-based trading strategies that enable investors to imitate the whole range of hedge fund styles mechanically.