Availability of exotic beta

abnormalreturns
October 9th, 2006

We have been somewhat skeptical of the ETF revolution in part because we felt there was too much in the way of me-too funds covering prosaic asset classes. However one area where ETFs can excel is in making available certain strategies to individual investors that were once off-limits. First, why is this interesting?

All About Alpha recaps a paper that looks at the question of how much alpha is truly available to investors in various hedge fund strategies. One of the conclusions drawn is that some of these returns are a function of so-called “hedge fund betas” or “exotic betas.” These are in a sense systematic returns not currently available in publicly traded investment vehicles.

We especially like this characterization:

Ibbotson & Chen almost seem to be suggesting that there could be a continuum of alpha from simple exotic beta to inexplicable, “skill-based” alpha.

For example PowerShares DB G10 Currency Harvest Fund (DBV) is an example of a strategy-based ETF that seeks to capture the return on the so-called currency carry trade. One can think of this fund as being at one end of this continuum of alpha. With a bit of thought one could come up with any number of other “exotic” investment strategies that could work in the form of an ETF.

This aspect of the evolution of ETFs is taking some time, but that ethos is trickling down into the world of mutual funds. Jen Ryan at TheStreet.com notes how one fund company is rolling out some new funds that have a decidedly “institutional” investment ethos. One of the earliest areas where mutual funds looked to expand their focus beyond simple asset classes is the area of so-called “real return” funds. Jonathan Burton at Marketwatch.com looks at these funds in light of higher consumer inflation.

Consumer choice is a hallmark of a capitalist society. Investments are no exception. As more exotic ETFs and publicly traded hedge funds come to market investors are going to have the opportunity to craft ever more complete portfolios. The challenge is to have a commensurate amount of education and commentary available to investors to allow them to rationally sort through the various risks of using more complex products. Sounds like a good job for the burgeoning investment blogsophere, don’t you think?