Alternative Beta Strategies

Written By

Dan Buckley

Updated

Jun 4, 2024

Alternative beta strategies – also known as “smart beta” or “factor investing” – is an approach to portfolio management that tries to capture market inefficiencies and enhance returns beyond traditional market-capitalization-weighted indices (i.e., indexing to the S&P 500 and the like).

These strategies leverage various factors or styles to build portfolios that are systematically different from standard benchmarks.

Key Takeaways – Alternative Beta Strategies

Diversify a portfolio by capturing risk premia across asset classes beyond traditional market beta.

Strategies like momentum, carry, and value exploit behavioral biases, structural risks for potential alpha.

Risk management, dynamic allocation are important for navigating changing market regimes.

Key Concepts

Beta and Alpha

Beta: Beta measures a portfolio’s sensitivity to market movements. A beta of 1 indicates that the portfolio moves in tandem with the market, while a beta greater than 1 indicates higher volatility, and less than 1 indicates lower volatility.
Alpha: Alpha represents the excess return of a portfolio relative to a benchmark, often considered a measure of a manager’s skill in generating returns above the market average.

The risk-free rate is another component of returns that measures the return on cash or short-term government bonds, like 3-month US Treasuries.

Beta is another layer that adds onto the risk-free rate (market risk), followed by alpha (deviations from market indices).

Alternative Beta

Alternative beta strategies aim to capture returns associated with specific risk factors or investment styles that are not fully exploited by traditional market-cap indices.

These strategies can be implemented through various methods, including index funds, exchange-traded funds (ETFs), and custom portfolios.

Types of Alternative Beta Strategies

Factor-Based Strategies

Factor-based strategies focus on specific characteristics or factors that have been shown to influence returns.

Common factors include:

Value: Investing in stocks that appear undervalued based on metrics such as price-to-earnings or price-to-book ratios.
Growth: Targeting companies with high earnings growth potential.
Momentum: Stocks that have shown strong performance over recent periods, expecting the trend to continue.
Size: Focusing on smaller companies that may offer higher growth potential.
Quality: Companies with strong financial health, including high profitability and low leverage.
Volatility: Targeting stocks with lower volatility, which can offer more stable returns. Research has shown that higher volatility stocks in the market don’t pay off in terms of higher returns.

Style-Based Strategies

These strategies tilt portfolios toward specific trading styles to exploit market anomalies:

Dividend Yield: Investing in stocks with high dividend yields, appealing to income-focused traders.
Low Volatility: Focusing on stocks with lower price volatility to reduce overall portfolio risk.
Fundamental Indexing: Constructing indices based on fundamental metrics like earnings, dividends, or book value, rather than market capitalization.

Multi-Factor Strategies

Multi-factor strategies combine several factors to diversify risk and enhance returns.

By blending factors such as value, momentum, and quality, these strategies aim to provide a more balanced approach to capturing alternative beta.

Implementation of Alternative Beta Strategies

Index Funds and ETFs

Many alternative beta strategies are available through index funds and ETFs, making them accessible to a wide range of traders/investors.

These funds typically have lower fees than actively managed funds, as they follow a rules-based approach to portfolio construction.

Custom Portfolios

Institutional investors and high-net-worth individuals may opt for custom portfolios tailored to their specific risk and return objectives.

These portfolios are often managed by specialized investment firms with expertise in factor-based and style-based investing.

Benefits and Risks

Benefits

Enhanced Returns – By capturing specific risk premia, alternative beta strategies can potentially offer higher returns than traditional market-cap indices.
Diversification – These strategies provide exposure to different factors and styles, reducing reliance on any single market segment.
Cost Efficiency – Many alternative beta strategies are implemented through low-cost index funds and ETFs.

Risks

Model Risk – The success of alternative beta strategies depends on the accuracy of the models and assumptions used to identify and capture factors.
Market Conditions – Certain factors may underperform during specific market conditions, leading to periods of lower returns.
Complexity – These strategies can be complex, requiring a deep understanding of the underlying factors and their interactions.

Let’s look at some trades involving alternative beta strategies:

To illustrate specific trades involving alternative beta strategies, we’ll focus on a few examples using factor-based approaches.

We’ll outline the trades step by step, including the example amounts.

Trade 1: Value Factor Strategy

Objective

Undervalued stocks to capture potential price appreciation.

Steps to Execute

Identify Value Stocks:

Use a stock screener to filter for companies with low price-to-earnings (P/E) ratios and low price-to-book (P/B) ratios.
Example: Identify 10 stocks with P/E ratios below 15 and P/B ratios below 1.

Determine Investment Amount:

Assume a portfolio size of $100,000.
Allocate 10% of the portfolio to each stock.

Execute Trades:

Purchase $10,000 worth of each identified value stock.

Example Stocks and Amounts

Stock A: 200 shares at $50 per share = $10,000
Stock B: 250 shares at $40 per share = $10,000
Stock C: 100 shares at $100 per share = $10,000
Stock D: 500 shares at $20 per share = $10,000
Stock E: 333 shares at $30 per share = $10,000
Stock F: 667 shares at $15 per share = $10,000
Stock G: 250 shares at $40 per share = $10,000
Stock H: 400 shares at $25 per share = $10,000
Stock I: 500 shares at $20 per share = $10,000
Stock J: 100 shares at $100 per share = $10,000

Trade 2: Momentum Factor Strategy

Objective

Stocks with strong recent performance to benefit from continued momentum.

Steps

Identify Momentum Stocks:

Use a stock screener to filter for companies with high relative strength over the past 1-12 months.
Example: Identify 10 stocks with the highest relative strength over the past 1 month.

Determine Investment Amount:

Assume a portfolio size of $100,000.
Allocate 10% of the portfolio to each stock.

Execute Trades:

Purchase $10,000 worth of each identified momentum stock.

Example Stocks and Amounts

Stock K: 100 shares at $100 per share = $10,000
Stock L: 200 shares at $50 per share = $10,000
Stock M: 500 shares at $20 per share = $10,000
Stock N: 250 shares at $40 per share = $10,000
Stock O: 333 shares at $30 per share = $10,000
Stock P: 400 shares at $25 per share = $10,000
Stock Q: 250 shares at $40 per share = $10,000
Stock R: 200 shares at $50 per share = $10,000
Stock S: 100 shares at $100 per share = $10,000
Stock T: 500 shares at $20 per share = $10,000

Trade 3: Low Volatility Factor Strategy

Objective

Stocks with low price volatility to reduce overall portfolio risk. (Focus on return relative to risk.)

Steps

Identify Low Volatility Stocks:

Use a stock screener to filter for companies with low beta (less than 0.8).
Example: Identify 10 stocks with the lowest beta values.

Determine Investment Amount:

Assume a portfolio size of $100,000.
Allocate 10% of the portfolio to each stock.

Execute Trades:

Purchase $10,000 worth of each identified low volatility stock.

Example Stocks and Amounts

Stock U: 250 shares at $40 per share = $10,000
Stock V: 333 shares at $30 per share = $10,000
Stock W: 200 shares at $50 per share = $10,000
Stock X: 400 shares at $25 per share = $10,000
Stock Y: 500 shares at $20 per share = $10,000
Stock Z: 250 shares at $40 per share = $10,000
Stock AA: 100 shares at $100 per share = $10,000
Stock BB: 500 shares at $20 per share = $10,000
Stock CC: 200 shares at $50 per share = $10,000
Stock DD: 667 shares at $15 per share = $10,000

Conclusion

These specific trades illustrate how alternative beta strategies can be implemented using value, momentum, and low volatility factors.

By systematically selecting stocks based on these factors, traders can potentially capture returns associated with these risk premia while diversifying their portfolios.