Bridgewater Aids Tool to Uncover 'Hidden Beta'

(January 10, 2012)  —  A tool to scrutinize hedge fund outperformance and recreate its market returns for investors has been launched by Markov Processes International (MPI).

Using the flagship fund of alternative asset manager Bridgewater Associates as a test case, MPI has developed a system to uncover the ‘beta,’ or market returns, from portfolios, allowing investors to see how their manager is doing. The Bridgewater Alpha Fund II is one of the world’s best performing funds for institutional investors.

In October, Bridgewater Associates published a paper entitled ‘Hedge fund returns continue to be dominated by beta’, which sparked MPI’s study to try and create a tool to hunt out market returns in alternative funds’ outperformance.

In a paper to accompany the tool’s launch, MPI said: “We seek to demonstrate how quantitative analysis and beta modelling techniques can be used by institutional investors to better understand fund behaviour, anticipate performance and improve due diligence, risk management and portfolio monitoring of hedge funds.”

MPI said the tool did not need to know the underlying stocks or asset allocation in the Bridgewater Pure Alpha II Fund to define the market returns from the outperformance.

The fund was launched in 1991 with target volatility of 18% and has close to assets under management of $23 billion.

The study found that a ‘significant part of Bridgewater Alpha Fund II’s performance could be reasonably estimated through dynamic long/short portfolios of ETF products that offer daily liquidity and a simple, low-cost fee structure’.

However, it added that funds run by Bridgewater Associates were complex and would adapt and exploit new market opportunities.

The MPI paper said: “Portable Alpha or Smart Beta, Essential Alpha or Diversified Beta, Traditional Alpha or Alternative Beta, Pure Alpha or Exotic Beta – whatever names are used, the line is blurry between passive and active investment strategies. However, instead of using standard benchmarks, investors can now compare investment funds to dynamic benchmarks in order to better distinguish the alpha, timing and beta skills of their managers.”

It continued: “Advantages of such methodologies lay in better risk management, portfolio monitoring and possibly hedging of market betas embedded in alternative investment mandates.”

To see a discussion on risk parity by co-CIO of Bridgewater Associates last year click here.