Understanding The Beta In ALFA

May 19, 2016

But as with everything, there are costs and benefits.

To isolate the cost of whipsaw, we can construct a fully unhedged version of ALFA by adding back in the market return in months when it was hedged.

To isolate the benefit of selectively shorting the market, we can construct a fully hedged version of ALFA by subtracting the market return in months when it was unhedged.

The beta of these two approaches is shown below to put some context around the beta of ALFA. The alphas are essentially similar.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).

 

ALFA was long only until September 2015, so any cost of whipsaw has only been realized in the past eight months. Over this period, ALFA was down 22.0% versus 16.4% in the unhedged index, a cost of 5.6% for the beta control.

On the other hand, the fully hedged index was down 21.3% over the period, which means the short positions outperformed the long positions.

This gives us some context for the whipsaw, and shows what we noticed in the alpha graph above: The premium in the hedge fund conviction just wasn’t as strong as it has been previously. But this is a common occurrence in all ETFs seeking factor premiums. If premiums always were strong, they somewhat paradoxically wouldn’t always be around. There must be some short-term variation for long-term outperformance to exist.

While the beta control was a drag on returns recently, extending our view back in history shows how strong the benefit of not always being long/short has been. The chart below shows the cumulative return of ALFA and our two hypothetical indexes.

Source Yahoo Finance. Analysis by Newfound Research. Data through 4/30/2016. Data begins on ALFA’s inception date (5/31/2012).

 

Up until ALFA first signaled a hedge at the end of August 2015, it had outperformed the fully hedged index by nearly 65%. Over the entire period, relative to the fully hedged version, ALFA was up nearly 50%, greatly eclipsing the cost of the recent whipsaw.

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