It is often said that alternatives perform one of two roles within a portfolio: they are either “alpha drivers” or “beta reducers.” Depending on the individual long/short manager, they can fill either role.
In the previous table, we saw how the sensitivity to the market, as measured by beta and R-squared, varies widely from fund to fund. These numbers should help an analyst or investor determine which role an individual long/short manager might play within a portfolio.
Compared to the typical long/short manager, the Defined Risk Strategy (DRS) approaches the market from the opposite end of the spectrum. While the overall goal is roughly the same—to produce respectable absolute returns through bull and bear markets—the way they seek to accomplish that goal is completely different. One of the fundamental precepts of the DRS is that it is difficult, if not impossible, to identify those stocks that will outperform or underperform on a consistent basis. In contrast, a long/short fund’s entire value proposition is based upon investing long outperforming stocks and shorting underperforming stocks.
The DRS seeks broad market exposure, utilizing broad and liquid ETFs to gain robust coverage of an asset class. Risk is managed utilizing broad-based options on those same asset classes. The DRS’s primary drivers of returns are its buy-and-hold market exposure, its hedging, and its premium collection. All three of these components are at an asset class level and are designed to provide value in different types of markets (i.e. rising, falling, or flat, respectively). The DRS can be described as a “top-down” manager whereas a long/short approach is the epitome of a “bottom-up” style.
Because the value propositions of a typical long/short manager and the DRS are so fundamentally different, a case could be made for pairing the two together. The two strategies approach investing in such different ways that they could form a complementary partnership. Specifically, a long/short fund with more upside market capture and higher beta could be a nice potential candidate for pairing with the DRS, since the DRS has traditionally been used in a risk-reducing role. This would be an example of combining an “alpha driver” with a “beta reducer.”