The Future of the Global Economy: One Step (ahem, Year) Ahead

Who can tell the future? 

Most people are not that good at predicting the future of the economy and the stock market, but there are quite a few pretty talented people who are. Most importantly, they are willing to bet their money (and a whole lot of it) on their vision of the future, instead of just yapping about it on television with no real consequences to themselves (think Ben Stein or Jim Cramer). These people are hedge fund managers, especially those who follow directional global economy based strategies.

Hedge funds are run by smart guys. They strive to generate attractive risk-and-return patterns for their investors through a wide variety of investment strategies. Broadly speaking, these strategies could be classified as “search for alpha” (e.g. “equity market neutral”) and “bets on beta” (e.g. “global macro”). Alpha strategies aim at generating returns patterns that are not related to the market or any known economic risk factors. Beta active strategies, on the other hand, generate returns by taking positions driven by underlying economic factors. The best beta active hedge fund managers are pretty good as a group in anticipating which of the economic factors would deliver superior performance in the future. If we could only see these positions, we would’ve been able to peek into the future (as perceived by a group of really smart hedge fund managers)…

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Smart Beta ETF Portfolios: Cloning Beta Active Hedge Funds

Cloning hedge fund returns is a tricky business. Some hedge fund strategies, like S.A.C. Capital Advisors’ trading in Elan and Wyeth shares off insider tips, cannot be replicated by any algorithmic cloning procedure. On the other hand, returns for many hedge funds appear to be driven by exposures to latent risk factors not readily discernible to average investors. As John H. Cochrane of the University of Chicago observes:

As I look across the hedge fund universe, 90% of what I see is not “picking assets to exploit information not reflected in prices,” it is “taking exposure to factors that managers understand and can trade better than clients.”

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Smart Beta as the “Easy” Button

Smart beta – another hot term these days… It has a nice familiar ring to it, as it sounds like an incremental improvement over the good old CAPM beta! There is something harmless and comforting in the name “smart beta”, especially after the past horrors of exotic derivatives and credit default swaps.

The brilliance of the marketing behind smart beta is akin to the “easy” button at Staples – it makes you think that there is a magic shortcut to solving the challenges of modern investing, almost as simple as pressing the easy button."easy" button at StaplesUnfortunately, the realities behind the easy button and smart beta investing are not simple at all. Instead of the easy button at Staples there are mind numbing choices of stationery and office products. Similarly, smart beta stands for hundreds, if not thousands, of funds that provide exposure to a multitude of risk factors, either in pure form or bundled with other risk exposures.

The true beauty of smart beta is in its very complexity, as it offers an opportunity for the extremely granular approach of fine-tuning your investment strategies across a multitude of risk dimensions based on your individual objectives. Navigating the smart beta world requires an understanding of all of the options, and it is ultimately your responsibility to pick the exact smart beta products that work specifically for you. And that isn’t easy at all, smart beta or not!