More than half of returns experienced by hedge funds could be explained by factors termed as ‘alternative beta’, rather than true alpha, research shows.

Analysis from Towers Watson showed that, after studying an equity long/short strategy between 1996 and 2013, 84% of the returns, on an aggregate basis, derived from beta strategies.

Within a equity long/short strategy, what the firm referred to as alternative beta was defined as the premium received for the volatility of equities, the momentum of stocks and the size of the equity investment.

Looking at the HFRI Composite Index, the representative index for hedge funds, 84% of the returns could be explained by a combination of bulk and alternative beta strategies, the consultancy said.

James Price, investment consultant at Towers Watson, said: “There might be some alpha in an individual strategy. However, when you start to collate the hedge funds together, the overall returns take on the properties of the opportunity set they are using.”

Price said the exposures to alternative betas did vary, but that approximately 60-70% of the returns could be explained by combining alternative betas.

“As an asset owner, you could access those alternative betas through other means,” he said.

“We tried to think very carefully about how we use this, and make sure what comes through is logistically consistent, and replicate what could have been.”

The research showed that, from 1999 to 2013, a minimum of 70% of HFRI composite returns could be explained by a combination of betas.

However, the paper also highlighted additional diversification benefits provided by the use of alternative beta.

The use of hedge funds in pension fund portfolios has commonly been for diversification benefits.

However, with hedge funds using equity, value and macro strategies, the diversification away from traditional portfolios could be overstated.

The correlation between alternative beta strategies, while providing additional and cheaper returns, could also add diversification benefits, Towers Watson said.

Its analysis showed the average correlation coefficient between equities and credit to be around 0.59, with 1 meaning the two assets are perfectly correlated in returns and losses.

However, the use of a foreign exchange carry strategy, another alternative beta category, and momentum equities only yielded a 0.03 coefficient.

Equities and volatility premium strategies have a correlation of 0.22, and equities versus a value strategy was negatively correlated at -0.22.

“They have very good diversification properties,” Price said, “especially compared with equities and bonds, which investors already own in their portfolios.

“It’s a way of injecting additional diversification into a portfolio. It is important to think about these risks. There is many different ways to look at the portfolio, and alternative betas is a valuable additional tool.”

Towers Watson said genuine alpha was a source of uncorrelated returns and worth its weight in gold.

However, pension funds should consider the fees being paid for alpha, which can be achieved through beta strategies, it said.

The paper added: “Over-diversified hedge fund strategies risk moving to industry-average returns and therefore closer to the returns that can be captured with beta. This is exacerbated when funds of hedge funds are used.”