The Risk and Return Characteristics of

Alpha Strategies

Diploma Thesis in Corporate Finance

Swiss Banking Institute
University of Zurich

09. November 2007

Prof. Dr. Marc Chesney

Assistant: Ganna Reshetar

Author: Mario Schlup

 I

Executive Summary
Alpha strategies are rule-based investment strategies that aim to provide investors with
superior returns and reduced volatility compared to traditional investments. The hedge
fund industry that has grown fast and steadily over the past decades has emerged as the
number one alpha provider to investors. However, investments in hedge funds usually
require a high initial investment, that makes them a venue only for institutional investors
and high net worth private investors. The trend of passive investing (indexing) that has
come from the mutual fund space has also emerged in alternative investment strategies.
Recently, issuers of derivative securities and hedge fund of funds have created passive,
rule-based alpha strategies whose idea it is to imitate hedge fund investment strategies
in a passive way. The advantage of these strategies over hedge fund direct investments
is that they require less initial investment, charge lower fees (usually 1 – 1.5% p.a., no
performance fee), do not have capacity constraints and are usually more transparent.
Moreover, alpha strategies act, as well as hedge funds do, as excellent portfolio diversifiers.

The purpose of this thesis is to analyze alpha strategies with respect to their risk exposure
and return behavior. Existing literature on alternative investments has also discovered
the beneficial diversification effects of alternative investment strategies due to their low
correlation to traditional investments. Analyzing the effect an alpha strategy has when
adding it to an existing stock and bond portfolio helps understanding these findings.
Since alpha strategies are characterized as alternative investments with the properties of
strategies that hedge funds employ, the characteristics of both investment instruments
will be compared.

At first, and in order to understand the nature of these alternative investment strategies,
some basics about hedge fund strategies need to be provided. They range from a definition
of absolute return strategies to the explanation of the mechanics of different hedge fund
styles. Subsequently, we define the models for the alpha strategy analysis, as well as
the features and purpose of variance swaps, as they are a crucial component for one of
the strategies. Then, the term alpha, its origins and sources are discussed, followed by
an analysis of the two sample strategies. The strategies analyzed in the thesis are one
long/short equity strategy and a volatility arbitrage strategy. The benefit of these two
 II

alternative investment styles is their rather simple replication by using index futures and
derivatives.
For the purpose of displaying the risk exposure of the two strategies, we employ factor
model regressions with the asset-based factor model and the Fama French factor model.
The asset-based factor model is suitable for alternative investments, as it has been shown
that its factors provide the models with a significantly higher r-square than with tradi-
tional factors. The results lead to remarkable r-squares, revealing the various risk factor
attributions of the strategies.
The main finding of the factor regressions is that both of the strategies are almost market
neutral with respect to equity markets but inhere exposures (although low) to more exotic
factors such as size factors and credit spreads. Neutralizing the systematic risk factors
with these regressions, we found that both of the strategies generate a certain amount of
alpha, although they are not actively managed. Whereas the long/short equity strategy
generated an alpha of just 0.046% in the period 2000 – 2006, the volatility arbitrage
strategy exhibited an alpha of 0.647% for the period 1990 – 2006. These results emphasize
that alpha can indeed have its sources in specific systematic factors, such as the factors
found for the strategies. That is also a reason why certain providers of alpha strategies
name them alternative beta strategies instead.
The performance analysis of the strategies shows that they both exhibit equity-like re-
turns in the long-run, while being exposed to significantly lower volatility than their equity
counterparts. A noteworthy attribute is the quick mean-reversion of the strategy returns
after market crash scenario, especially for the volatility arbitrage strategy. In a portfolio
context these characteristics combined imply that the efficient frontier can be optimized
when adding alpha strategies to a portfolio. It can be shown for a portfolio consisting of
stocks and bonds, that when adding the volatility arbitrage strategy as an example, the
efficient frontier moves towards the upper left hand corner of the diagram.

Summarizing the benefits of alpha strategies, the low correlation to traditional investments
such as stocks and bonds, the high liquidity, no capacity restraints and high transparency,
it is well possible that they could outperform average hedge fund managers on an after fee
basis. Further developments of alpha strategies might involve cross-asset class instruments
and more dynamic, rule-based trading strategies that enable investors to imitate the whole
range of hedge fund styles mechanically.