Alpha overlay: employing active management risk
In simplest terms, alpha overlay is the process of generating excess returns through active management, independent of an underlying asset class. Properly executed, alpha overlay leads to better investment results with no more risk than traditional investment management for the following reasons:
q The total return of a portfolio equals the return of the asset classes invested in plus the managers’ alpha; this is equally true if the alpha produced is in the same markets as the asset class or in other markets.
As a result, a portfolio constructed by independently choosing the asset class (beta) and the alpha is no more risky than one managed by following the traditional approach (ie, with alphas coming from the same markets as the betas);
q However, choosing alphas from wherever they are best obtained and through creating a much more diversified portfolio of alphas, a properly executed alpha overlay strategy can produce much better risk-adjusted alphas;
q Alpha overlay managers can attach their overlay portfolio to virtually any asset class This allows investors to generate attractive alphas in asset classes that are otherwise difficult to generate alphas in;
q The risk-adjusted alpha can be easily calibrated to coincide with each investor’s specific risk tolerances.
So, with the new paradigm, investors specify the betas they want, independently choose their alphas and tell their managers how aggressively to run the alphas. For example, Bridgewater currently overlays its alpha on 26 different client specified betas (ie, benchmarks) and runs these overlays at client specified risk targets that range from 25 basis points to 2400 basis points.
When properly implemented, alpha overly is generating such superior and more tailored results than traditional investment management that it is profoundly altering how money is being managed.
The separating of alpha and beta, and the creating optimal portfolios of each, may be the most important changes in the way institutional money is being invested since the adoption of the concepts of Modern Portfolio Theory. The purpose of this article is to explain comprehensively both the theories and the operational considerations of alpha overlay.
Alpha overlay: theory and application
The primary objective of an active investment manager is to generate alpha for investors. From an economic standpoint, the source of this alpha is irrelevant since all dollars spend equally well. Yet, from the standpoint of convention, we are used to seeing alphas coming from the same source as betas. In other words, investors expect their active equity and fixed income managers to provide underlying asset class exposure and then some. Logically, however, it is clear that they can produce a better portfolio of alphas by thinking about them as independent portfolios of return streams, disconnected from the underlying betas. Alpha, in general, is derived from exploiting market inefficiencies. This means that markets that are less understood can provide greater opportunities for alpha. Less understood markets are usually less invested in, or at least represent a lower proportion of most investors’ strategic asset mix. On the other hand, better understood markets are usually more efficient, and thus, more invested in. For example, equity markets are the most invested in, most studied, best understood and usually the highest portion of a typical institutional portfolio. If this is true, then it is also true that investors continue to link their alphas to their strategic asset mix, and thus systematically concen-trate their alphas in the most efficient markets. In so doing, investors are implicitly constrain-ing their ability to generate the best alpha possible. By thinking about the beta and alpha decision separately, the potential to generate higher alpha is greater.
Separating alpha from beta can also benefit investors from a portfolio engineering perspective as well in that the typical institutional portfolio contains highly unbalanced alpha. Equity manager alphas tend to be large (positive or negative) and bond manager alphas tend to be small. Even if a strategic asset mix had an equal weighting to stocks and bonds, the volatility of equities is much higher than that of bonds. The equity alpha will dominate the bond alpha and the total portfolio alpha will look a lot like the equity alpha even though the risk adjusted returns of top equity and fixed income managers are almost identical (see the following table). This imbalance is exacerbated in practice because most institutional strategic asset mixes hold a greater percentage in equities than bonds. In the following table, the third column shows the overall portfolio alpha resulting from a 65% weight to equities and a 35% weight to bonds. As can be seen, the information ratio of the 65/35 portfolio is hardly any better than the equity or bond alphas because there is no true diversification and the portfolio is dominated by a larger exposure to the more volatile equity alpha. Since top equity and bond alphas are practically the same on a risk-adjusted basis and are also generally uncorrelated, the investor can gain significant benefits by balancing them better. In the last column we have shown how an investor can significantly improve the overall portfolio information ratio by balancing the exposure to the equity and bond alphas so that there is equal volatility impact from each.
Alpha overlay applies the power of portfolio theory to alpha generation, producing superior results through better engineering. Most traditional managers seek alpha from only a couple of asset classes where the alphas within the asset classes can be highly correlated. An example would be the active equity manager who is overweight media and communication stocks. By deviating from the benchmark in these sectors, the manager might produce alpha that is not overly correlated to the benchmark, but the sector overweights are likely to produce alpha positions that are highly correlated to each other. Therefore, the overall diversification benefit of adding another stock is minimal. Alpha overlay strategies, on the other hand, seek alpha from multiple markets and through various styles so that the cross correlation between the alphas is much lower, thereby enhancing overall diversification in the alpha portfolio. The following chart shows the relative volatility reduction that occurs when an investor adds 20 uncorrelated alpha return streams relative to either a few or many highly correlated alpha return streams. By combining uncorrelated alpha return streams an investor can reduce the alpha volatility by a factor of five, with no reduction in expected return. Because alpha overlay combines numerous, uncorrelated alphas into one portfolio, it has a structural advantage relative to traditional approaches. This diversification of alpha is what allows higher value added at any level of risk, or more consistent value added at any level of return.
Most investment management firms offer numerous actively managed products. Each of the firm’s products may have a positive expected alpha, but also a high degree of inconsistency. The average return-to-risk ratio (e.g. information ratio) for top quartile active managers is about 0.35. This implies significant inconsistency of alpha. From the manager’s standpoint, having an inventory of products with an average 0.35 information ratio is desirable since one of their products is likely to be performing well and thus they will have something to sell. From the investor’s standpoint, however, there is a high probability of investing in a product that is not performing well, because each product individually is inconsistent. To be 90% confident that a manager with a 0.35 information ratio will add value, one has to wait 15 years.
The alpha overlay concept is attractive because it aligns the interests of the investor with that of the firm by bundling all of these alphas together into a single, “best alpha” portfolio. This concept is similar to a multi-product investment manager packaging its best products together, each carrying an information ratio of 0.33 (1% alpha and 3% volatility). Grouped together, the investor would still receive the 1% excess return but the volatility would be a lot less than 3%, perhaps as low as 1%. This optimal alpha, then, would offer the average investor a 1.0 information ratio on top of their benchmark, instead of receiving a 0.33 information ratio. Putting this into perspective, a 1.0 ratio implies that the investor only has to wait 2 years to be 90% certain of out-performing the benchmark.
Although it is true that a higher relative information ratio will always produce better returns when two portfolios are run at the same volatility, it is sometimes rightfully argued that investors should not focus on an information ratio at the expense of actual returns. This is true since some managers produce such high volatility alpha that another manager might be unable to surpass it even if the second manager has better risk-adjusted returns. The key point is alpha overlay managers do not experience such problems because implementation is done mainly through the use of futures and forwards that require little cash outlay. This makes it easy to adjust the targeted volatility by simply adjusting the size of the position. The same mix of positions that produce an information ratio of 1.0 can be scaled to almost any targeted volatility (eg, tracking error) the client desires. Therefore, it is easy with an alpha overlay to move from the risk-adjusted return world to the actual return world. The following chart provides a picture to help think about how an alpha overlay might be considered by different types of investors. This overlay has an information ratio of 1.0. Investors can run the strategy at a 50bp tracking error as a cash enhancement strategy, as the “active” component to passive fixed income or equity exposure at a higher tracking error or as a stand alone absolute return strategy (eg, a hedge fund).
When designing an alpha overlay strategy, Bridgewater tailors the aggressiveness and structure of the account to the specific level of risk desired by each client. As a result, the alpha strategy can be a “hedge fund” like product when managed to a cash benchmark with a high volatility level, or it can be a “core plus” strategy when overlaid on a bond or stock benchmark with a lower volatility level. Similarly, the alpha strategy can be a “global tactical asset allocation” strategy when overlaid on top of a multi-asset class benchmark. For all of these reasons, the concept of alpha overlay is like a new technology that fundamentally changes the way things are done to produce a better and more efficient outcome. As a result, the growth in this type of mandate is rising exponentially.
The growth of alpha overlay strategies as a replacement for traditional active management alpha represents a material improvement in the way portfolios are managed. It enables investors to achieve more alpha for the same or less risk, and it provides for a more balanced alpha with less event risk. This is not just theory; alpha overlay mandates are now being implemented by the smartest and most progressive institutional investors. Alpha overlay managers can attach their overlay portfolio to virtually any asset class. Alpha overlays are generally implement through the use of futures and forward instruments, thereby eliminating the need to tie up cash or sell existing assets. The same alpha that generates high risk-adjusted returns can be run at almost any volatility (ie, tracking error). Markets and investors have a way of evolving toward better solutions over time. Because alpha overlay offers substantial structural advantages, it produces more efficient portfolios and will soon be regarded as the superior form of active management.