There has been a powerful movement in the investment industry toward separating ‘alpha’ from ‘beta’ investing. In simple terms, beta investments are well-diversified market exposures that can be purchased through index funds linked to a variety of equity and fixed income indexes. Alpha investments are investments that exhibit low correlation with major market exposures and are designed to outperform money market ( LIBOR+ to be exact); these strategies are typically embodied in hedge funds.
There are numerous benefits associated with segregating investments into alpha and beta portfolios, and the advantages pertain to both asset owners and asset managers. To fully appreciate the power of this investment approach, it is necessary to examine the current industry practice.
Existing fund products are predominantly long-only strategies, which provide investors with both broad market exposure and securities selection expertise. In markets where investors are more absolute-return focused and with shorter holding horizon, fund offerings also incorporate timing strategies via aggressive sector rotation or tactical shifts into cash to mitigate downside risk.
The problem with this investment paradigm is that asset managers are unable to specialise. An equity portfolio management team must simultaneously possess stock picking and industry selection skill, portfolio optimisation know-how, as well as marketing timing expertise. That is a tall order.
In reality, most asset management companies are simply unable to cultivate and sustain this expertise. More often than not, a superior stock picker finds himself distracted by the need to predict industry and macro cycles, where he has no comparative advantage. Additionally, since large cap equity funds and investment grade bond funds have the greatest capacity for capital raising, skilled managers are forced into these arenas where there is little opportunity for outperformance. In this way, the most skilled managers are improperly allocated to an area with low returns to skill, and most active management fees are paid for performances that are largely indistinguishable from a low fee passive diversified portfolio.
Alpha beta separation
The push toward alpha beta portfolio separation came as a consequence of the popularity and success of low-cost and efficient index funds and hedge funds and fund of hedge funds. Low cost index managers, who specialise in portfolio optimisation, execution and securities lending have been squeezing active management fees. True alpha managers, in turn, have left traditional asset management jobs to launch hedge funds that make concentrated bets. Their skills are accentuated by both the freedom to short and leverage as well as a better alignment of interest through heavy use of incentive fee structure.
Asset owners and their investment consultants quickly realised they could do better by putting 100% of their money in a 5bps index fund and leverage up to invest in a basket of hedge funds at 2 + 20, than investing in an active fund with 60bps management fee. In the former case, very little fee is paid for a broad market exposure or beta, while most of the fees are spent to incentivise alpha managers to provide excess return. Both the beta and alpha managers can be highly specialised and completely undistracted by investment objectives outside of their expertise. Additionally, compensation structures can be separately designed for beta and alpha management.
The asset management industry, by separating alpha from beta, has been evolving from an integrated model to a modular model, where investors can freely select their favourite beta exposure and top it off with a collection of alpha managers who operate in highly inefficient niche markets. That is, a pension plan can invest in a Lehman Aggregate Bond index portfolio for its beta exposure, then overlay it with an emerging market debt hedge fund to generate excess return.
The practice of alpha beta separation leads naturally to the concept of alpha stacking. In essence alpha stacking is nothing more than modularising the investment process and seeking out the best of breed managers to add value in each step of the process. The concept can be easily illustrated with a simple example.
Suppose the asset owner has a simple investment objective of preserving purchasing power with a risk constraint to not achieve negative returns. Given this specification, the natural solution (the policy portfolio) is a money market investment, which can deliver 1% real return with no risk. However, we also realise that we can do much better if we are willing to live with an occasional down year. This allows us a risk budget to construct a strategic portfolio to augment return.
The traditional solution is a balanced 60% equity/40% fixed income approach, which is likely to increase portfolio real return to 5%, while increasing portfolio volatility to 9%. However, we can do better if we were to hire an asset allocator with expertise in alternative asset classes. Diversifying into alternative asset classes like commodities, emerging market bonds and equities, and high yield instruments, will further enhance portfolio return and reduce volatility through optimal asset mix construction. This alpha asset allocation manager may augment return by 200bps relative to a standard 60/40 portfolio posture.
With the desired asset mix determined, we need to select the appropriate indices to implement our betas. There are a variety of index choices for global large cap and small cap equities as well as for investment grade and high yield bonds. Selecting a more efficient index (high capacity, low turnover, and better performance) can add considerable returns1. Similarly, selecting an implementer, who can enhance index returns via superior execution and securities lending, also contributes to portfolio alpha. This step may augment returns by 100bps relative to higher fee active portfolios.
We can do better still by completing the portfolio with uncorrelated overlay strategies via investments in hedge funds, currency strategies, market neutral equity strategies, CTAs or fixed income arbitrages. This may augment return by another 200bps. Stacking alphas in this example has resulted in an absolute real return oriented portfolio that can deliver 10% real rate of return.
The separation of alpha and beta continues the asset management industry’s evolution toward modularisation and enables greater customisation. The ultimate goal is toward an alpha stacking construct where specialised skilled managers are retained to deliver alpha in every step of the investment process.
1Non-cap-weighted indexes, like FTSE/RA Fundamental Indexes™, which have gained tremendous populary in the marketplace, are reputed to add 200bps to 300bps relative to comparison indexes. In full disclosure, the author is a co-originator of Fundamental Indexation™, and Research Affiliates markets and license Fundamental Index products and services.
Non-cap-weighted indexes, like FTSE/RA Fundamental Indexes™, which have gained tremendous populary in the marketplace, are reputed to add 200bps to 300bps relative to comparison indexes. In full disclosure, the author is a co-originator of Fundamental Indexation™, and Research Affiliates markets and license Fundamental Index products and services.
Jason C Hsu is principal and director of research and investment management at Research Affiliates, based in Pasadena, California.