Tapping sources of alpha
The total investment return from an asset portfolio can be divided into two components:
q Alpha – the return from taking active risk (ie, not mirroring the market or a proxy thereof, such as an index); and
q Beta – the return from taking on exposure to market risk.
It is not always apparent where the division between alpha and beta lies. The ability to make this distinction is key to determining what part of the overall return is due to an investment manager’s skill and what constitutes the compensation for taking on market exposure.
The search for alpha begins with its quantification. Alpha is usually calculated as the difference in return generated from the asset portfolio and the portfolio’s benchmark. The difference arises from taking positions in individual securities of different magnitude to the securities’ weight in the benchmark. Those securities eligible for inclusion in the benchmark should be the same as those defining the opportunity set for the active investor. The ability to invest in securities not eligible for, as distinct from not included in, the benchmark introduces other sources of beta into the overall return picture. We will, however, focus on the factors involved in the generation of alpha below.
Four factors impact the potential for generating alpha in an asset category. These are:
q Information advantage;
q Regulatory and structural factors;
q Opportunities created by the presence of other market participants; and
q The impact of transaction costs.
The presence of the above factors makes it worthwhile to expend resources in seeking to identify investment managers with skill to generate alpha over time.
The decision as to which securities to overweight and which to underweight relative to the benchmark should, ideally, be an informed one. The ‘information advantage’, which means different things to different people, is key in the realm of active management. The free flow of information is important in this regard. We would expect those markets with regulated freedom of information flow (eg, the Regulation for Fair Disclosure in the US) to prove more difficult to add value in than those markets with less widely disseminated information.
However, quantity of information flow does not necessarily equate to quality – in fact, some hypothesise that information overload may cause poor decision-making. The ability to identify useful information and to organise this information to support the decision-making process are key contributors to alpha generation.
Regulations, particularly changes in regulations, may unintentionally create alpha-generating opportunities for market participants with superior understanding of these factors. A current example relates to changes in accounting regulations which may reveal companies to be in an unexpected state of financial health.
This revelation may lead to changes in valuations of those companies affected. Those able to identify the likelihood of such changes in valuations will have an opportunity to outperform the balance of the market due to these insights.
Other alpha-generating opportunities that arise from regulation-related distortions may include taxation, restrictions on ownership by specified types of investors and limits on the ability to short securities.
The greater the number of profit-orientated market participants, the less likely one is to make profits in that market and/or the lower the average profit per market participant is likely to be. However, it should be noted that parties do participate in markets for reasons other than profit maximisation. These participants include those:
q Hedging risk in the normal course of business;
q Seeking to gain exposure to a particular market as a whole rather than necessarily trying to outperform the market (ie, passive investors); and
q Participating in one investment market which necessitates passive exposure to another market in which the potential for alpha generation exists (eg, investors who buy foreign securities also become participants in currency markets in order to settle the primary transaction).
Transaction costs diminish the amount of alpha that maybe captured, as opposed to what is theoretically available, in a particular market. Efficient implementation of investment decisions is critical in this regard. However, even if an investment manager implements its decisions efficiently, the trade-off between the capture of alpha by trading and the erosion of alpha due to trading should be considered. There is a point at which it is no longer economically efficient to pursue further trading opportunities.
The ‘fundamental law of active management’ holds that the degree of investment freedom, as captured by the number of investment decisions the investment manager is able to take, influences the potential for an investment manager to generate alpha. The greater the number of available decisions, the higher the expected active return. However, there are asset categories with a limited number of investment decisions which have proven to be rich sources of alpha (eg, active currency). In these instances, other components of ‘the law’, for example, the information coefficient, are high enough to offset the impact of the limited number of investment decisions.
One needs to be aware of the possible introduction of external sources of beta into a portfolio as the degree of investment freedom is increased – the investment opportunity set may be broader than that of the benchmark. While one needs to guard against becoming too pedantic in assessing whether the search for alpha has been successful or whether beta has made an ‘accidental’ contribution, an understanding of the sources of return and the risks taken to achieve them is important in determining whether the investment programme has met its stated objectives.
In principle, active managers are employed to generate alpha by demonstrating ‘superior insight’ and this should be the main component of excess return. Active management is an expensive way to gain beta exposure.
The mathematics behind the risk and return properties of a combination of assets demonstrate that return is additive, while risk is not if its sources are less than perfectly correlated. This means there are benefits, in terms of greater return per unit of risk, of combining different sources of risk. This is particularly true when combining sources of active risk.
Active risk is a function of each investment manager’s view of the market, how they expect to outperform and how they implement this view. Almost by definition, no two investment managers will perform in exactly the same way and there is likely to be a high degree of differentiation in the profile of active returns generated. Combining a number of independent alpha sources is an effective way of harnessing the power of diversification to enhance the efficiency of a portfolio of assets.
There has been a trend towards more even allocation of investment risk budgets between market risk and active risk in recent times. This has lead to a greater emphasis on the search for alpha, at both individual and aggregate portfolio level. The key is to clearly consider the factors that impact the availability of alpha in a particular space as well as the existence of investment managers able to capture any alpha expected to be available.
The power of the mathematics that govern the risk and return characteristics of a combination of assets should also be used in seeking to improve the return per unit of active risk taken on by combining independent sources of alpha.
Ralph Frank is senior consultant at Mercer Investment Consulting firstname.lastname@example.org