Turning to private markets
The expectation of continuing low returns over the next decade has left investors scrambling for new approaches to asset allocation, desiring to move beyond the horizons of modern portfolio theory and on to the postmodern universe.
One stab at defining a postmodern portfolio theory is presented in a recent report by Bernard Winograd, president and CEO of Prudential Investment Management. In his essay, ‘Alpha and Beta – Translated from the Greek’*, he examines the recent shifts in the meanings of these terms and looks at the ways in which the use of the concepts can be used in portfolio construction.
In Winograd’s view: “The clarity that careful use of the concepts of alpha and beta adds to the portfolio construction process is a good thing in many ways. Its development and elaboration are sure to be an intellectual highlight of the portfolio construction debate for some time to come.”
He begins by offering clear definitions of alpha and beta. Beta’s original meaning, in the context of stock investing, was the measurable tendency of an investment to move with the market. However, in the context of using alpha and beta in portfolio construction, the meaning has changed and the term need not be applied just to individual equities. “Beta has become a synonym for market movement or exposure. Thus, getting return from beta in a portfolio construction context means getting return from being exposed to the market,” Winograd states.
He goes on to compare alpha and beta: “It beta is being contrasted with alpha, which means, in this context, the earning of return by beating the market.”
The difference between alpha and beta can be used to settle an ongoing debate by providing the proper definition of an asset class, according to Winograd. An asset class, in his view, “is a class of investments that has similar beta characteristics”.
He reaches this conclusion by reviewing the predictability of the returns of different asset classes over the long run. “While the absolute relative returns may vary in different eras, a 10-year, or at most, a 20-year period is all we usually need to look at to see the familiar ranking of returns emerge – equities first, real estate next, then bonds, then cash. It’s not a random return. It’s one that is driven by the risk and return tolerances built into the capital markets for each kind of instrument, calculable in accordance with the capital asset pricing model (CAPM). It’s predictable in the long term because it is enforced by arbitrage – if the return gets out of line, capital flows so as to push it back in line.”
He goes on to conclude, “When an asset class has a long-run, predictable return because of the arbitrage in CAPM, it is a source of beta.” And this beta, at the same time, defines it as an asset class. Winograd also claims to end the debate about hedge funds: hedge funds are not an asset class, because they do not have beta, under this use of the term.
Now this is where postmodern portfolio theory begins. “Essentially, what the enthusiasts for a postmodern portfolio theory are saying is that there are not enough returns from beta and that investors need alpha to get to their target returns. Or, more subtly and usefully, investors should decide how much of their expected return they want to come from beta (just by having exposure to asset classes whose returns are predictable) and how much they want to come from alpha, which results from picking managers who will earn better returns than the broad asset classes.”
The use of alpha and beta can further differentiate modern portfolio theory (MPT) from the postmodern, when looking for uncorrelated sources of return. “Instead of analysing what mix of asset classes will achieve your objective, consider analysing your mix of alphas to maximise their expected returns and minimise their correlation.”
The search for uncorrelated alpha has led many investors to hedge funds, but Winograd recommends steering a different course. In his view, there are two other sources of excess return that are more likely than hedge funds to produce excess returns for investors: the old-fashioned long-only manager, and private asset classes.
It is with the long-only manager that the concept of portable alpha comes in. “Find a manager who adds value relative to a liquid benchmark, hire that manager, short the benchmark using a derivative, and the excess return is ‘pure’ alpha and can be ‘ported’ into an alpha-generating portion of the portfolio without effecting your beta exposure.” Winograd does not deny that the tricky part here is identifying the right managers, and he recommends linking the relative sizes of the alpha and beta proportions of the portfolio to the level of confidence in the manager. But he also points out the fees of traditional long-only managers are decidedly lower than the funds’ fees.
Winograd recommends taking a look at private asset classes because they are sources of both alpha and beta. The alpha comes in because “private markets generally are characterised by greater spreads between top and bottom quartile performance than public markets and by much greater persistency of returns among managers than, say, hedge funds… what this means, in our new parlance, is that there is more opportunity to find alpha in private markets than in public markets.” And the beta comes in because of the variety of asset classes to choose from.
Winograd recognises the challenge here as well. “Because these asset classes are difficult to benchmark and measure, many institutional investors have a deep bias against them. But portfolio construction is supposed to be about finding uncorrelated sources of return, not just doing what is easy.”
Multiplying the number of beta sources is nothing new. Winograd points out that it is what many institutional investors are doing when they allocate a portion of their equity to overseas markets, for example, or to large, mid, and small cap managers. But he also recommends looking further at the possibilities for beta diversification: “The greater the number of uncorrelated asset classes and the more resulting in uncorrelated beta, the better.”
Looking consciously and explicitly at alpha versus beta allocations is one of the hallmarks of postmodern portfolio theory. Because it allows for clear evaluation of the nature of risk in a potential investment, it also forces investors to choose the strategy that suits them most. “For example, portfolios reaching for return, with a high degree of confidence in their manager’s selection capabilities, should make alpha bets, particularly among managers of private asset classes where persistency of performance is demonstrable. On the other hand, highly conservative portfolios with limited resources to research managers effectively may find it best to stick to an all-beta approach to generating returns.
“In short, beta diversification is the most accessible source of uncorrelated returns for those who confine their investing to public market assets, which alpha and beta can both be sources for those with the resources, scale and aptitude for private market investing.”
* ‘Alpha and Beta – Translated from the Greek’, October 2004, available at investmentmanagement.prudential.com