Alpha and Beta with respect to Institutional Portfolio Management
Portfolio returns can be broadly explained as a reward commensurate
with the risk exposure. The returns can
be broadly classified into alpha (α) and beta (β). Beta represents the market return or the
reward for systematic risk. In simpler
terms, beta can be explained as the general return for just being in the
market. In contrast, alpha represents
the excess return investors try to generate by taking additional risks or
altering their exposure away from the general market risk. In other words, alpha is the reward for
unsystematic risk.
Alpha-Beta
Separation
Investors will be able to better manage their portfolio, if they are
able to separate their returns into alpha and beta. However, they are inseparable or the costs
not justifiable. But even individual
investors can get exposure to both alpha and beta. For example, investments in mutual funds
yield beta (large portion) and alpha, generated by the fund manager.
Individual investors, nowadays, can gain market returns or beta by
investing in exchange traded funds (ETFs), which track indices, such as S&P
500 and NIFTY 50. These funds have high
liquidity and low tracking error, reducing transaction costs. Index/market exposure can also be gained
through trading in derivative instruments, such as futures and options. Individual investors can also gain exposure
across other/multiple asset classes through mutual funds. For example, gold ETFs and debt:equity funds
at various proportions. These strategies
provide individual investors with opportunities to ‘buy the market’ at low
costs and high liquidity.
Alpha:
Elusive, hence costly
Alpha-beta separation makes more sense for sophisticated institutional
investors, such as banks, insurance companies, and large fund houses. The ability to segregate total returns into
alpha and beta will help institutional portfolio managers to gain more control
into asset allocation, thereby refining investment strategies, lowering costs,
and maximize returns.
Most investors invest with the goal to ‘beat the street’. Institutional investors seek the guidance of
fund managers and investment advisors to help them achieve above-average
returns. The return, which is generated
over and above the general market return, is termed as alpha. It is the return that is achieved, primarily
from the skills of the portfolio manager.
In the world of portfolio management, “Alpha
is a code word for an elusive skill certain individuals are endowed with that
gives them the ability to consistently beat the market. It is used in contrast
with another Greek term, beta, which is shorthand for plain-vanilla market
returns anyone with half a brain can achieve.” [The Quants – Scott Patterson]
However, it still remains a question whether these exceptional fund
managers will be able to generate positive alpha consistently. Efficient Market Hypothesis (EMH) suggests
that no investor will be able to make extraordinary returns over the long term,
as the current market price factors all past financial information and future
expectations. Moreover, many research
papers empirically conclude that very few, if at all any, will be able to beat
the market consistently. (Carhart, M., (1997), “On Persistence in Mutual
Fund Performance"” Fund managers who do well in one year are no more
likely to do well the following year.)
Despite major evidence, investors flock a few portfolio managers who
have generated above-market return. But the
services of these alpha generators come at a cost. For example, most hedge funds charge 1%-3% of
Asset Under Management (AUM) as management fee and 10%-30% of profits above
benchmark. Understand that this is over
and above transaction fees.
Consider the above example, where the hypothetical annual performances
of an ETF are compared with an actively managed fund. For ease of calculation, assume zero
tax. It shows, even a 3% alpha will
almost disappear, given the costs of fund management. Transaction costs usually are higher for
active management, compared to passive investment in ETF, due to frequent
changes to portfolio. Effectively, the
actively managed fund yielded 12.35%, marginally higher than the 11.89% return
from ETFs.
Alpha
fees for Beta?
Alpha and beta are very important concepts in the context of
institutional portfolio management, right from asset allocation to performance
evaluation and attribution. Benchmarks
play a crucial role in the calculation of alpha. For example, a portfolio manager with Nifty
50 as the benchmark will be able to outperform in bear market by investing a
portion of the fund in debt markets or government securities. And he will also likely outperform during
bull market by investing a part of the portfolio in mid-cap/small-cap
(high-beta) securities. Also, some hedge
funds may outperform during bull markets, just by using leverage.
Another downside for institutional investors in parting a part of the
fund with alpha generators is the additional costs paid for beta, not
alpha. For example, consider a hedge
fund which uses 50% of fund in his alpha strategy but the rest in the index ETF
(his benchmark). The institutional
investor will be paying management fee for the 100% of fund (including the 50%
invested in ETF) allocated to that hedge fund.
Effectively, the investor will be paying alpha-level fee for beta-level
returns.
However, true alpha generators also exist. For example, consider a long-short market
neutral fund. These funds typically have
a benchmark of zero, as they strive to catch returns from idiosyncratic risk
exposure. Some part of the portfolio can
also be allocated to private equity funds, which have close-to-zero correlation
with the general market. And, the
benefits of diversification can be achieved through allocation to other
alternative asset categories, such as commodities and real estate (REITs).
Alpha-Beta
Separation in asset allocation: A case
After having familiarized with the basics of alpha and beta, let us
consider them in the context of an institutional investor through a
hypothetical case. An investment manager
of a pension fund has Rs. 1,00,000 in asset under management. Let us assume, there are no or limited
constraints on his investment decisions.
Traditionally, he would chose to allocate his money to three asset
classes, namely equities, fixed income securities, and alternative asset
classes, primarily hedge funds. The
proportion of investments in these asset classes will be decided by the fund
manager, based on his risk and return objectives. While alternative asset classes will be
treated as pure-alpha strategies, the allocation to equity and debt instruments
will be split into beta and alpha generating investments. The flaws with this traditional asset
allocation strategy are (1) Not all investments in alternative assets will be
alpha-generating; (2) The investment manager will not be able to achieve his
target asset allocation, as some hedge funds will be long only funds, increasing
the pension fund’s allocation to equities; and (3) Increased costs, as the
investment manager will be paying for both alpha and beta generation.
Instead, the investment manager can achieve his desired portfolio
allocation and investment objectives through alpha-beta separation. Under this strategy, the investment manager
must allocate a large chunk of his fund under passive investment vehicles, such
as low-cost mutual funds, synthetic hedge funds, and ETFs. The rest of the fund can be invested in pure-alpha
generating equities, debt instruments, and alternative investments. By following this strategy, the investment
manager will be able to over the challenges under traditional approach.
Traditional Approach vs. Alpha-Beta Separation Strategies
Alpha-beta separation provides the investment manager will multiple
advantages, including effective cost control (e.g., management fees) and better
alpha capture. Flexibility in managing
portfolio is another significant benefit from this strategy. As alpha and beta assets are handled
separately, any changes in asset allocation can be executed with minimum
costs. Portfolio requires rebalancing to
stay within target asset allocation due to changes in market value; Portfolio
rebalancing is usually done periodically or whenever the allocation strays a
certain, say +/- 2 pps percentage points beyond target.
However, the strategy comes with certain limitations or
disclaimers. During portfolio execution
the investment manager must be aware of the liquidity level of assets, such as
private equity funds and small-cap equities.
Alpha separation from mutual funds may involve substantial hedging
margins, as certain index funds had to shorted to remove the beta from the
mutual fund and gain pure-alpha exposure.
Hence, the cost and effort may not be justified for small individual
investors and may be appropriate only for institutional investors and premium
high net worth (HNI) clients.
Extended Concepts
Liability-linked
Portfolio Management
Institutional investors, such as pension funds, have to make periodic
pension payment and hence, will have to consider their liabilities during
portfolio allocation. For example,
consider a pension fund under defined benefit plan. It can choose to immunize its pension fund by
investing in fixed income securities, with future interest receipts matching or
exceeding future pension payments.
However, for most institutional investors all or most of future
liabilities are uncertain. e.g., insurance companies. In those cases, investment managers must take
into consideration the correlation of liabilities to asset classes before
investment decisions. The pension funds,
whose payments are linked to interest rates or inflation, must have exposure to
fixed income securities/treasury inflation protected securities (TIPS). Also, if the pension fund is for employees in
equities industry, then the fund manger must reduce his exposure to general
markets. This is because the pension
payments are linked to employees’ salaries and salary growth, which is linked
to equity market performances. Remember,
the fund manager is not working for the pension fund, but for the employees of
the company, the ultimate beneficiaries of the fund.
Careful
consideration of Beta
Asset beta of companies also must be considered by the fund manager
during the investment decision process.
If the fund manager is handling the treasury operations (managing excess
uninvested profits) of a technology major, such as Apple, he can generate more
diversification benefits (more returns for same or less risk) by taking into
consideration the beta of his investments and assets of the technology
company. For example, he may choose to
reduce his exposure to NASDAQ Composite ETF, which is more technology-weighted.
Concluding
Remarks
Alpha and beta contribute a great deal to institutional portfolio
management, right from asset selection to asset allocation to performance
evaluation and attribution. They help
separate the skilled fund managers from their doppelgangers. Investment managers, who are able to
segregate alpha from beta, will be more effective in reducing costs, managing
risks, and increasing returns.
Major
Sources
- Professor
Robert F. Whitelaw, Ph.D., Salvatore J. Bruno & Anthony B. Davidow. “Alpha/Beta
Separation: Getting what you pay for.”
- David
Blanchett, CFA, CFP, Paul Kaplan, Ph.D., CFA. “Alpha, Beta, and Now…
Gamma.” September 2012.