Thursday, April 11, 2013

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

  1. Professor Robert F. Whitelaw, Ph.D., Salvatore J. Bruno & Anthony B. Davidow. “Alpha/Beta Separation: Getting what you pay for.”
  2. David Blanchett, CFA, CFP, Paul Kaplan, Ph.D., CFA. “Alpha, Beta, and Now… Gamma.” September 2012.

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