Alpha / Beta 'Separation' Doesn't Actually Require Separating Anything

Despite being maligned as financial alchemy, alpha/beta separation refuses to die (probably because it’s a good idea, but we’re biased). For example, Carl Hess, Watson Wyatt’s Global Head of Investment consulting said in this press release:

As we move into a different and difficult market environment, we expect there will be more rapid developments around some emerging trends. One notable theme is transparency, particularly the separate identification of alpha and beta, as well as an increased focus on risk, both from investors and managers alike.

Hess isn’t talking about exotic investment strategies or screwy derivatives contracts. He’s simply referring to the fact that investors should be buying alpha and beta separately, not mashed together. Apparently institutional investors agree.

In this recent Journal of Indexes article on alpha/beta separation, Robert Whitelaw, Salvatore Bruno and Anthony Davidow write:

In many ways, the history of modern investment management is punctuated by two fundamental revolutions: the creation of the first mutual funds in the 1930s and 1940s, and the creation of the first index funds in the 1970s. In each case there was a tremendous democratization of the investment landscape. Broader and broader segments of the population gained both the access and the expertise to become effective investors, at lower costs than ever before.

The separation of Alpha and Beta is the next revolution in investment science. Investment strategies that effectively isolate Beta are tremendously powerful in managing risk and containing costs. Those that segregate true Alpha can provide investors unique, uncorrelated sources of return.

Whitelaw, Bruno and Davidow are as biased as us, to be sure. They comprise the core of alternative beta manager IndexIQ (click here for Index IQ’s handy PDF version of the article above). But they have obviously put their money, and their careers where their mouths are.

The appeal to institutional investors is that they can dial up or dial down their allocation to active management without being hamstrung by the alpha/beta split inherent in a traditional active long-only strategy. The following chart by Watson Wyatt’s Janet Rabovsky (from an article available here) illustrates when you might want to do that.

When the green line (the Russell 1000) ends up being ranked in the top half of all “managers”, passive investing is a good bet. When it ranks low, active management was better. Rabovsky suggests that the VIX might predict the value of active management (red line).

But whatever their particular theory, institutional investors are only able to rebalance between active and passive management if they know how much of each they currently hold. Alpha/beta separation – even if that separation of simply notional instead of physical – is a necessary prerequisite.

Comments

[Alphameister:]

Why would an investor go to passive investment at a time when risk is high instead of actively seeking low-beta stocks or managers?

Aug 06 08:58 AM

[Avooch:]

Alphameister,

Agree with your essential premise. These are the times when prosaic fundamental analysis reigns.

Passive Investing means one will have a fair amount of equity in a company like GE - whose Enterprise Value is trading at around 36 times EBITDA !

Who would want to buy a company that just got hammered in an accounting scandal at 36 times EBITDA ?

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Don't Get Massacred !

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Aug 06 09:27 AM

[WhoisJohnGalt:]

This goes without saying for anyone on this site, but regardless of strategy preference, you have to track your investments diligently. Not to say it's easy at all to time the highs and lows, but a "passive portfolio" is extremely susceptible to systemic risk and downturns. Investing in indices on the basis of superior diversification (tough to evaluate even half of the 500/1000 companies) is simply lazy. If you are that complacent of your few stock convictions, wait it out with cash for an acceptable price.

Aug 06 10:23 AM

[Moon Kil Woong:]

I agree with WhoIsJohnGalt. It is best to actively manage your investments and at times hedge your total market risk actively as well. As for people benefitting from mutual funds, I tend to LOL. Not only are they paying needless commisions and usually getting the exact same exposure, but have to pay income tax on theoretical gains. They essentially become drone workers for the mutual fund managers who harvest a percentage of their assets every year.

Sadly not everyone has the time or expertise to correctly allocate their assets, but it appears that most professional managers tend not to have the expertise as well.

The one thing a person can glean off of this article is that as volatility goes up they should look to hedge their market risk independent of individual stock risk if affordable.

Aug 07 07:37 AM