The Pathway To Alpha Is With Diversified Beta

 |  Includes: SPY
by: Craig Israelsen


Achieving alpha at the portfolio level requires diversified beta exposure.

Pure beta exposure is cheap and easy to access by shopping among a vast array of ETFs.

The key to achieving portfolio alpha--when using beta products--is adequate diversification.

Building an alpha-generating portfolio requires both depth and breadth. Of the two, breath is the real driver of alpha.

Depth is achieved by using ETFs as opposed to a single issue of stock. Investing in one ETF permits the investor to own dozens or hundreds of different "things" (stocks, bonds, commodities, etc.). This type of diversification represents depth.

Breadth is achieved by investing in a variety of different ETFs-funds that specifically cover different asset classes. Breadth is the underlying principle behind the term "asset allocation" and the ability to generate meaningful alpha.

ETFs that mimic the S&P 500 Index, as an example, invest in 500 large US stocks. This type of fund has adequate diversification depth, but does not have breadth because it represents only one asset class (that being large cap US stock). An ETF that has depth does not necessarily have breadth. Breadth is achieved by investing in a wide variety of asset classes-and virtually all ETFs focus on depth, not breadth. Thus, a truly diversified portfolio must use a wide variety of ETFs to achieve true asset allocation---and breadth.

Consider the analogy of making salsa. A variety of different types of tomatoes may be used in a salsa recipe, but blending together a wide variety of tomatoes is certainly not salsa. Tomato "depth diversification" does not make up for a lack of breadth diversification. More ingredients are needed that are very different from tomatoes, such as onions, salt, peppers, cilantro, etc. Only after these diverse ingredients are mixed together with the tomatoes do we have salsa.

Here's the challenge: some may assume that a fund with 500 stocks is a diversified portfolio-but they are mistaking depth diversification for breadth diversification. An ETF with 500 US stocks in it (or any large number of stocks) is a wonderful starting point if wanting to build a diversified portfolio, just as tomatoes are a logical starting ingredient if making salsa. But, an ETF with 500 large cap US tickers is not a breadth-diversified fund. As advisors and investors think in terms of asset class breadth they will make better use of depth ingredients (ETFs and/or mutual funds) in their search for alpha.

Of Alpha and Beta

ETFs by definition are beta instruments (at least in the classic sense). The beta of ETFs that are attempting to mimic the S&P 500 Index should be 1.00. Any beta other than 1.00 represents some sort of tracking error.

Alpha, technically speaking, should not exist in an exchange traded fund. In fact, an ETF that mimics the S&P 500 should actually have a negative alpha of the same size as the ETF's expense ratio.

So, how is alpha achieved when dealing with ETFs? Very simply, by assembling a wide variety of ETFs that have low correlation with each other and rebalancing them on a regular basis. The net result of this diversified beta-based portfolio is the synergistic creation of alpha. Said differently, pure and simple asset allocation is one possible pathway for ETF investors who are seeking alpha.

Of course, the measurement of alpha gets tricky because alpha is only meaningfully calculated against a benchmark that is comparable to the portfolio itself. And that's tough because there are very few broadly diversified benchmark indexes that incorporate a wide variety of asset classes.

The alpha generating portfolio being introduced here is a model that I developed in early 2008. I call it the 7Twelve® Portfolio. It utilizes 12 equally weighted asset classes. The 7Twelve model is shown below. Each "box" or asset component can be represented by an exchange traded fund. Each "box" has an 8.33% allocation and is rebalanced back to 8.33% annually.

7Twelve® Portfolio

Approximately 65% of the Allocation

in Equity and Diversifying Assets

Approximately 35% of the Allocation

in Bonds and Cash

US Equity

Non-US Equity

Real Estate


US Bonds

Non-US Bonds


Large Companies

Developed Markets

Real Estate

Natural Resources

US Aggregate Bonds

International Bonds

US Money Market

Medium-sized Companies

Emerging Markets


Inflation Protected Bonds

Small Companies

Click to enlarge

The 7Twelve Portfolio performance benchmark that I will utilize is the classic 60/40 portfolio that allocates 60% to US stock and 40% to US fixed income. I have chosen Vanguard Balanced Index (MUTF:VBINX) as a representative 60/40 portfolio. In short, we are comparing the performance of the 7Twelve Portfolio against the classic 60/40 portfolio to determine if 7Twelve generated any alpha over the past 5, 10, and 15 years (as of 12/31/2013).

As shown below, the multi-ETF 7Twelve Portfolio failed to generate alpha over the past 5 years. Now, if the benchmark portfolio had been something other than a 60/40 model 7Twelve may have produced alpha. It's all dependent on what portfolio is chosen as the benchmark when it comes to calculating alpha.

Over the past 10 years (2004-2013) the 7Twelve portfolio produced a 10-year annualized return of 8.17%, or 127 basis points higher than Vanguard Balanced Index. Thus, 7Twelve produced alpha of 127 basis points.

During the past 15 years 7Twelve produced alpha of 279 basis points. Interestingly, if the 7Twelve portfolio was not re-balanced over the 15-year period (that is, if the 12 ETFs being utilized were simply bought and held) the amount of alpha generated declined to 243 basis points. Rebalancing is part of the alpha generating process when utilizing a wide variety of ETFs in a broadly diversified portfolio.

Building broadly diversified portfolios is a logical method to achieve alpha over the long haul.

7Twelve® Portfolio vs. 60/40 Vanguard Balanced Index

Calendar Year

Total % Return*

(Assuming annual

rebalancing in 7Twelve Portfolio)

7Twelve® Portfolio

(Using 12 ETFs)


Balanced Index















































5-Year Average Annualized % Return




10-Year Average Annualized % Return




15-Year Average Annualized % Return




Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.