Avoiding Beta That Masquerades as Alpha

We've argued repeatedly that investors and advisors should be more aware of the distinction between alpha (idiosyncratic, manager-driven returns that are relatively uncorrelated to any underlying asset class or benchmark) and beta (systematic, market-driven returns that track underlying asset classes or benchmarks).

Two recent items suggest that such awareness is on the rise among institutional and individual investors. Here's an excerpt from Pensions and Investments:

Some institutional investors are betting on highly concentrated equity portfolios to gain more alpha while at the same time expanding allocations to their core passive strategies, according to consultants, managers and pension fund executives.

As global equity markets are showing signs of a lengthy slowdown and investors are more cautious about costs, a new approach to the traditional core-satellite strategy is spreading across the world. The idea is anchored on the premise that investors in active equity strategies that hug a particular benchmark might be paying for alpha but getting mostly "closet" beta, consultants and managers said.

Another contributing factor is the poor performance of enhanced indexing and quantitative risk-control strategies. Once considered as a reliable way of harvesting alpha, many of these strategies -- which tend to make a large number of small bets against an index -- have nosedived in performance, driving investors to seek different sources of return, consultants said.

According to proponents of the updated core-satellite approach, investors should use a largely passive core portfolio coupled with more concentrated bets to maximize alpha in a cost-efficient way by using one or more concentrated managers.

And here's more from Advisor Perspectives:

Distinguishing alpha from beta matters because fees for beta from well-established asset classes should be very low, while fees for alpha are very high. Furthermore, you should select alpha providers carefully so the fees are worth it! Separating alpha from beta (in a clearly defined measurement or evaluative sense, not necessarily by investing separately in them) insures[*] you will pay high fees only for positive expected alpha, not for the delivery of a beta along with random, unskillful alpha production.

The point here isn't to argue for some super-strict separation in which alpha-seeking instruments must have zero beta (which, even if theoretically possible, is vanishingly unlikely in practical terms). It's to argue that there's a lot of beta out there masquerading as alpha. Investors and advisors who know the difference, and resist paying for one while receiving the other, should do better, on balance, than those who don't.

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* Pedantic diction-related aside: The word here should be ensured, which implies making something sure, not insured, which implies the business of insurance.

Sources

Thao Hua, "Finding Alpha With Few Bets," Pensions and Investments, June 23, 2008

Robert Huebscher, "Don't Pay Alpha Fees for Beta Performance," Advisor Perspectives, July 8, 2008