Alpha vs. Beta

by: Veryan Allen

Alpha beta separation? Beta-based asset allocation is supposedly the main driver of returns. Many papers claim that it is almost all that matters. They reached that conclusion because asset allocation is what the selected investors focused on. Despite many errors, that biased sample has dominated conventional wisdom for too long. Setting a stock/bond/alternatives mix may determine variability of returns only for those that emphasize it. It is easy to debunk this portfolio construction "axiom" if you seek reliable performance.

Suppose corporate pensions were required to invest 100% in their plan sponsor's stock. Then we would conclude that security selection drove returns. Or assume investors flipped coins each month to determine whether to be 100% stocks or bonds. Tactical timing would be the only performance factor. You only have to look at the underfunded status of many institutions to see that conventional "choose your betas" asset allocation needs new thinking. Many assume that those with long term outlooks should have "more" in risky assets due to their alleged higher "expected" return. Instead of assets, investors would be wise to focus on the alpha/beta split. For anyone with lower risk tolerances and dislike of deep drawdowns, alpha gets the vote.

In reality, the best determinant of superior risk-adjusted returns is investment skill, not the percentage in different unskilled asset classes. If the "seminal" studies had confined their analysis to high frequency portfolios, obviously they would find that ability at high frequency trading drives performance! Is it valuable information to "discover" that asset allocators' returns largely depend on their asset allocation?

It's been a great decade for the S&P500. No beta, but every day had an opportunity set of 500 fluctuating securities to capture alpha. It was an even better 25 years for the Nikkei. Again no beta, but vast alpha was generated from security selection and timing by those with skill. In aggregate, "stocks" can and do underperform "bonds" for decades. 60/40 sounds prudent until rephrased as 90/10 risk. Why have a risk appetite when equity indices fail to compensate with sufficient reward even in bull markets? Last century's 8% return on 16% volatility was an insult but a negative return with even more risk is absurd.

The more vituperative commentary on hedge funds, the more cash one should invest in alpha vendors. Why tie up precious capital in high risk beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to short sell and buy. Most portfolios are still very beta biased while some investors implement a beta plus alpha model. The inevitable progression is to alpha only, which has a superior efficient frontier. I do not understand why investors must surrender to the volatility of the long only "market".

Selecting the right betas at the right time is a form of alpha anyway. Choosing the which and when of asset classes takes as much talent and expertise as at the security level. I have no idea where the markets are going in the long term but will not take the risk of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we live in a world that rewards passivity in any activity? I don't think so, which is why they are called activities. Alpha comes from acumen-driven action.

Successful investing is about leveraging your informational, structural and analytical advantages or outsourcing to those that do. Let's look at a few portfolios that did well over long periods but didn't asset allocate, preferring to focus on securities selection or timing. A prominent slow frequency trader, Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast, Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Munehisa Honma's managed futures fund specialized in trading one security in multiple time frames. Producing alpha depends on the knowledge and technology edge being applied to the appropriate time horizon.

Alpha/beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/9. That was the error inherent in the portable alpha idea. It was a beta-centric way of getting people into hedge funds but failed because it kept asset allocation front and center. It diluted the absolute return attribute and changed it into a relative return enhanced index product. The alpha/beta separation advocates allocate too much risk budget to beta. Why bother with beta at all? Cheap beta is expensive considering its risk. Risk and cost conscious investors favor alpha.

Beta bets drive most portfolios because that is what most investors do. It is like the people who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance! It is false logic akin to the black swan phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its weakness. Efficient, unbeatable markets imply the non-existence of skill. Focus on beta because alpha is just "random" luck in a zero sum game? Beta people like index funds because they want you to invest in "the market". But the safest way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don't manage risk, don't time and outsource security selection to benchmark construction firms. They stay fully invested in bear markets. A beta-centric portfolio is where investors decide an asset allocation and then look around for managers to basically deliver the return from that asset class and hopefully a bit of alpha on top from active mandates. Most long only funds have R-squares with their benchmark over 75% - i.e. beta explains most of their returns. Alpha sourcing and manager selection shouldn't be secondary but that is the result when beta bets dominate the allocation of investment capital.

Alpha people see a market of securities offering long/short opportunities over different time horizons within and between asset classes. An alpha centric portfolio is where investors select managers to analyze, trade and hedge. Of course you have to be very good and work extremely hard to find alpha. Any manager that depends on beta is not a hedge fund. A truly efficient portfolio does not pollute itself with any beta. Dismissing all hedge funds is like avoiding all stocks because of Enron, Worldcom and Nortel. Don't invest in fixed-income because some bonds default?

Naturally pure alpha sources do not fit well into a beta allocation process. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that average performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise, I am often asked where I think the "market" is going. That is a beta question. Some stocks go up and others go down.

Do I want "hedge funds" that outperform? No. I want hedge funds that make money which is a different concept. I know that good hedge funds will perform well and bad ones will not. Alternative beta is just another beta and is therefore best avoided. Most betas are becoming more correlated whether by geography or the equity/credit/real estate connection to the economy. Alpha is the true diversifier because there are so many different ways of generating it. Focus on alpha if you want reliable performance regardless of "the markets". Why pay attention to asset classes (pdf) when investing in different skill-based strategies makes more sense? For the risk averse conservative investor, alpha and beta is inferior to alpha only.

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