Optimal Alpha: Beyond Portable Alpha

by: Christopher Holt

As regular readers may recall, Alpha Male was at a hedge fund conference last fall involving a large number of institutional investors. While the “main stream media” was not invited, AllAboutAlpha.com was able to report on few general themes and some of the extra-curricular events. One of the speakers was Robert Zink of behemoth money manager Bridgewater Associates, managers of over $150 billion in AUM (and pioneers of pioneers of alpha-centric investing). He brought with him a very interesting message, but we ran out of space and time to report on it back in October.

Thankfully, a loyal reader just passed along this article by Zink’s boss Ray Dalio (CEO & founder of Bridgewater and super-rich guy) and reminded us to post on these issues. In the article, Dalio makes essentially the same arguments as Zink did last fall - that any asset class can be leveraged or de-leveraged to assume any level of risk. Dalio also claims that alpha-centric investing will cause the lines between “hedge funds”, “long-only equity” and all other asset classes will melt away as all asset managers fight for “the whole enchilada“.

First Dalio lays out a holistic theory of investing that explicitly recognizes alpha and beta - what we would call “alpha-centric” investing. Bridgewater calls their brand of alpha-centric investing "Post-Modern Portfolio Theory [PMPT]”. In Dalio’s words:

For lack of a better term [ed: we have one], I will call the engineering process described in this article Post-Modern Portfolio Theory [PMPT], because it builds on the concepts of portfolio theory, and then goes a few steps beyond. The traditional application of Modern Portfolio Theory [MPT] first combines asset classes based on their expected returns, risks and correlations, and once the asset allocation mix is determined, identifies the best managers in each asset class. By contrast, PMPT differs in three key ways: first, returns from alpha and beta are separated; second, the sizes of alpha and beta are altered to more desirable levels; and finally, far more diversified portfolios of each are derived. As a result, a PMPT portfolio will not only have returns and risks that are more calibrated to suit the investor’s objectives, but also will be much more diversified than the traditional portfolio.

Dalio goes on to discuss how traditional portfolios of stocks, bonds and cash tend to derive the vast majority of their volatility from beta - simply because they comprise mostly beta. Adding more risk from alpha could be very beneficial, he says. However, he also admits that since alpha is a zero (negative) sum game, the investor needs to feel confident they are above average at picking managers. And apparently many investors do fancy their manager-selection prowess since as Dalio points out, the amount of alpha-risk being taken by his clients has been rising recently.

An “Optimal Beta Portfolio”
In the ensuing discussion on “building the optimal portfolio” Dalio lays the groundwork for Zink’s subsequent conference presentation. He says:

I believe that this relationship exists because assets can be made ‘competitive’ with each other and ‘arbitraged’ through the use of leverage. In other words, by borrowing cash to buy more of an investment, one can raise both the expected return and the expected risk of that investment. For example, through the use of leverage, bonds can be made ‘competitive’ with equities.

In a nut-shell, Dalio says that a target return of, say, 10% can be achieved by levering up high Sharpe, low return asset classes rather than simply buying the existing high return/high volatility asset classes. This reminds us a little of the proverbial “picking up nickels in front of a steam roller” strategy (finding low return, high Sharpe trades and leveraging the h*** out of them) - except the low return, high Sharpe trades aren’t arbitrage trades, but simply real estate, high yield debt and fixed income that require less leverage. Academically speaking, Dalio is simply moving each asset class up and down a capital market line and arguing that the often-maligned Sharpe ratio is more important than return and risk in isolation.

The benefit? Diversification. Recognizing the infinite leveragability and de-leveragability of any asset class allows you to construct a well diversified portfolio using all asset classes at your disposal, not just the ones with the required return profile. The only constraint according to Dalio is that all of the asset classes that are leveraged or de-leveraged must have returns higher than cash. In other words, they need to have positive Sharpe ratios. (Otherwise, borrowing to lever them up would be a losing proposition.)

Once all asset classes have been normalized through leverage, all that matters says Dalio, are the cross correlations between each asset class. The result is a portfolio of several asset classes, rather than just equities. (He also says this approach would reduce kurtosis (fat-tail) risk but does not go into detail).

An “Optimal Alpha Portfolio”
Bridgewater has two approaches to alpha-centric investing that show why the term “portable alpha” is insufficient in describing the myriad of investment strategies available in today’s new investing paradigm:

1. Clients pick a beta portfolio and overlay Bridgewater’s “pure alpha” on top, or,
2. The alpha generated by active managers is distilled from the beta and aggregated together into a de facto alpha portfolio. (Dalio’s preferred approach)

“The Future of Investment Management”

In conclusion, Dalio makes a number of prophecies about asset management. Apologies to Bridgewater’s lawyers for likely overstepping “fair use” copyrights by excessively quoting Dalio’s article below. But we at AllAboutAlpha believe he is totally right on with these observations.

Firstly, he envisions a division of labor in the industry…

Since I firmly believe in the inevitability of evolution, and I believe this PMPT approach to structuring portfolios is substantially better than the more traditional MPT approach, I am confident that the investment management industry will evolve toward having two broad types of investment managers – those who efficiently create betas and those who are alpha generators.

Second, he believes the alpha genie of out of the bottle…

“I am convinced these changes will happen extremely fast and trigger profound changes in both investing and the investment management business.”

Third, he credits hedge funds as being agitators of this paradigm shift…

Hedge funds are making progress along these lines, in part because they have the most freedom to engineer their alphas. These funds are helping to foster change throughout the investment industry, causing investors to ask themselves if they should let their traditional managers operate by the same rules as hedge funds.

And finally, he suggests (as does William Sharpe in his new book) that strategic asset allocation is a false religion…

“Rather than 'equity managers' competing with other 'equity managers' in the investor’s equity piece of the pie, all alpha generators will compete with each other for the whole enchilada.”

…The unsaid warning to us all: Dalio intends to eat all of our (enchilada) lunches.