With its (appropriate) focus on generating returns, the asset management industry tends not to spend inordinate amounts of time on introspection - on the way firms in the industry management and organize themselves. As management consultants are fond of saying, “form follows function.” That’s consulting-speak for “structure follows strategy.”
A great example of an organization that realizes the holistic implications of alpha/beta separation is Sweden’s AP7, one of the country’s many so-called “buffer funds” designed to fund the retirements of its citizens. Regular readers may recall AP7 and its forward-thinking CIO Richard Grottheim. As we reported in January, AP7 has recently awarded what it calls “pure alpha briefs” that are essentially notional overlays applied to the fund’s passive portfolio.
A few weeks ago, Grottheim and colleagues, including one from the Stockholm School of Economics, revealed how AP7 is set up to undertake this kind of innovation in a new white paper. In this paper, Grottheim and friends propose an organizational structure that they say shows “not only significant improvement in portfolio performance, but also a more transparent and cost efficient portfolio structure.”
While the authors acknowledge that alpha/beta separation has been used for return attribution for several decades, they argue that it “can evolve to a framework for portfolio management."
Beyond the obvious benefits of focusing on alpha (flexibility for both investors and managers), the structure and business processes implemented at AP7 have other benefits according to the authors:
- Diversification: “…passive or beta management typically allow for improved diversification benefits as more securities are included in the portfolio management.”
- Fee Transparency: “…separate management of alpha and beta lets investors capture the full economies of beta management and pay active management fees that reflect a manager’s skill.”
- Lower Costs: “[Manager transition] is associated with substantial costs which reduces the efficiency in the market substantially.”
But re-writing the playbook brought new challenges. One was the requirement for new risk measures. As Grottheim and colleagues report:
The standard deviation of alpha return is hardly the ultimate risk limit. Instead a risk budget was defined by using expected tracking error, the return target and the notional amount. The purpose of the risk budget is to cover potential losses and is not capital to be used for active bets in the day to day operations. In addition to the general risk budget, constraints on short selling and VaR are implemented in the day-to-day risk management.
The paper contains one example of an active long only manager with an apparent propensity for index-hugging. When the index was stripped from the return stream, it was found that the manager was actually producing a negative alpha (charts below).
While you’d think the market can be tracked perfectly by a passive investment, even the beta portion of the AP7 portfolio contained enough tracking error to leave an active footprint once the market was removed (right chart below), although things seem to be improving in recent years.
Grottheim says the search for alpha has been a bit tougher however. Apparently, managers have had trouble getting their heads around the lack of any physical capital. Their longs and shorts are given life via overweighting and underweighting a separate passive portfolio - meaning they don’t actually manage any money. Managers are asked to construction an overlay as if they managed x Swedish kronor. That “x” is called the “notional amount.”
Naturally, changing the notional amount (the denominator in the return calculation) would dramatically change the return of the overlay. So you can see how things get a little weird. While there are technically no assets under management, compensation has ended up being a combination of both management and performance fees.
In conclusion Grottheim makes the following observations about the transition at AP7:
One important lesson is that the asset management industry has not been fully prepared to meet the new demand of separate management of alpha and beta as opposed to traditional active portfolio management…However, the market seems to adopt this new asset management framework and asset managers are increasingly interested in providing services.
Another important lesson of the alpha-beta-separation framework is the overall improvement in portfolio performance. Traditional active managers that were hired struggled to deliver alpha and AP7 as a whole did not obtain a positive alpha. The new setup has implied a cost efficient beta exposure and a positive and significant alpha.