Monday, August 29, 2011

Managing the Total Portfolio: Beta and Alpha and the Reason for Holding the Investments

What is the natural evolution of the investment management industry?

Today the industry is heavily siloed, with portfolio managers managing components of the larger portfolio, but with comparably far fewer people assisting with creating the overall composition.

Virtually everyone in finance and investment management professes to understand the difference between beta and alpha and to use them both appropriately, but in my experience most are acutely aware that something is missing in the way that they are used. And in the juncture between these two first paragraphs, we might find clues to the future development of the industry.

Beta is for all intents and purposes the overall total portfolio strategic asset allocation (SAA) policy, and it is also the asset class benchmark for each major component or asset class in that policy; it is also the benchmark for each manager chosen. These are beta--easily seen because they can be implemented with some combination of one or more passive index funds. This means that they don't require active insight in order to be properly maintained--and they only need to be rebalanced periodically, a process which is also passive, or at least informationless. And it is cheap.

Alpha is variations from this total portfolio SAA benchmark or its component asset class benchmarks. Most commonly we think of alpha as the result of stock selection, style selection, or one of the other disciplines used in managing specific bond or equity portfolios. It also includes market timing, benchmark timing, tactical asset allocation, manager selection, and other similar methods that over- or under-weight specific asset classes, managers, or other component benchmarks, in the effort to add value.

Basically, beta is about riding the market without trying to beat it. Alpha is about trying to beat the market. Beta has a positive expected return, proportional to the degree of risk taken, without need for skill, and it is inexpensive. Alpha has a zero expected return for average skill (it is a zero sum game), and only is positive for exceptional, above average skill. And skill costs money--the alpha is shared between the alpha generating active manager and the client. After fees and costs, it is difficult to have a positive expected alpha, although it is not a myth that positive expected alphas can and do exist. For less than exceptionally skillful active managers, the active risk taken away from benchmark is for all practical purposes uncompensated risk. Thus the need for concentration on developing and maintaining skill, and on not giving up the benefits of skill through poor portfolio construction techniques. Over the long term, the unskillful active manager doesn't earn its keep against a simple and inexpensive index fund, meaning that it is difficult to stay employed by the client base (these clients are learning that they can get the beta component, the benchmark itself, nearly free; the alpha component should better be positive if it is going to earn its fees).

Grinold and Kahn, in their seminal book, Active Portfolio Management, lay out the path for managers seeking to add alpha--a true expected positive alpha, not merely big talk; reading between the lines, it is also the path for investors to seek added alpha through skillful manager selection. They give the briefest of hints about the composition of the total portfolio, the combination of beta or SAA policy with the search for alpha, in the appendix to Chapter 4 of that book. It is this appendix that forms the starting point for much of my work. The other jumping off points are the work of William F. Sharpe in his famous 1964 paper developing the beta-alpha capital asset pricing model, and the 1973 paper of Robert Merton, showing how to think about asset pricing in a multi-period context. All of these starting points are widely accepted; they are in the "sweet spot" of modern portfolio theory.

One can see the synthesis of this technology for adding active managers to the overall investment structure of the client in my article (with others), Optimizing Manager Structure [alpha] and Budgeting Manager Risk, in the Journal of Portfolio Management, Spring 2000.

In an unpublished article, I have worked out the optimal utility function to guide an investor in forming portfolios of beta and alpha, where the alpha comes from all the usual sources, including both single asset class or partial asset class active funds, as well as multi-asset class tactical asset allocation funds and even zero asset class (zero beta and also partial beta) hedge funds of all types. Read working paper

Coupled with an approach to SAA policy that considers the purpose for which the investments are maintained--the liability for a pension plan, the future spending plan for an individual facing retirement needing income over multiple periods (See Waring and Whitney 2009--we have a complete, total portfolio, beta- and alpha- appropriate investment policy framework. This is an important breakthrough for those that desire to solve the investors real problem, tieing the work of Merton into a directly implementable form.

This vision, incorporating sources of alpha, sources of beta, and the multi-period purposes for which the investments exist, hasn't been remotely achieved in practice even by today's best investment managers. But it is easy to grasp and makes a great deal of common sense by all who have been well-trained in financial economics. It represents one very good picture of where the investment management industry will evolve--a total portfolio approach, sensitive to the objectives of the investor and appropriate in its beta and alpha composition.

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I started off by asserting that few in investment management and finance are happy that where we are today represents the best that we can do in terms of how we separate and handle beta and alpha. First, few strategic asset allocation advisors or portfolio managers think about the total portfolio of the client and the client's objectives for his or her investments stated in terms of funding future cash needs as a multi-period stream that can have no greater present value than the value of the portfolio funding it.

Instead of the total portfolio, today's industry structure forces most portfolio managers to think about their own silo -- small cap growth, or corporate bonds, or hedge funds, or whatever--instead of the bigger total portfolio picture.

Instead of thinking about the client's future cash flow needs, any total portfolio thinking is bound to be in an asset-only framework, or if in a liability-centric framework it will be in a highly-handicapped single period framework instead in a cash-flow oriented multi-period framework. Moreover, most active managers and for that matter most finance people think not of true strategic asset allocation, but mentally re-define SAA to include big market timing shifts--which are active to the very core, clearly alpha and not beta (tactical asset allocation, not strategic). And few if any investors think of their manager selection policies with notions of beta and alpha clear in their minds.

Clearly there is room for improvement. Alpha and beta are critically different, beta being inherently rewarded proportionally to risk, and alpha only being rewarded proportionally to above-average skill. And given that beta is inexpensive and alpha is inherently expensive, it is critical, for expected return, expected risk, and cost reasons to manage them both appropriately, meaning differently.

This has to be the goal for every investor, and for every manager.

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