Unraveling Alpha & Beta

Unraveling Alpha & Beta The Art of Portfolio Management

Team Finnovate Jigar Jani [email protected] 9869559899 Nidhi Bang [email protected] 9833276282

NMIMS University MBA Capital Markets Mumbai

Contents Executive Summary

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Introduction to Alpha and Beta

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Alpha Beta Separation

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Concept of Portable Alpha & Strategies

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Portable Alpha – Benefits

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Portable Alpha – Limitations

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Conclusion

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Executive Summary Active investment managers provide two types of return: the return generated from market exposure or “beta” and the return that comes from selection skill or “alpha.” Active “beta” returns typically come from market timing. That is, increasing market exposure in up-markets and decreasing it in down-markets. Passive beta returns come from index fund exposure. “Alpha” comes from security selection within an asset class. As such, the value-added from a true alpha strategy does not depend upon the direction of the market. A true stock-picker, for instance, would have a beta of 1.0 relative to their market benchmark, and all value-added would come from their “active risk” or stock picking. The amount of alpha generated depends on the skills and the abilities of the active managers. Traditionally alpha and beta were generated from the same sources; managers invested a large amount in a particular market and expected returns equivalent to that generated by the market normally (beta) plus something more, by underweighting or overweighting some stocks in that market (alpha). However, this imposed many restrictive constraints on active managers in combination management of alpha and beta.

Modern Alpha Beta Investment Management Strategies are providing a newly emerging framework for the investment of funds. Alpha Beta Separation and Portable Alpha are the two key features of Modern Portfolio Management Theory

The approach of making separate alpha and beta allocations is generally referred to as alphabeta separation in which there are different portfolios for alpha and beta generation. Beta portfolios usually consist of assets that generate regular and sustained returns. Alpha portfolio consists of assets that relatively less efficient but have a potential for a higher degree of payoff.

Portable alpha refers to the process of separating the alpha from the beta and then applying it to other portfolios. Porting of alpha can be achieved through overlay or by strategic asset allocation which involves outright allocation to portable alpha or capital commitment to portable alpha strategies while using futures or swaps to maintain the existing overall asset allocation referred to as “equitization”. There are advantages as well as disadvantages of the portable alpha strategy. 3

As institutional investors increasingly come to recognize that asset management based on an asset-only benchmark is essentially playing the wrong game and that the appropriate manner in which to manage a fund is in an asset-liability context, a major paradigm shift is taking place with profound implications for the asset management business. In this newly emerging context, alpha and beta portfolio separation and portable alpha strategies are accepted among leading professional asset managers as the more appropriate method of managing investment funds.

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Introduction to Alpha and Beta The Greek letters of Alpha and Beta, in terms of finance and investing, bear their roots in the CAPM (Capital Asset Pricing Model). CAPM is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given the non-diversifiable risk of the asset.

Beta describes how the expected return of a stock or portfolio is correlated to the return of the financial market as a whole. An asset with a beta of zero means that its price is not at all correlated with the market; that asset is independent. A positive beta means that the asset generally follows the market. A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up.

Alpha is a risk-adjusted measure of the active return on an investment. It is a common measure of assessing an active manager's performance as it is the return in excess of a benchmark index. The difference between the fair and actually expected rates of return on a stock is called the stock's alpha.

If the above terms are very technical, we define beta simply as the return of the market (for example, the S&P 500) and alpha as the return that a manager provides above the market return through superior security selection. In this sense, we can decompose an active investment manager’s return into the two components as follows:

Total Return = Return of the “market” + Return added through security selection OR Total Return = Beta + Alpha A manager’s beta consists of the return from the overall market with no active management, while the manager’s alpha comes from her skill at investing differently than the rest of the market. To draw a simple analogy, when you are bowling with the wind behind your back on a very windy day, a portion of your bowling speed is due to the wind and part is due to your own effort. If you are bowling at 100 mph but have a 20 mph tail wind, you should probably think twice about announcing yourself as the next fast bowling sensation. Similarly, any

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investment manager owes the beta part of her return to the market and the alpha part to her skill.

In this usage, everyone must keep in mind that alpha and beta are two very different sources of return. In beta investing, everyone can win, and the asset class can reward all investors as it earns the return on capital that CAPM demands. In alpha investing, every gain is someone else’s loss, as there is no alpha in the returns for the total asset class. Consequently, success in alpha investing requires a different kind of skill and a different tolerance for risk than beta investing.

According to the Modern Portfolio Theory, there are not enough returns from beta and that investors need alpha to get to their target returns. Investors should decide how much of their expected return they want to come from beta (just by having exposure to asset classes whose returns are predictable) and how much they want to come from alpha, which results from picking managers who will earn better returns than the broad asset classes.

Alpha Beta Investment Management Strategies are providing a newly emerging framework for the investment of funds. Alpha Beta Separation and Portable Alpha are the two key features of this new paradigm for asset liability management.

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Alpha Beta Separation Traditionally, most investors acquire alpha from the same market segment or asset class from where they get their beta. As an example, imagine an investor has determined to allocate 40% of the portfolio to the NIFTY Index stocks. The investor usually expects a return equal to the return of the NIFTY Index (the beta), plus some excess return above the market (the alpha). To accomplish both objectives simultaneously, the manager maintains a portfolio of stocks diversified enough to perform in line with the NIFTY index while underweighting and overweighting stocks that are expected to underperform or outperform respectively. In other words, the alpha and beta comes from the same “place” – in this case, NIFTY stocks. In this case, the manager is trying to derive alpha from one of the most efficient index in India where it is least likely to generate alpha.

There are a variety of reasons why traditional managers struggle to consistently outperform the benchmark when alpha and beta are generated from the same sources. They operate under various constraints as follows: 1) Minimum allocations to certain sectors 2) Not exceeding certain percentages invested in any one security or sector 3) Minimal or no ability to short securities or sectors 4) Requirement to deliver performance within a certain minimum tracking error 5) Limitations regarding the types of securities in which they can invest (e.g., derivatives)

Recognizing the inefficiency in generating alpha from the same market from which beta is generated, the investment industry has started to separate the alpha and beta allocations. The beta portfolio usually consists of investments in assets, markets or securities that are well established and which provide consistent and regular returns. The alpha portfolio consists of investments in less efficient markets segments or assets classes where the potential magnitude of payoff would be higher. Alpha can also be generated by employing non traditional strategies such as short-selling and leverage or, alternatively, employing fewer constraints in investment management process.This approach of making separate alpha and beta allocations is generally referred to as alpha-beta separation.

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Concept of Portable Alpha & Strategies For the purpose of asset liability management, the beta portfolio is designed in such a way that it matches to the liability structure. However, in practice, the amount of assets available for investment is likely to be less than that required to achieve a perfect match with the liability payments. Also investment institutions may invest more in a particular favored asset class where high returns are expected. This would result into an asset liability mismatch wherein alpha is expected to outperform in relation to the behavior of the liabilities. In such cases it is appropriate to adopt a portable alpha strategy whereby the gains are secured by porting the amount of excess gain by alpha into the beta portfolio.

Portable alpha strategy is beta neutral portfolio and refers to the process of separating alpha from beta and then applying or “porting” it to other portfolios. Porting of alpha can be achieved through overlay or by strategic asset allocation which involves outright allocation to portable alpha or capital commitment to portable alpha strategies while using futures or swaps to maintain the existing overall asset allocation referred to as “equitization”.

Porting of alpha by using a portfolio consisting of entirely futures requires very little cash due to the margin requirement and can be applied over all or part of the portfolio, such strategies of porting alpha are called as “overlay” or “leverage” strategies.

Let us consider a small example of portable alpha by overlay strategy. A manager of mid cap equities who generates 4% alpha each year can hedge the small cap market exposure, or beta, by selling NIFTY MIDCAP Index futures against the portfolio. This results in a pure alpha return that can be applied to the overall fund

Equitization refers to investing in long futures position providing a return close to that of the underlying index plus portable alpha which then be obtained by investing in asset classes or sectors that provide higher alpha or by shifting allocation to less efficient markets were the sources of alpha are higher.

Let us consider a small example to explain the process of equitization. Consider a portfolio of a fund consisting 36 % allocation to NIFTY, 23 % to US Equity, 28 % to bonds and 8 % to

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real estate. Suppose that the fund wants to increase its alpha returns by investing in NIFTY MIDCAP index but while maintaining its strategic asset allocation.

The NIFTY MIDCAP portable alpha can be funded by reducing the NIFTY allocation from 36% to 26%. Assume the 10% reduction in the NIFTY allocation is equal to Rs. 1,000,000. The basic investment process is as follows:

Step 1: Investment manager deposits Rs. 50,000 to satisfy the margin account with a broker. This allows for the purchase of Rs. 1,000,000 in NIFTY index futures, leaving Rs. 950,000 to be used for investment.

Step 2: Investment manager buys NIFTY index futures to establish market exposure equal to Rs. 1,000,000 (10%) to bring the NIFTY asset class allocation back to the original 36%.

Step 3: Investment manager purchases Rs. 950,000 in NIFTY MIDCAP stocks. This Long-Only portfolio is designed to beat the NIFTY MIDCAP Index, but it has a beta of 1.0 relative to the index.

Step 4: Investment manager shorts NIFTY MIDCAP futures of Rs. 950,000 to eliminate market exposures or beta.

The result is that the plan sponsor is able to maintain the original 36% strategic equity market exposure (original 26% + 10% NIFTY Futures) plus the MIDCAP index portable alpha.

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Portable alpha strategies can be used to raise returns, reduce volatility, and/or achieve other objectives such as better asset-liability matching. Portable alpha strategies can help improve portfolio performance for institutional investors of all stripes.

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Portable Alpha – Benefits There are considerable benefits of transporting alpha within or across asset classes. Successful portable alpha programs enable investors to:
Budget risk based on a plan’s investment policy and capital market forecast.
Maintain strategic asset allocation as desired and provide flexibility to rebalance portfolios with index futures.
Transport alpha via an overlay program that is supported by a small amount of cash in a margin account.
Not make wholesale changes to the existing manager structure.
Clearly measure portable alpha performance. Through equitization, institutional investors can combine traditional asset classes with portable alpha and measure performance against an appropriate broad market index.

Portable Alpha – Limitations Transporting alpha has its own limitations. The key is to understand have derivatives work within a portfolio context.


Derivative transactions costs will surely reduce alpha.
From time to time, index futures may not track the benchmark perfectly. Investment managers and investors need to actively manage the futures position.
Certain asset classes may not have liquid futures contracts available and more expensive instruments such as ETFs or swap contracts would increase costs.
Investment guidelines - A portable alpha strategy typically involves derivatives and leverage to hedge market risk. While some institutional investors have a clear mandate permitting derivative usage, many do not.
Portable alpha funding is an important subject since it has multiple impacts on a plan. Reducing any asset class to fund portable alpha may not be an easy decision

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Conclusion By dissecting returns into their underlying components – alpha and beta – and then seeking to optimize results from each component separately, investors can meaningfully increase expected returns while maintaining levels of market risk that are most appropriate to their objectives.

As institutional investors increasingly come to recognize that asset management based on an asset-only benchmark is essentially playing the wrong game and that the appropriate manner in which to manage a fund is in an asset-liability context, a major paradigm shift is taking place with profound implications for the asset management business. In this newly emerging context, alpha and beta portfolio separation and portable alpha strategies are accepted among leading professional asset managers as the more appropriate method of managing investment funds.

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