Reader Alert: This is Part Two of ‘The true cost of beta’. To read Part One, click here.
So how does one go about getting alpha? The only way is to get off the benchmark and loosen investment constraints such as limits on short selling, portfolio concentration, and types of markets and securities allowed in the portfolio.
In theory, the fewer the constraints, the more opportunity the manager has to generate extra return. Of course, that also means more things can go wrong (negative alpha).
Alpha drivers fall within six categories. The first two categories of alpha drivers could very well be found in portfolios like that of our Canadian equities manager.
Long/short investments. These investments give the portfolio manager more ability to generate alpha from both long and short positions. By being both long and short, the manager eliminates, or at least diminishes, total market exposure, thus lowering the portfolio’s beta. If the manager is perfectly market neutral (fully hedged), the only return left is alpha. The aforementioned 130/30, in which the manager is long 130% and short 30%, is classified as a beta driver given the resulting beta of 1.
So perhaps our manager is short as well as long in his equity positions, therefore lowering his beta — maybe even all the way down to zero. The lower his beta, the bigger the portion of his 20% return attributable to selection skill. Or perhaps the manager is long individual stocks, but is also short the market as a whole through the sale of futures contracts on the index. Here again, his beta could be brought down to zero, and his 20% return totally attributable to selection skill. In this case, his skill would be present only on the long equity side of the portfolio, given that the short side is pure negative beta.
Portfolio concentration. Concentrated portfolios make large bets on a few securities. Traditional mutual fund managers usually seek diversification in order to minimize tracking error relative to their benchmark, resulting in bulk beta. Concentrated portfolios such as corporate governance and private equity funds assume greater tracking error in an attempt to produce larger active return. How many securities does our portfolio manager hold? 60? 10? Do these securities belong in the S&P/TSX’s investment universe?
The other alpha driver categories require that we move away from a stock-only portfolio, so our manager probably would not apply these in this case.
Absolute return investments. This manager’s objective is to seek alpha in any opportunities. The absolute return manager is unconstrained in investment style or strategy, buying and shorting just about anything under the sun. Her main objective is to always have positive returns over a certain time interval.
Segmented markets. These are markets most investors never get involved with. Commodities, junk bonds, and the pink sheet market are usually off limits to institutional investors due to liquidity or quality constraints. These markets may provide opportunities to find alpha since they are less crowded and less efficient.
Nonlinear return distributions. The stock market’s returns are considered to follow a roughly normal (bell curve) distribution, with outlier or extreme events expected to be few and far between. Strategies such as merger arbitrage, event-driven strategies, or trend-following managed futures aim to reflect a return profile resembling what you would find in the options market, such as buying out of the money calls going for a long shot, or covered-call writing, which is akin to collecting insurance premiums monthly.
Alternative beta exposure. A manager can expand the systematic risk exposure beyond the typical stock and bond portfolio. Exposure to asset classes such as currencies, commodities, real estate and even volatility — taken individually – is considered beta. But alpha is achievable, either through strategic and timely selection among them, or simply by actively seeking out these betas, which are classified as alternative relative to the typical stock/bond factor exposure. Each alternative asset class has its beta, as described in the above section covering the various forms of beta. Yet exposure to these alternative asset classes and their risk factors, relative to the classic 60/40 portfolio, is considered to be alpha generated through a better beta.