The true cost of beta

This is part 1 in an alpha and beta series.

There are two components of an active portfolio’s return. Beta is passive and stems from simply being invested in the market. The other, alpha, stems from a manager’s skill in selecting investments that will add return above what the market gives on its own.

Beta drivers

The beta described in the example below is referred to as the classical beta. This is the standard beta that measures the exposure of a security or portfolio relative to a major index and serves as a measure of the security’s or portfolio’s exposure to systematic risk in the equity market. But beta is actually a continuum that starts with the pure classical beta and continues on to include other types of beta.

Classical beta has zero active return and a corresponding zero active risk exposure. As we move up along the continuum, active risk exposure increases, as does the possibility of active return. Here are some of the betas we find along that continuum.

Bespoke beta is a measure of exposure to local risks such as sector, country and style. (Style is beta, not alpha.) Sector-specific ETFs, such as iShares XEG, that cover the Canadian energy industry are good examples of local beta products, as are country or region ETFs such as Vanguard’s Emerging Markets ETF, as well as ETFs that cover a specific capitalization or style subset of the market.

Alternative beta is a measure of exposure to unusual systematic risks. Examples of alternative beta would be exposure to foreign currencies, commodities and real estate. Alternative betas expand systematic risk exposure beyond typical stock and bond portfolios.

Fundamental beta is meant as an alternative to the usual capitalization-weighted index. These indexes weight stocks within the index based on factors such as the price/book or dividend ratio.

Claymore’s suite of RAFI Fundamental Indexes is a good example of fundamental beta, as are ETFs invested exclusively in high dividend-paying stocks.

Active beta, also called enhanced indexing, tries to earn excess return in the markets using quantitative strategies resulting in portfolios whose return is mainly beta-driven, but use long/short strategies to a varying extent. 130/30 products belong to this type of beta. The beta of 130/30 (or any combination ranging from 0/100 to 200/100) is always 1, as with the market, but may allow for more alpha generation through their reduced short-selling restrictions. These are sometimes called beta 1 products.

Bulk beta includes the typical actively managed mutual fund. Although we would expect an “active” mutual fund to have a healthy dose of alpha in its performance, the majority of the typical mutual fund’s return is generated by factor exposure (beta) rather than active return factors (alpha). Bulk beta investments are highly correlated to their benchmarks. Also, since these products are basically packaged systematic risk exposure, they have access to the whole of the underlying market’s liquidity and therefore have a large capacity for AUM.

Beta first, then alpha

Alpha is the excess return that one is left with once all the beta-driven return has been accounted for. Let’s look at our example of a fund manager who beat the S&P/TSX beta-driven return by 2.39%. What if the manager was mostly invested in small cap stocks? Is the S&P/TSX index still an appropriate benchmark?

A better benchmark would be a small cap index. But given that alpha derives its value from what has been determined as beta factors, changing the reference beta means that we will wind up with a different result for alpha. The return of the S&P/TSX Canadian Small Cap Index for the year was 38.53% in 2010, which is the more relevant beta-driven return we should be looking at in evaluating the manager. A small cap manager with a 20% return would have greatly underperformed the appropriate benchmark.

The average return of small cap managers covered by Globefund in 2010 was 26.22%, or 12.41% under benchmark. Comparing firm size is a very important return factor that should be considered in defining a portfolio’s beta and therefore the manager’s skill in generating alpha. In this particular case, the manager could be seen as skilfully generating 2.39% of added return, or as a not-so-skilful manager trailing his benchmark by 18.53%.

Perhaps our portfolio manager does stick with large cap stocks, but has a value-oriented management style. He looks for securities he believes have temporarily fallen out of favour, or whose true value has not yet been discovered by the markets and whose price is consequently below what he considers to be fair value. For the year 2010, the S&P/TSX Canada Select value and growth indexes respectively had a return of 16.67% and 19.30%. The appropriate benchmark return for our manager in this case would be 16.67%, rather than the S&P/TSX’s 17.61%.

In this instance, choosing the wrong benchmark actually underestimated the manager’s skill at generating alpha-driven return.

Alpha is a tricky thing to measure properly. Its correct measurement depends on being able to identify all the beta-driven performance factors beforehand. Unidentified beta drivers can be mistakenly interpreted as manager skill. In addition, alpha is not static. Some investment strategies that had once been considered as alpha have been found to be previously unidentified beta, such as firm size and style. For example, a value manager may have beaten the S&P/TSX Composite over a number of years, but how did he fair against the Dow Jones Canadian Select Value Index?

Alpha drivers

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.

Alpha and beta separation

The distinction between alpha and beta (in its various forms) should interest investors beyond its theoretical considerations.

Beta is more predictable than alpha. If the markets fall and a portfolio’s return is solely determined by market exposure, or pure beta, the portfolio’s value will fall by the exact amount the market does. If the portfolio is managed actively, who is to say whether the manager will outperform or underperform the market? Alpha can only be determined after the fact and requires the investor take a leap of faith.

Unfortunately, persistence of skill among active managers is hard to find. From one period to the next, an active manager can easily outperform or underperform the market. This unpredictability can add risk to the investor’s portfolio.

The second important distinction is cost. Alpha is much more expensive than beta in terms of management fees and trading cost. If the investor is paying alpha-like fees, we would hope he is getting equivalent management effort. Here, the notion of bulk beta is important. Mutual funds promise superior returns through active management and as a result charge high management fees. The average Canadian large cap equity fund’s MER is about 2.50%.

Of course, one has to consider the embedded commission trailer that the advisor receives from that, which is usually around 1% and should probably not be considered when discussing fees for managing the portfolio. This leaves management fees of 1.50%, not including the Trading Cost Ratio, which varies between 0.01% and 0.40%, depending on portfolio turnover. But since most mutual funds are really bulk beta products, shouldn’t they be priced as such?

The cost of beta is now known through the proliferation of index-tracking ETF products in the retail marketplace. Access to market risk can cost as little as 0.07%, as with BetaPro’s HXT ETF, which tracks the S&P/TSX 60 index, or 0.06% for Vanguard’s S&P 500-tracking ETF, or 0.24% to buy the American bond market through iShares’ Barclays Aggregate Bond fund.

For the first time, investors have at their disposal different alternatives for accessing the markets, and they can weigh the pros and cons of each. Indeed, if expensive active mutual funds were once the primary way for investors to have access to market beta, they now have a low cost through index-based ETFs. Would you really want to pay 21 times that amount for an index-hugging bulk beta mutual fund that has no potential for generating excess return?

Accurate pricing of beta and the resulting alpha/beta separation will most probably have a major impact on the asset management industry and on the way it offers its asset management solutions to the investor. A possible indication that such changes are already under way is that mutual fund AUM numbers worldwide, in the United States and here in Canada have not yet reached pre-crisis levels, while ETF AUMs keep on growing.

One would certainly expect expensive, low-value-added bulk beta products to be the first to feel the squeeze, but the changes may go beyond simply correctly pricing expensive beta products. We may see specialization of firms: some will come up with new ways of creating beta, while others will strive to generate attractive and sustainable alpha. More and more, the investor will demand genuine alpha efforts in return for alpha-type fees. Investors will get beta at its true price.

Guy lalonde is an investment advisor and portfolio manager at National Bank Financial and is based in Pointe Claire, Quebec.

Guy Lalonde