Putting it All Together (3 of 3)
| Jul 4th, 2006 | Filed under: CAPM / Alpha Theory, Portable Alpha & Alpha/Beta Separation | By: Alpha Male |
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By: Bob Litterman, Goldman Sachs
Published: 2003
Excerpts:
“While Active Alpha Investing can improve the risk-adjusted returns of a portfolio, three practical issues need to be addressed: the role of risk management, a firm’s organizational structure and governance.
“All positions in the portfolio should deliver an expected excess return equally proportional to their marginal contribution to portfolio risk. If this ratio is not the same for all positions, it is possible to allocate funds from a position with a lower ratio to one with a higher ratio. We believe that such a process will improve the portfolio’s expected return while leaving the portfolio’s risk unchanged. A risk budget is simply a conceptual device for trying to measure total risk to a plan and the marginal contributions to portfolio risk of each component.
“Investors would typically consider the traditional long-only manager as part of the strategic equity exposure and view the two hedge fund strategies and the private equity strategy as part of the allocation to alternative investments. Investors typically focus on the capital allocated to the broad categories of equities and alternatives. Such a categorization is misleading, however, because all four strategies have active risk sourced in the equity markets, and three of the four contain an exposure to the equity market itself.
“Traditionally, most plan staff effort has been focused on choosing and monitoring underlying active managers. The result has been unsatisfactory, not so much in terms of poor performance, as in terms of too little active risk being taken. Active risks need to be budgeted and monitored in a way that encourages their ability to create value. Taking too little active risk should be just as concerning as taking too much. This applies not only to underlying managers, but to the plan staff as well. Board oversight should focus on the big risks to the plan, interest rate exposures and market risk, rather than on the management of the active risk.”
