Alpha, Beta & Bicycles

By: Michael Dalis, State Street Global Advisors
Published: August 24, 2006

Saddle up for the “Tour de Alpha”!

Michael Dalis of State Street compares asset management to a bicycle race (work with us here).  He says that no one has ever won the Tour de France without first cooperating with his competitors.  Like an episode of “Survivor: Pyrenees“, cyclists must work together to stay in the game – taking turns slip-streaming behind each other until the last few kilometres.

Dalis says that alpha/beta bifurcation and the further separation of various betas and alpha sources allow managers to focus on their “edge” and allows them to work together without eating each others’ lunches. For example, he suggests active managers throw in the towel on beta management, relinquishing this to a “beta manager” that:

“…play(s) several roles complementary to the alpha manager, including building market exposure, shorting out market exposure related to a long-only alpha strategy…”

He goes on to provide several circumstances where “coopetition” works:

“Hiring a beta sub-advisor may be valuable in several areas, including the following:

Equitization: Exposing uninvested cash to the market through synthetic, or derivative, vehicles such as futures and swaps.

Strengthening Weak Spots: Incorporating passive components in select parts of a balanced fund, perhaps replacing poorly performing active strategies or lack of product in certain asset classes.

Building Dedicated Market Exposures: An example would be the fixed income manager whose alpha strength is in mortgages, and whose weakness is in credit, choosing to focus its resources on mortgages and hiring a sub-advisor to build and maintain passive credit exposure.

Passive Implementation: An international equity team that generates its alpha by selecting countries or sectors, rather than individual stocks, has the opportunity to use the beta manager’s passive country and sector exposures to more efficiently implement the strategy.

Portable Alpha: Engaging a beta manager that potentially can play several roles complementary to the alpha manager, including building market exposure, shorting out market exposure related to a long-only alpha strategy, and managing the cash and collateral associated with futures positions.

A Literal Separation of Alpha and Beta: Separating portfolio construction so that core strategies allocate to both an alpha and beta portfolio – the alpha portfolio being the firm’s absolute return strategy, and the beta portfolio being manufactured by a beta manager at the lowest possible tracking error and cost.

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