The Five Faces of Alpha (II): “True” alpha reveals itself
| Apr 7th, 2010 | Filed under: CAIA Alternative Viewpoints Columns, CAPM / Alpha Theory, Hedge Fund Industry Trends, Today's Post | By: Guest |
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Today we bring you part 2 of Erik Einertson’s special to AllAboutAlpha.com “The Five face of Alpha” (first installment here)…
Alpha #2: Insurance Beta
The second type of “Alpha” often found in the market can be referred to as insurance beta or Informationless Investing (Weisman 2002). This type of exposure has persistent tilts towards strategies that have an insurance like payout. The payout for this type of strategy will experience long periods of modest positive returns (and high IR) followed by short periods of large negative performance. While the selling of insurance can be part of a diversified portfolio, it is the tactical use of these strategies that creates real alpha, not the systematic tilts toward these exposures. Unfortunately, many investors in these types of strategies are unaware their portfolios have this type of risk exposure. More…
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Thanks for the article, this is a great summary of the problems faced by investors when attempting to identify alpha. One question – in the table of HFRI indices showing a variety of metrics including skew why was equity long/short (equity hedged) not included? Seems odd considering that is where the majority of investor assets in the hedge fund space reside.
Thank you for a truly good 2-part article. Question: insurance beta vexes me because I cannot grasp the beta factor in the same way that i can grasp (eg) the small cap premium in FF. After all, i don’t think it’s a volatility factor per se … is it possible what you are calling “insurance beta” is not so much common factor but rather merely that the typical regression-based alpha/beta methodology is not formally incorporating risk?
I will try and reply to both of your questions is one email.
Sami – I used equity market neutral in the analysis. There is certainly is good reason to do the analysis on equity long/short equity hedged as well. I just used an abbreviated list and went from there. Looking back, it would have been good to add that to the list.
David – To answer your question directly, I am calling beta something that doesn’t require real skill and is static. You and I can create this exposure (I am certainly not implying that you don’t have skill) without really accounting for what is happening in the market. A strategy that wrote deep out of the money puts, but uses market data and, for example, and stopped writing them early in 2008 would exhibit less skew and, as a result, I believe would be more alpha like. I am trying to move away from the definition of beta as just a regression based idea.
The idea of insurance beta isn’t that it has “beta” in terms of exposure to normal market movements. A good example would be the CMO insurance sold in huge quantities by AIG. They were able to book profits from the day they wrote contracts on the CMOs and hadn’t really accounted for the possibility of a big downturn in housing when accounting for possible losses. In the end, the size of the insurance payment overwhelmed the strategy.
I am very interested in doing further research to see if there is a long-term risk premium associated with skew. My instinct is that it varies considerably and at most times is negative because investors underestimate the risk of these extraordinary events and are attracted by the short-term high IRs.