# A quarter vs. three nickels and a dime…

Does anyone remember the series of fake commercials on Saturday Night Live in the late 1980’s for the “First Citiwide Change Bank”?   (click here for a video excerpt from one of these commercials). Fictitious First Citiwide wanted to introduce bank customers to the world of options they had to change a large denomination bill.  Said the commercials:

“You can come to us with 16 quarters, 8 dimes and 4 nickels, we can give you a 5 dollar bill.  We can give you 5 singles…Or 2 singles, 8 quarters and 10 dimes.  You’d be amazed at the variety of options you have.”

“We will work with the customer to give that customer the change that he or she needs…We will work with you.”

“We have been in this business a long time. With our experience, we’re gonna have ideas for change combinations that probably haven’t occurred to you. If you have a fifty-dollar bill, we can give you fifty singles.  We can give you forty-nine singles and ten dimes. We can give you twenty-five twos. Come talk to us.  We are not going to give you change that you don’t want. If you come to us with a hundred-dollar bill, we’re not going to give you two-thousand nickels – unless that meets your particular change needs. We will give you the change equal to the amount of money that you want change for!”

Okay.  So what?  Well, this Vanguard article entitled “Alpha-Beta Separation: Appealing Theory, Problematic Reality“, begins with the familiar line “Would you rather have a quarter or three nickels and a dime?”, and goes on to describe alpha as the dime and beta(s) as the nickels.

Regardless of one’s views on the practicality of alpha-beta separation, this is actually a great analogy since an investor should indeed be indifferent between a quarter and three nickels and a dime.  Ergo, alpha-beta separation is a joke worthy of an SNL sketch, right?  Or is it?

Says Vanguard:

“Despite its theoretical appeal, alpha-beta separation is problematic in practice. First, its success depends on a debatable assumption, namely that persistent alpha is easy to identify. Second, this approach limits a plan sponsor’s search for alpha to a relatively narrow set of investment strategies, increasing the risk of ending up with a handful of change worth less than a quarter.”

Pure alpha impossible to isolate

The articles cites a Vanguard principal who says, “Your alpha may be beta in disguise…Alpha depends on how you define the risk factors.”

For example, says Vanguard, the ability to generate alpha may change depending on the time period analyzed:

“Because alpha and beta appear to be correlated, it may take more than one time period to determine whether a strategy generates true alpha. What appears to be alpha in one period may disappear when market dynamics change in the next. For example, Figure 4 shows that while 71% of large-growth funds produced alpha from 1996 to 2000, only 11% did so from 2001 to 2005.”

Constraining search for alpha to market-neutral funds sub-optimal

Vanguard seems to suggest that since alpha cannot be adequately isolated, the search for alpha must necessarily move to the world of market neutral funds.  But such a “narrow set of market-neutral strategies” is actually too much of a constraint, they say.

Cost management benefits of alpha-beta separation realized by long-only funds too

Vanguard points out that long-only investors are quite cognizant of the fact that beta is cheap and most of their fees should be attached to the alpha portion of returns, not the beta portion.  So physically separating alpha from beta isn’t actually required…

“You can assume that all portfolio cost is paying for alpha, even in a long-only portfolio…Once you make that assumption, you can compare cost relative to annualized expected alpha across all strategiesâ€”long-only or market neutral. This is generally what plan sponsors do today.”

In conclusion, Vanguard acknowledges that identifying alpha-producing managers of any ilk is difficult for investors.  In other words, at best, alpha-beta separation is no better or worse than log-only investing – and at worst, it introduces serious constraints.

First Citiwide Change Bank Revisited

But could the mere flexibility inherent in alpha-beta separation (whether using portable alpha or separate alpha and beta sources) add value – regardless of its impact on portfolio return?

One of the Citiwide customers interviewed in the spoof SNL commercials gives us an important clue:

“I was driving through Pennsylvania on the toll-way and to save time I was using the exact change lanes.  I had just run out of quarters and I was getting a bit nervous when I spotted a sign for a Citiwide branch at the next exit…Let me tell you, it was a pretty good feeling.”

Investors who aim for specific market exposures and would like to independently adjust the active and passive components of their portfolios are essentially seeking exact change.  Yet the traditional long-only industry often provides no change at all.  You want three nickels and dime?  Too bad for you – you get a quarter!

So when the customer service representative from First Citiwide Change Bank said proudly “You’d be amazed at the amount of options you have,” he might as well have been talking about alpha-centric investing.

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