Alpha “Unleashed”

Just in case you thought portable alpha was a slam dunk and you have moved on to other issued like hedge fund replication or 1X0/X0, check out this new white paper from Stefan Hubrich at T. Rowe Price.

Hubrich says that portable alpha is “alpha unleashed” – which is great, assuming you haven’t unleashed a negative alpha crazed dog, of course.  But instead of stopping at the marketing hyperbole, he proceeds to go into 45 pages of detail on how exactly to unleash your alpha.  He says that a number of critical questions must be answered before opening the cage door:

“Such an approach raises a host of very practical questions related to the derivatives employed in stripping the underlying beta off of the alpha-generating strategies.

  • For a given investor, what is alpha, and what is beta?
  • For a given strategy, what is the actual exposure to the betas the investor cares about?
  • For a given exposure, what derivative portfolio offers the most efficient beta-stripping solution?
  • And, once the approach has been implemented, how can we verify ex-post whether the approach chosen has added or destroyed value?”

Hubrich points out that portable alpha is all about flexibility and efficiency, and not about generating excess returns simply by messing around with the alpha and beta components of a fund (a straw-man argument commonly put forth by cynics).

“…by treating alpha and beta as two separate allocations, one introduces additional degrees of freedom. Under the old paradigm, investors faced a constrained efficient frontier, in that allocating x% of funds to a given strategy meant to allocate x% to both its alpha and its beta. In the world of portable alpha, by contrast, that constraint is released, and alpha and beta can be treated as separate assets.”

The three most immediate benefits of a portable alpha strategy, according to Hubrich, are:

  • “..rebalancing the asset allocation is greatly facilitated, in that it only requires an adjustment of the synthetic derivatives overlay.”
  • “…investors can swap managers across asset classes without upsetting their asset allocation.”
  • “…a higher degree of cost transparency follows automatically.”

He divides the process into two steps.  The first is the removal of “incumbent betas” and the second is the addition of the desired betas.

The removal of incumbent betas is often skipped if hedge fund are used as an alpha source since hedge funds are often assumed to be all (or mostly) alpha.  But in reality, hedge funds do contain a lot of beta – particularly of the “alternative” kind.  Long-only alpha sources, on the other hand, generally provide greater liquidity, transparency and return history than hedge fund alpha sources.  On this topic, he concludes:

“…there is nothing in portable alpha per se that would require hedge fund investment styles, financial leverage, and the like.”

The two big questions, says Hubrich are a) what is the cheapest way to remove the incumbent beta? and b) how much hedging should be applied to remove that beta.

Naturally, the cost (swap, future etc.) of stripping out the incumbent beta needs to exceed the alpha produced by that fund.  In fact, he acknowledges that cost might even be prohibitive if the alpha source is totally lame.

He spends most of the second half of the 56 page paper discussing the correct amount of beta to hedge out.  Firstly, he defines “a naive hedge” as one that is calibrated from the long-only manager’s stated benchmark.  In its simplest form this would be a short position in the benchmark index of exactly the same size as the assets allocated to the manager in the first place.

But the naive hedge can over or under estimate the true amount of incumbent beta in the fund.  The fund’s active positions might conspire to make the effective beta higher or lower.  The trick, according to Hubrich, is to calculate your hedge based on a factor analysis, not on the physical contents of the fund.

“…a portable alpha investor who does not believe in his (or anyone else’s) ability to forecast beta exposures and covariances, is well-advised to choose a naïve hedge.”

He also touches on a key point about beta – that its existence depends on your point of view.

“…beta lies in the eye of the beholder. If, to the investor, it feels like beta, then we call it beta. For example, the asset manager may claim that the beta exposure showing up in the beta risk is an unintended consequence of his security selection approach. Or he may suggest that the regression is mis-specified due to multicollinearity issues, and may even provide us with a correct alternative specification where the beta exposure vanishes. Our answer would be: no matter. If to the investor it looks like a duck, quacks like a duck, and tastes like a duck, we’ll let her call it a duck.”

“There is nothing wrong with supposedly market-neutral strategies delivering beta, as long as it is a type of beta that the investor cannot get retail somewhere else. In our framework, if a hedge fund’s beta is not contained in the investor’s beta set, we simply go to the logical conclusion and call it alpha.”

“Successful market timing – often labeled active beta – would be rewarded as alpha in our framework.”

And so it appears that when you introduce new alternative betas (new factors and dynamic trading), portable alpha becomes more complex.

Hubrich has unleashed potentially mind-numbing new challenge for portable alpha practitioners.

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