French business school spin-off Edhec Risk and Asset Management Research Centre is in the business of education. So it may come as no surprise that a recent white paper by the organization concludes that we all need more education on modern portfolio construction techniques.
While the report ostensibly covers the results of a survey of investment professionals, it does contain a certain element of brow-beating (“practitioners rely mostly on the assumption of a normal distribution…skewness and kurtosis is thus ignored…advanced techniques are not widely used…shortcomings in the area of portfolio construction…“).
However, Edhec makes several valid points about the resistance to measuring higher moments (skew & kurtosis, co-skew & co-kurtosis – see related AAA post) and relative returns vs. absolute returns. Says the report:
“It is often stated that the risk relative to a benchmark, often a market index, is the primary concern in the fund management industry. As it happens, slightly more than one third of those responding to the question do not set relative risk objectives.”
“For portfolio allocation, absolute risk measures are more widely used than relative risk measures, a finding that weakens the claim that the definition of risk as relative risk is now the industry standard…Remarkably, tail risk is not commonly taken into account when relative risk is being assessed, but it is when absolute risk is being assessed. To all appearances, the industry has not yet drawn on academic research results in the areas of asymmetric risk and tail risk and used it in the context of tracking error. The failure to do so is surprising, as it is straightforward to apply these concepts not just to simple returns but also to the returns in excess of a benchmark.”
Despite obfuscated hedge fund marketing that links alpha with “absolute returns”, alpha is a relative measure. In other words, you can’t calculate alpha without first knowing beta. To be sure, practitioners surveyed by Edhec measured relative performance (i.e. tracking error). But they apparently did not measure risk vs. a beta benchmark…
The report continues:
“Slightly fewer than 3% of those responding to the question use other relative risk objectives, including measures such as the beta with respect to a benchmark.”
Obviously, this doesn’t bode well for the measurement of alpha. But it also doesn’t help those who want to pay a fair value for investment management services. Measuring absolute risk captures the risk characteristics of the underlying benchmark. Bifurcating returns into alpha and beta components, then comparing the risk characteristics of each, provides a better picture of the value-added (or value-subtracted) by active management.
Why the lack of interest in these concepts? Says Edhec:
“All but a minority of practitioners acknowledge the benefits of advanced portfolio construction techniques. However, there appear to be inefficiencies in the transfer of knowledge from research to application. As stated by the respondents…eliminating these inefficiencies will likely require effort on the part of both researchers and practitioners.”