Although the mainstream financial media now routinely ridicules “exotic” investment strategies such as portable alpha, institutional interest in managing alpha and beta separately has not gone away. As we have reported on these pages, portable alpha strategies performed poorly in 2008 not because there was anything wrong with the concept, but because the supposedly-uncorrelated alpha sources happened to keel over and die along with the market. As a result, portable alpha investors lost money on the beta side and the alpha side.
Sophisticated investors are well aware that the real culprit was the questionable uncorrelation of the funds of funds often used as an alpha source – not portable alpha per se. An interesting paper by Rob Brown of Benchmark Plus Management makes the case that portable alpha will experience a “rebirth” and will eventually become “dominant” and “commonplace”. (available here in P&I’s white paper library)
“Some have suggested that we are better served by older and more traditional organizational structures such as Core & Satellite. Such conclusions are incorrect and are based on insufficient understandings of what was implemented and what transpired in 2008.”
Them’s fightin’ words. But what makes this paper well worth reading is that Brown takes a holistic view of portable alpha – calling it an “organizational structure” (in bold italics) throughout. Regular readers may remember a fascinating first-hand account of the organizational implications of a portable alpha approach by Richard Grottheim, the head of one of Sweden’s public pension funds (see related post). Brown’s paper should be read in concert with Grottheim’s.
Brown not only suggests that investors put aside common asset class definitions, but he goes as far as to say they should “completely ignore each manager’s asset category” and simply find the best alpha-producers. Then, argues Brown, the investor can rebalance to their target asset allocations using derivatives.
Better than Long-Only, Better than Core-Satellite…
Brown contrasts portable alpha’s organizational structure with those of traditional and core-satellite investing:
“Portable Alpha’s comparative advantage over other organizational structures was its inherent flexibility, adaptability, and most importantly how it breaks the stifling linkage between alpha and beta (between outperformance and market exposure). Other organizational structures preserve the highly restrictive alpha/beta linkage…”
“Core & Satellite directly inhibits the flexible, adaptive replacement of one manager with another as alpha opportunities migrate, since the majority of each major asset category is locked up in some index or high-tracking-to-index semi-active core manager.”
Where alpha itself is born
As we have argued here, Brown contends that alpha is always in a dynamic equilibrium. He writes: “new sources of alpha come into existence while old ones disappear altogether” and presents three mechanisms that determine a manager’s ability to produce alpha:
- market efficiency
- manager’s investment process
When you think about it, he is essentially restating Grinold & Kahn’s Fundamental Law of Active Management (or “FLoAM” for those who enjoy goofy-sounding acronyms). The manager’s investment process determines her ability to turn opportunity into return and is therefore analogous to the “Transfer Coefficient”. The amount of competition for alpha opportunities determines the available opportunity-set for each manager, or the “Breadth” in the FLoAM. And Brown is essentially describing the FLoAM’s manager “skill” when he refers to “market efficiency” – albeit in passive terms that more accurately describe the manager as an alpha-taker, not really an alpha-creator.
The rest of the paper lists out six “implementation gaps” that Brown says led to the disappointment with portable alpha last year.
With more investors questioning the ability of beta to carry the day, an alpha-centric structure that allows institutions to “arrange the building blocks of their aggregate portfolios” is now required according to Brown. Thus,
“Unless a new and superior alternative organizational structure comes along, it is inevitable that Portable Alpha will eventually become the traditional mainstream design by which virtually all institutional portfolios are managed.”