Alpha/Beta “Separation” doesn’t actually require “separating” anything

Part Granny Smith, part Golden Delicious...

Despite being maligned as financial alchemy, alpha/beta separation refuses to die (probably because it’s a good idea, but we’re biased).  For example, Carl Hess, Watson Wyatt’s Global Head of Investment consulting said in a press release last week:

“As we move into a different and difficult market environment, we expect there will be more rapid developments around some emerging trends. One notable theme is transparency, particularly the separate identification of alpha and beta, as well as an increased focus on risk, both from investors and managers alike.”

Hess isn’t talking about exotic investment strategies or screwy derivatives contracts.  He’s simply referring to the fact that investors should be buying alpha and beta separately, not mashed together.  Apparently institutional investors agree.

In this recent Journal of Indexes article on alpha/beta separation, Robert Whitelaw, Salvatore Bruno and Anthony Davidow write:

“In many ways, the history of modern investment management is punctuated by two fundamental revolutions: the creation of the first mutual funds in the 1930s and 1940s, and the creation of the first index funds in the 1970s. In each case there was a tremendous democratization of the investment landscape. Broader and broader segments of the population gained both the access and the expertise to become effective investors, at lower costs than ever before.

“The separation of Alpha and Beta is the next revolution in investment science. Investment strategies that effectively isolate Beta are tremendously powerful in managing risk and containing costs. Those that segregate true Alpha can provide investors unique, uncorrelated sources of return.”

Whitelaw, Bruno and Davidow are as biased as us, to be sure.  They comprise the core of alternative beta manager IndexIQ (click here for Index IQ’s handy PDF version of the article above).  But they have obviously put their money, and their careers where their mouths are.

The appeal to institutional investors is that they can dial up or dial down their allocation to active management without being hamstrung by the alpha/beta split inherent in a traditional active long-only strategy.  The following chart by Watson Wyatt’s Janet Rabovsky (from an article available here) illustrates when you might want to do that.


When the green line (the Russell 1000) ends up being ranked in the top half of all “managers”, passive investing is a good bet.  When it ranks low, active management was better.  Rabovsky suggests that the VIX might predict the value of active management (red line).

But whatever their particular theory, institutional investors are only able to rebalance between active and passive management if they know how much of each they currently hold.  Alpha/beta separation – even if that separation of simply notional instead of physical – is a necessary prerequisite.

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