In portfolio management, sometimes the sum of the parts is greater than the whole

partsEarlier in the week, we told you about a great 100 page “mini-book” on alpha/beta separation.  The authors (Analytic Investors’ Roger Clarke & Harindra de Silva and Brigham Young University’s Steven Thorley) provide a clear and cogent argument for why you’d want to separate and re-proportion the active and passive components embedded in any actively-managed investment mandate.

While the generic case outlined in the document involves a traditional long-only active fund, the authors also explore the potential role of hedge funds in alpha/beta separation.  They point out that despite the popular assumption that hedge fund returns are nearly all alpha, this is “only partially true” in aggregate.

Hedge Funds not all about alpha – Just mostly about alpha

The following table shows the average proportion of risk derived from alpha and beta across  arbitrarily-selected hedge fund strategies:


As you can see from the 5th line in the table, beta (vs. 3 equity and 2 fixed income factors) was responsible for only about 25% of returns, but 60% of risk.

That’s certainly a lot of “beta at alpha prices.”  But it’s not so bad compared to mutual funds:


The proportion of returns across four large and well known mutual funds (names in the paper at the bottom of page 28) averages around 85% (94% of risk).

Purists may take issue with the plain vanilla factors used by the authors to isolate alpha (i.e. nothing non-linear), but the conclusion is clear: the average hedge fund contains a higher proportion of alpha than the average mutual fund.  This reduced the amount of beta-reducing short exposure (ETFs futures, swaps etc.) required to isolate alpha.

Of course, these betas are based on a time series analysis of return streams.  But what if the fund’s exposures vary over time?  One solution is to use the current betas of the funds’ holdings to calculate a weighted average beta for the fund.  But whatever method method is used, the authors point out that unlike a lot of beta-estimating, this kind must be prescriptive (i.e. ex ante), not descriptive (ie. ex poste).

A more “economically justified way to compare fees”

Against this backdrop of the higher alpha-proportion of hedge funds, Clarke, de Silva and Thorley question the tendency for investors to compare hedge fund apples with mutual fund oranges:

“…seemingly small fees associated with traditionally managed funds can be quite high per unit of alpha…A more economically justified way to compare fees is to calculate the ratio of the dollar fee paid to the dollar amount of realized alpha, a framework more or less consistent with the current “performance fee” structure of the hedge fund industry.”

While performance fees would be a step in the right direction, they also point out two flies in the ointment:  hedge fund performance fees are asymmetrical, and they often use a hurdle that does not adequately capture exotic beta exposures.

“Alpha and Beta Reunion”

While it can work for liquid strategies such as hedge funds, calculating a reliable and actionable beta for many alternative investments is next to impossible.  You can’t strip out private equity beta, for example, since there is no reliable and liquid private equity index (you can, however, now short infrastructure beta through this recently announced product).

Sometimes, physically separating alpha and beta in order to recombine them in different proportions is possible, but inefficient since beta and alpha components would contain off-setting positions.  One solution to this, of course, is a short-extension (130/30) strategy.  In essence, a 1×0/x0 strategy aims to achieve the same thing as any alpha/beta separation strategy: re-proportioning the amounts of alpha and beta risk in an active fund.

The table from the report below shows that the proportion of alpha and beta risk changes with the gross and net exposures:


“Alpha/Beta Separation Likely to Accelerate”

In conclusion Clarke, de Silva and Thorley write that alpha/beta separation (in all of its forms) is a secular trend for several reasons:

“The practice of alpha–beta separation is likely to accelerate important institutional trends already in motion. These trends include, but are not limited to, the polarization between low-cost beta and high-fee alpha-only product providers, changes in the balance of active versus passive management in the more liquid capital markets, the inclusion of alternative asset classes in institutional portfolios, and the use of risk budgeting in portfolio construction.”

Traditional funds produce both alpha and beta.  By knowing how much of each is being delivered, investors can affect a more optimal outcome.  As the trio points out “…alpha–beta separation reminds the investor that in the complex world of active fund management, the sum of the parts is often greater than the whole.”

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One Comment

  1. Jay
    November 12, 2009 at 12:12 pm

    This analysis is irrelevant since it excludes 2008. That’s when true HF beta (leverage, illiquidity, etc.) was exposed. Additionally, HFs now have their own form of beta, it’s called momentum and crowdedness.

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