Following on our theme last week of drivers and passengers on the road of life, in the world of alternative investment funds, there are alpha generators and there are beta grazers.
At least that’s how a recent academic paper entitled, “Are all Currency Managers Equal?” by Momtchil Pojarliev of New York-based Hathersage Capital Management LLC and Richard M. Levich of New York University Stern School of Business (click here to download), phrases the landscape of alternative investment managers, particularly those who focus on currencies as part of their strategy.
Of particular interest is the authors’ timely and fortuitous focus on currency managers, and the fact that they are often overlooked as a category of alternative investment managers.
Specifically, the study brings together the concept of alpha and beta generation from a currency investing perspective. Using factor models and different types of rankings, the authors conclude that there may be enough persistence in currency investment styles and performance to benefit institutional investors who add a currency component to their global equity positions.
The key questions the authors explore: Can alternative investments provide meaningful diversification to investors with large equity exposure? And are all currency managers equally adept at offering diversification benefits, or can one indentify managers that are better suited to provide diversification for institutional managers with global equity exposure?
By Pojarliev’s and Levich’s account, performance enhancement does appear greater when currency managers are selected on the basis of in-sample alpha rather than on the basis of total return. In other words, there is a distinct difference between alpha generators and beta grazers in the currency manager world, and there are distinct methodologies investors can look at to separate the two.
To illustrate their findings, Pojarliev and Levich examine four hypothetical portfolios:
- The Total-Return portfolio, where the currency allocation is invested in an equal-weighted exposure of the top three managers with the highest total return generated during their in-sample period.
- The Beta-Chasing Portfolio, where the currency allocation is invested in an equal-weighted exposure of the top three beta grazers from their in-sample period, i.e. those with the highest estimated R-square.
- The Alpha-Hunter Portfolio, where the currency allocation is invested in an equal-weighted exposure of the top three alpha hunters, i.e. those with the lowest estimated R-square.
- The Alpha-Generator Portfolio, where the currency allocation is invested in an equal-weighted exposure of the top three alpha generators during their in-sample period, i.e. those with the highest point estimate for alpha.
Their findings? After adjusting for volatility, Portfolio 1 demonstrated a return of 123 bps per annum with an information ratio (IR) of 1.62. Portfolio 2 that relied on the most proven beta-chasers achieved excess returns of only 57 bps per annum with a lower IR=0.77. Portfolio 3, meanwhile, generated returns in excess of 182 bps per annum (and IR=2.78) while the alpha generators in Portfolio 4 produced excess returns of 257 bps per annum (and IR=2.80). The table below illustrates the results in more detail.
What’s more, the authors found from their results that the standard deviations of returns for Portfolios 1-4 were all lower than the for the benchmark portfolio. “By conventional wisdom, higher returns go hand-in-hand with higher risk. But Portfolios 1-4 generated higher returns with lower total risk than the benchmark,” they say.
In other words, there just may be a free lunch after all!
So how does one build an alpha-portfolio in the currency manager realm? That they don’t really say. What they do note is that currency managers seem to provide diversification to investors with global equity exposure. “The unfunded nature of currency management makes currency alpha easy to transport on top of any underlying portfolio, as it only requires minimal cash for margin (normally 10%).”
Further, from their research, a global equity portfolio that diversifies using “alpha hunters” would have outperformed a portfolio invested in “beta grazers” by 125 bps per annum between their sample period of April 4, 2008 and June 30, 2010. Selecting the best alpha hunters, i.e. the managers with the highest alpha (“alpha generators”) improves the results further by another 75 bps per annum. The chart below illustrates the performance of global equities and the impact of adding currency managers.
In contrast, focusing simply on managers with the highest total return would have increased excess returns versus beta chasers, but fallen short by 59 bps and 134 bps versus portfolios relying on alpha hunters or alpha generators. This result could lead institutional investors to pay closer attention to the return attribution of their currency managers.
Like any strategy, some managers are more likely to have persistently good performance with greater diversification benefits than others. In this sense, all returns may appear equal, but some returns will be more equal, and more beneficial, than others. Choosing the “right” currency managers could increase the diversification benefits considerably for a global equity portfolio.
Interesting, to be sure. At least there’s hope that alpha generators still exist out there – just not where everyone has been looking.