Unraveling Alpha & Beta

The Art of Portfolio Management

Team Finnovate

Jigar Jani
janijigar@gmail.com
9869559899

Nidhi Bang
bangnidhi@gmail.com
9833276282

NMIMS University
MBA Capital Markets
Mumbai
Contents
Executive Summary 3

Introduction to Alpha and Beta 5

Alpha Beta Separation 7

Concept of Portable Alpha & Strategies 8

Portable Alpha – Benefits 11

Portable Alpha – Limitations 11

Conclusion 12

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Executive Summary

Active investment managers provide two types of return: the return generated from market
exposure or “beta” and the return that comes from selection skill or “alpha.” Active “beta”
returns typically come from market timing. That is, increasing market exposure in up-markets
and decreasing it in down-markets. Passive beta returns come from index fund exposure.
“Alpha” comes from security selection within an asset class. As such, the value-added from a
true alpha strategy does not depend upon the direction of the market. A true stock-picker, for
instance, would have a beta of 1.0 relative to their market benchmark, and all value-added
would come from their “active risk” or stock picking. The amount of alpha generated
depends on the skills and the abilities of the active managers.

Traditionally alpha and beta were generated from the same sources; managers invested a
large amount in a particular market and expected returns equivalent to that generated by the
market normally (beta) plus something more, by underweighting or overweighting some
stocks in that market (alpha). However, this imposed many restrictive constraints on active
managers in combination management of alpha and beta.

Modern Alpha Beta Investment Management Strategies are providing a newly emerging
framework for the investment of funds. Alpha Beta Separation and Portable Alpha are the
two key features of Modern Portfolio Management Theory

The approach of making separate alpha and beta allocations is generally referred to as alpha-
beta separation in which there are different portfolios for alpha and beta generation. Beta
portfolios usually consist of assets that generate regular and sustained returns. Alpha portfolio
consists of assets that relatively less efficient but have a potential for a higher degree of
payoff.

Portable alpha refers to the process of separating the alpha from the beta and then applying it
to other portfolios. Porting of alpha can be achieved through overlay or by strategic asset
allocation which involves outright allocation to portable alpha or capital commitment to
portable alpha strategies while using futures or swaps to maintain the existing overall asset
allocation referred to as “equitization”. There are advantages as well as disadvantages of the
portable alpha strategy.

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As institutional investors increasingly come to recognize that asset management based on an
asset-only benchmark is essentially playing the wrong game and that the appropriate manner
in which to manage a fund is in an asset-liability context, a major paradigm shift is taking
place with profound implications for the asset management business. In this newly emerging
context, alpha and beta portfolio separation and portable alpha strategies are accepted among
leading professional asset managers as the more appropriate method of managing investment
funds.

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Introduction to Alpha and Beta

The Greek letters of Alpha and Beta, in terms of finance and investing, bear their roots in the
CAPM (Capital Asset Pricing Model). CAPM is used to determine a theoretically appropriate
required rate of return of an asset, if that asset is to be added to an already well-diversified
portfolio, given the non-diversifiable risk of the asset.

Beta describes how the expected return of a stock or portfolio is correlated to the return of the
financial market as a whole. An asset with a beta of zero means that its price is not at all
correlated with the market; that asset is independent. A positive beta means that the asset
generally follows the market. A negative beta shows that the asset inversely follows the
market; the asset generally decreases in value if the market goes up.

Alpha is a risk-adjusted measure of the active return on an investment. It is a common

measure of assessing an active manager's performance as it is the return in excess of a
benchmark index. The difference between the fair and actually expected rates of return on a
stock is called the stock's alpha.

If the above terms are very technical, we define beta simply as the return of the market (for
example, the S&P 500) and alpha as the return that a manager provides above the market
return through superior security selection. In this sense, we can decompose an active
investment manager’s return into the two components as follows:

Total Return = Return of the “market” + Return added through security selection
OR
Total Return = Beta + Alpha

A manager’s beta consists of the return from the overall market with no active management,
while the manager’s alpha comes from her skill at investing differently than the rest of the
market. To draw a simple analogy, when you are bowling with the wind behind your back on
a very windy day, a portion of your bowling speed is due to the wind and part is due to your
own effort. If you are bowling at 100 mph but have a 20 mph tail wind, you should probably
think twice about announcing yourself as the next fast bowling sensation. Similarly, any

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investment manager owes the beta part of her return to the market and the alpha part to her
skill.

In this usage, everyone must keep in mind that alpha and beta are two very different sources
of return. In beta investing, everyone can win, and the asset class can reward all investors as
it earns the return on capital that CAPM demands. In alpha investing, every gain is someone
else’s loss, as there is no alpha in the returns for the total asset class. Consequently, success in
alpha investing requires a different kind of skill and a different tolerance for risk than beta
investing.

According to the Modern Portfolio Theory, there are not enough returns from beta and that
investors need alpha to get to their target returns. Investors should decide how much of their
expected return they want to come from beta (just by having exposure to asset classes whose
returns are predictable) and how much they want to come from alpha, which results from
picking managers who will earn better returns than the broad asset classes.

Alpha Beta Investment Management Strategies are providing a newly emerging framework
for the investment of funds. Alpha Beta Separation and Portable Alpha are the two key
features of this new paradigm for asset liability management.

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Alpha Beta Separation

Traditionally, most investors acquire alpha from the same market segment or asset class from
where they get their beta. As an example, imagine an investor has determined to allocate 40%
of the portfolio to the NIFTY Index stocks. The investor usually expects a return equal to the
return of the NIFTY Index (the beta), plus some excess return above the market (the alpha).
To accomplish both objectives simultaneously, the manager maintains a portfolio of stocks
diversified enough to perform in line with the NIFTY index while underweighting and
overweighting stocks that are expected to underperform or outperform respectively. In other
words, the alpha and beta comes from the same “place” – in this case, NIFTY stocks. In this
case, the manager is trying to derive alpha from one of the most efficient index in India where
it is least likely to generate alpha.

There are a variety of reasons why traditional managers struggle to consistently outperform
the benchmark when alpha and beta are generated from the same sources. They operate under
various constraints as follows:
1) Minimum allocations to certain sectors
2) Not exceeding certain percentages invested in any one security or sector
3) Minimal or no ability to short securities or sectors
4) Requirement to deliver performance within a certain minimum tracking error
5) Limitations regarding the types of securities in which they can invest (e.g., derivatives)

Recognizing the inefficiency in generating alpha from the same market from which beta is
generated, the investment industry has started to separate the alpha and beta allocations. The
beta portfolio usually consists of investments in assets, markets or securities that are well
established and which provide consistent and regular returns. The alpha portfolio consists of
investments in less efficient markets segments or assets classes where the potential magnitude
of payoff would be higher. Alpha can also be generated by employing non traditional
strategies such as short-selling and leverage or, alternatively, employing fewer constraints in
investment management process.This approach of making separate alpha and beta allocations
is generally referred to as alpha-beta separation.

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Concept of Portable Alpha & Strategies

For the purpose of asset liability management, the beta portfolio is designed in such a way
that it matches to the liability structure. However, in practice, the amount of assets available
for investment is likely to be less than that required to achieve a perfect match with the
liability payments. Also investment institutions may invest more in a particular favored asset
class where high returns are expected. This would result into an asset liability mismatch
wherein alpha is expected to outperform in relation to the behavior of the liabilities. In such
cases it is appropriate to adopt a portable alpha strategy whereby the gains are secured by
porting the amount of excess gain by alpha into the beta portfolio.

Portable alpha strategy is beta neutral portfolio and refers to the process of separating alpha
from beta and then applying or “porting” it to other portfolios. Porting of alpha can be
achieved through overlay or by strategic asset allocation which involves outright allocation to
portable alpha or capital commitment to portable alpha strategies while using futures or
swaps to maintain the existing overall asset allocation referred to as “equitization”.

Porting of alpha by using a portfolio consisting of entirely futures requires very little cash due
to the margin requirement and can be applied over all or part of the portfolio, such strategies
of porting alpha are called as “overlay” or “leverage” strategies.

Let us consider a small example of portable alpha by overlay strategy. A manager of mid cap
equities who generates 4% alpha each year can hedge the small cap market exposure, or beta,
by selling NIFTY MIDCAP Index futures against the portfolio. This results in a pure alpha
return that can be applied to the overall fund

Equitization refers to investing in long futures position providing a return close to that of the
underlying index plus portable alpha which then be obtained by investing in asset classes or
sectors that provide higher alpha or by shifting allocation to less efficient markets were the
sources of alpha are higher.

Let us consider a small example to explain the process of equitization. Consider a portfolio of
a fund consisting 36 % allocation to NIFTY, 23 % to US Equity, 28 % to bonds and 8 % to

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real estate. Suppose that the fund wants to increase its alpha returns by investing in NIFTY
MIDCAP index but while maintaining its strategic asset allocation.

The NIFTY MIDCAP portable alpha can be funded by reducing the NIFTY allocation from
36% to 26%. Assume the 10% reduction in the NIFTY allocation is equal to Rs. 1,000,000.
The basic investment process is as follows:

Step 1: Investment manager deposits Rs. 50,000 to satisfy the margin account with a
broker. This allows for the purchase of Rs. 1,000,000 in NIFTY index futures, leaving Rs.
950,000 to be used for investment.

Step 2: Investment manager buys NIFTY index futures to establish market exposure
equal to Rs. 1,000,000 (10%) to bring the NIFTY asset class allocation back to the
original 36%.

Step 3: Investment manager purchases Rs. 950,000 in NIFTY MIDCAP stocks. This
Long-Only portfolio is designed to beat the NIFTY MIDCAP Index, but it has a beta of
1.0 relative to the index.

Step 4: Investment manager shorts NIFTY MIDCAP futures of Rs. 950,000 to eliminate
market exposures or beta.

The result is that the plan sponsor is able to maintain the original 36% strategic equity market
exposure (original 26% + 10% NIFTY Futures) plus the MIDCAP index portable alpha.

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Portable alpha strategies can be used to raise returns, reduce volatility, and/or achieve other
objectives such as better asset-liability matching. Portable alpha strategies can help improve
portfolio performance for institutional investors of all stripes.

10
Portable Alpha – Benefits

There are considerable benefits of transporting alpha within or across asset classes.
Successful portable alpha programs enable investors to:

Budget risk based on a plan’s investment policy and capital market forecast.

Maintain strategic asset allocation as desired and provide flexibility to rebalance
portfolios with index futures.

Transport alpha via an overlay program that is supported by a small amount of cash in
a margin account.

Not make wholesale changes to the existing manager structure.

Clearly measure portable alpha performance. Through equitization, institutional
investors can combine traditional asset classes with portable alpha and measure
performance against an appropriate broad market index.

Portable Alpha – Limitations

Transporting alpha has its own limitations. The key is to understand have derivatives work
within a portfolio context.

Derivative transactions costs will surely reduce alpha.

From time to time, index futures may not track the benchmark perfectly. Investment
managers and investors need to actively manage the futures position.

Certain asset classes may not have liquid futures contracts available and more
expensive instruments such as ETFs or swap contracts would increase costs.

Investment guidelines - A portable alpha strategy typically involves derivatives and
leverage to hedge market risk. While some institutional investors have a clear
mandate permitting derivative usage, many do not.

Portable alpha funding is an important subject since it has multiple impacts on a plan.
Reducing any asset class to fund portable alpha may not be an easy decision

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Conclusion

By dissecting returns into their underlying components – alpha and beta – and then seeking to
optimize results from each component separately, investors can meaningfully increase
expected returns while maintaining levels of market risk that are most appropriate to their
objectives.

As institutional investors increasingly come to recognize that asset management based on an

asset-only benchmark is essentially playing the wrong game and that the appropriate manner
in which to manage a fund is in an asset-liability context, a major paradigm shift is taking
place with profound implications for the asset management business. In this newly emerging
context, alpha and beta portfolio separation and portable alpha strategies are accepted among
leading professional asset managers as the more appropriate method of managing investment
funds.

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