Alpha and beta

CAIA level 1

Super asset classes

Capital assets
claim to future cash flows. Fundamental value is NPV of expected future CF

Assets that are used as inputs to creating economic value (commidties) Assets that are a store of value (Art, Gold, Precious metals) + real estate

Strategic vs tactical asset allocation

Strategic
Applies to fundamental asset classes Long term asset mix Secular views vs current market conditions Setting of policy targets

Strategic vs tactical asset allocation

Tactical
Short term Takes advantage of current market conditions Goal is to maximize return (adjusted for risk) Based on the capacity to acquire a diversified exposition to an asset class Purpose to expand fundamental asset classes Alternative assets should be considered as part of a broader asset class

Efficient vs. inefficient asset classes

Efficient
Liquid Availability of current information Historical data Typically liquid segment of traditional asset classes

Efficient vs. inefficient asset classes

Inefficient
Illiquid or new segments of traditional asset classes: small caps, high yield, emerging, structured, Non traditional

Constrained vs unconstrained
Alternative asset managers are typically un (less) constrained Traditional asset managers are highly regulated and more conservative
Inhibits flow of information Less idea generation / more herding

Asset allocation vs. trading strategy

Traditional managers (mutual funds) are defined mostly by their investment exposure to which they have a low tracking error Alternative asset managers have no benchmark and need to produce idiosyncratic return through their trading strategy, inducing much higher turnover

Asset class vs. trading strategy risk premiums

Traditional risk premium: reluctance to take risk Liquidity premium: highly variable with horizon / accounting Complexity premium: necessity to have sophisticated analytics Asymmetric risk premium: insurance & diversification Unknown risk: psychology and mood (or rationality)

Alternative asset classes and the new investment paradigm

Risk premium: premium linked to uncertainty of prices / forecasts for valuation Beta drivers: exotic market risk premiums captured in an efficient manner Alpha drivers: anomaly pockets without regard to benchmarks

Alpha drivers
Long/short investing strategy (typically not completely market neutral) Absolute return strategies: opportunistic investments Market segmentation: focused investment on neglected market segments, typically where traditional investors are hampered Concentrated portfolios: active risk management strategy where action is taken (ex: activist hedge fund, private equity) Nonlinear return processes: option like payoffs, insurance returns Alternative/cheap beta: Opportunities to cheaply diversify portfolios (ex: commodity, real estate, ETFs)

Application if beta and alpha drivers in portfolio construction

Asset allocation should seek optimal allocation of both beta and sources of alpha. Efficient markets are sources of beta, inefficient markets sources of alpha Boundaries are not strict Alpha can be created across asset classes Alpha and beta allocation can be dissociated through overlay

Beta continuum
Classic beta Bespoke beta Alternative beta Fundamental beta Endogeneous alpha Cheap beta

Classic beta
CAPM beta Market beta Broad index beta

Bespoke beta
Local risk premium Tailored risk exposure Sector, style, theme index Typically represented by an ETF

Alternative beta
Systematic risk premium outside of stock and bonds Currency, commodities Real estate, Private equity VIX, momentum, ?

Fundamental beta
Non cap weighted indices Research Affiliate Fundamental Indices (Robert Arnott) Value, high dividend, equal weighted,relation? Source of Endogeneous alpha

Cheap beta
Complex basket of risks in one security e.g. convertible bonds

Active beta
Products which use quant tools to capture systematic irregularities Most popular is 130 /30 Tactical asset allocation With relatively tight tracking error constraints Relatively expensive

Bulk beta
Large investment capacity / liquid investment universe Marginal return improvement objective Tight tracking error constraint / linear relationship

Alpha estimation
Returns which remains unexplained by systematic risks Some element of unknown Residual of a linear regression of excess return Some element of validity of risk model

Asset managers positioning

Product innovators
Focused offer Thought leadership

Process drivers
Asset gatherer / demand focused Industrial economies of scale

Balanced funds
Traditional one stop shopping Stuck in the middle herd mentality

Alpha estimation
Linear multiple regression may be flawed Illiquidity, credit, arbitrage, is asymmetric Over fitting leads to instability and noise What is the proper governance model to distinguish between alpha and beta?

Information asymmetry and governance

Manager is best positioned to distinguish skill and risk premium (luck) Risk can remain hidden and managers want it so Beta is a cheap commodity and alpha a valuable treasure Unbundling beta and alpha is based on the risk model used Incentives vs. skin in the game

Fundamental law of active management

How to best use research resources? Concentrate to gain leading edge Diversify to optimize risk/return (assuming no correlation between bets) IR = IC x SQR (Breadth) IR = alpha / SE (alpha) Transfer coefficient : applicability of forecasts should be optimal ( re 130/30)

Sharpe ratio is not appropriate to decide upon inclusion in portfolio

Sharpe ratio = excess return / SD (excess return) Auto correlation (time period) Asymmetry and kurtosis Correlation to rest of portfolio

Which of the following best describes tactical asset allocation? It refers to a portfolios: A. Short-term allocation that seeks to provide a beta exposure that will meet a portfolios funding requirements. B. Short-term allocation that seeks to provide active returns to supplement a portfolios funding requirements. C. Long-term policy allocation that seeks to provide a beta exposure that will meet a portfolios funding requirements. D. Long-term policy allocation that seeks to provide active returns to supplement a portfolios funding requirements.

One category of investment vehicles that is an example of an alpha driver: A. Index funds B. 130/30 funds C. Long only mutual funds D. Equity market neutral hedge funds

When using beta and alpha drivers in the construction of an investment portfolio, an institutional investor should: A. Focus on extracting active returns from beta drivers and allocate staffing and resources to the alternative assets with the largest alpha. B. Focus on extracting active returns from beta drivers and allocate staffing and resources to the mutual funds with the highest beta exposure C. Primarily use beta drivers to gain systematic market risk exposures and allocate staffing and resources to the alternative assets with the largest alpha. D. Primarily use beta drivers to gain systematic market risk exposures and allocate staffing and resources to the mutual funds with the highest beta exposures.

Which of the following should not be considered a super asset class? A. Capital assets B. Intangible assets C. Assets that are used as inputs to creating economic value D. Assets that are a store for value

Which of the following actions is MOST accurately associated with tactical asset allocation? A. Investment decisions with a long term perspective. B. Investment decisions that do not emphasize current market conditions. C. Investment decisionswith a primary goal of maximizing return. D. Investment decisions that do not depend on ability to diversify.

Which of the following sets of investment categories or products is MOST accurately described as being driven by beta rather that alpha? A. Enhanced index and 130/30 funds. B. Enhanced index and long/short investing. C. Passive index and nonlinear returns. D. Passive index and absolute returns.

Which of the following types of beta is most associated with active returns rather than with systematic risk premiums? A. Classic beta B. Bespoke beta C. Alternative beta D. Bulk beta

Janmar Fund selects investments to match an index that it has created. The index concentrates its positions on investments that are viewed as being substantially underpriced relative to others based on Fama-Frenchs three-factor model for describing equity market risk premiums. The Janmar Funds strategy is best described by which pair of beta-related concepts? A. Exogenous beta and fundamental beta B. Exogenous beta and cheap beta C. Endogenous beta and fundamental beta D. Endogenous beta and cheap beta

How are beta driven products generally described? A. As requiring substantial information to implement B. As difficult to create without relatively high costs C. As having returns uncorrelated with the overall market D. As attempting to capture systematic risk premiums

How is the alpha of a particular investment differentiated from the beta? A. The alpha is ex post and is identified using option pricing models B. The alpha is ex post and is identified using factor models C. The alpha is ex ante and is identified using option pricing models D. The alpha is ex ante and is identified using factor models

What is considered to be the most important task in distinguishing alpha from beta in the performance of an investment manager? A. Identifying true systematic risk exposures B. Observing alpha and properly deducing beta C. Measuring the returns of relevant factors

There are several common reasons why alpha is argued to be a zero sum game. Which of the following is NOT one of those reasons? A. Investors have similar levels of wealth B. Investors have similar risk tolerances C. Investors have homogenous return expectations D. Investors have similar tax rates

Which of the following is MOST accurate with regard to the information coefficient (IC) in the Fundamental Law of Active Management? A. The IC is the correlation between portfolio returns and market returns across active bets B. The IC is the correlation between portfolio returns and market returns through time C. The IC is the correlation between forecasted returns and actual returns across active bets D. The IC is the correlation between forecasted returns and actual returns through time